The Four Pillars of Real Estate

 

The reason I love real estate is because it provides four pillars for wealth creation for property investors. The best way to describe these pillars is by using a real-life example, so I will use one of my recently acquired properties to prove my point in describing each pillar:

Property Details:

Property Type: 3 bed, 2 bath single family home

Property Location: Worcester, MA

Purchase Price: $295,000

Down Payment: $59,000 (20%)

Loan interest: 3.5%

Pillar I:  Appreciation

Except for rare periods, such as 2008-2011, real estate tend to appreciate year-over-year. In Worcester, MA, the average rate of appreciation has been 2.75% annually over the past 20 years. Assuming this same level of growth continues, one could calculate that this property would appreciate by $8,113 in year one. Because real estate appreciates on the whole value of the home ($295,000), but I purchased it with only 20% down ($59,000), this appreciation represents a 13.75% return on my equity. Not bad for pillar #1!

Pillar II:  Cash Flow

Investors tend to purchase properties because of the cashflow - It is certainly the reason why I have entered the business. At this property, the monthly payment for principal, interest, tax, and insurance (PITI) is $1,430. The property is rented for $2,200, which leaves me a monthly cash flow of $770, or $9,240 per year. That is another 15.66% return on my original down payment.

Note: These cash flow numbers do not include accruals for vacancies and capital expenditures because those can vary greatly from property to property. When accounting for those two items, the monthly cash flow lowers to $440 ($5,280 annually) and the return on the down payment lowers to 8.95%. Want to learn more about cash flow? Consider this recent book on the topic.

Pillar III:  Principal Pay Down

Principal pay down is the most underrated pillar of all four. Most investors don’t even consider this pillar, but I find it to be critical as a stealthy wealth creator. The PITI number of $1,430 discussed under pillar II includes  $375 that goes towards paying down the original loan. This is essentially money back to you, since the tenants are paying the loan off on your behalf. At this property alone, this represents $4,500 in year one.

The additional good news here is that year one is the lowest year for principal pay down because of the way the amortization schedules are designed. This number will continue to grow every single year, eventually making this a very significant pillar (on a 30-year mortgage, 50% of the mortgage payment becomes “principal pay down” at year 15). 

Pillar IV:  Tax Benefits

This is a very popular real estate pillar, and it is easy to understand why. The tax benefits of owning real estate are tremendous. The reason why is that many expenses are tax deductible, which is great. But the greatest benefit of all is the fact that you can depreciate your building (but not the land). For the property utilized in this example, an accountant would value the building at $236,000 and the land at $59,000. The $236,000 can be depreciated over 27.5 years, or $8,582 per year. This means that, assuming I don’t have any additional expenses during the year, I would only have to pay income taxes on the difference between the $9,240 cash flow and the $8,582 depreciation, which is $658. This means I would be paying income taxes on 7.12% of my total income on this property. 

Can you imagine how powerful this pillar would be if I had 20 similar properties producing $184,800 in annual cash flow? Only $13,158 of that sum would be taxable. Wow!

Note: The discussion here is based solely on my limited experience working with my CPA during my first year of property ownership. Actual tax strategies should be discussed with a qualified professional. Also, here’s a great book to learn more about real estate tax benefits. 

Real Estate Pillars Recap:

Pillar I:  $8,113 in appreciation

Pillar II: $9,240 in cash flow

Pillar III: $4,500 in principal pay down

Pillar IV:  Most of the above benefits would be tax free unless I sold the property, which I have no intention of doing!

Can you see more clearly now how powerful real estate is as a wealth creator? The more properties you own, and the longer you own the properties, the better these numbers will become because of increasing rents, compounding in appreciation, and more favorable amortization tables.  

Note: When selling, consider a 1031 exchange to avoid capital gains tax and depreciation recapture. Again, work with a professional for actual tax advice. Here’s a really affordable book on 1031s.