Collect Rent, Don’t Pay It!

Owning real estate is an essential way for the average American worker to build wealth. I would assert real estate ownership is a financial truth!  One thing is for sure, paying rent an entire adult life will make it difficult to build net worth. Why not get a return on rent money instead of improving a landlord’s net worth?

More accurately stated, be the landlord, not the tenant! The reason I love real estate investing is its positive increase in value over time is pure “physics”. Stock market investments may ebb or flow over time, but real estate is a constant. They are not making any more land. As long as birth rates outpace death rates, inhabitants of our planet will always need a place to stay!

So why do so many people continue to pay rent and avoid taking the plunge into real estate? First and foremost, there are times in our lives when it just makes sense to pay rent.  I’ve had to pay thousands in rent over the years due to work requirements and other circumstances. Others may choose to live in a high cost of living area where it is nearly impossible to buy.

Additionally, there are two major hurdles that must be overcome before diving into real estate.  First, with a very few exceptions such as a VA or FHA loan, investing in real estate requires capital for a down payment. Down payments usually equal 20-25% of the purchase price.  Most people should be able to accumulate enough to get over this hurdle after a few years of saving aggressively in an investment account. Similarly, for a mortgage loan, one usually needs a good credit score. If poor decisions earlier in life wrecked credit, don’t despair! Like most things, credit can be repaired, it just takes time and discipline.

All that being said, my personal assumption is many people avoid real estate investing out of fear. Fear for the personal and financial commitment real estate investing requires. The natural fear of the inherent risks. Fear of interacting with tenants. These fears are certainly understandable. Hopefully I can assuage some of these fears!

The dynamics of real estate ownership changed quite a bit in the last 20 years. From the mid-1960s, to the 1990s, owning real estate required substantial cash on hand, due to mortgage rates often topping 10%. To buy a home, a sizeable down payment was required or the monthly mortgage would be out of reach for many workers.

This century has seen mortgage interest rates remain around 5% or lower. This opened the door (pun intended) for workers to buy their own homes and more importantly invest in real estate. With a few exceptions during recent recession periods, home ownership is steadily increasing.

Some younger buyers may define success as securing a 2000 square foot single family home in a stamped out community in the suburbs. For me, this is a very short sighted approach to real estate investing and home ownership.

In many cases, younger buyers who spend their hard earned capital on these “starter” homes will soon long for something more. This is a very real phenomenon known as “keeping up with the jones”. Additionally, families have a tendency of growing in size!

The first time home owner could find themselves missing an opportunity to realize the true investing potential of real estate. I was 42 years old when we bought our first single family home!  The thought of waiting for a nice home until the 40s could be unfathomable for many.

I believe there is a better approach to investing in real estate. First, work hard, build good credit and save aggressively with those taxable investment accounts during the 20s. In the early 30s, purchase a first property (preferably multi-family) with a business perspective rather than on emotion.   This first real estate purchase will serve as the cornerstone for a profitable, long term real estate investment portfolio. Then, when the time is right, most likely near mid-life, take the plunge on that dream home.

My wife and I married in our late 20s, paid rent and lived frugally. Over seven years, we stacked up capital in our taxable investment account.  When the opportunity presented itself, we placed a 25% down payment on a duplex. We lived in one side and rented the other. The rental income covered our mortgage, insurance and taxes. What we would normally budget each month for rent, went back into our investment account and started compounding.

Sounds like a no brainer right? This is where the sacrifice comes in. We were in our mid 30s with two small children and living in a duplex. It was a bit cramped and needless to say, we couldn’t entertain many guests. Most people in our circumstance would have purchased a single family home in a nice little subdivision.

We took a different path and made sacrifices for our families’ long term financial well-being. Thanks to income gained through that first purchase, we’ve been able to acquire additional rental properties over the years. Our investment property rental income and equity in those properties has increased steadily over the years.

My wife and I still dutifully save in our long term investment accounts for college and retirement. But our long term financial future has been set due to some wise decisions early on about real estate.   And yes, we did eventually get that lovely brick, single family home in a nice subdivision.

So how do you make money with real estate? I’ll elaborate on two of the three sources of real estate income during this blog and on the third during next week’s blog.

First and foremost one profits from real estate via rental income. How much income a property will produce depends on numerous variables I’ll dive into during future blogs. This is why that first purchase must be made entirely from a business perspective and not emotion. Regardless, for a good investment property, the monthly rent collected should equal more than all expenses associated with the property.

The IRS and financial advisors will define this rental income as “passive”. I assure you, nothing is “passive” about real estate investing! From the moment of first viewing a listing to collecting rent, every aspect of real estate investing involves a decision or action. Considering real estate investing a part time job helps cope with the challenges a landlord may face.

The second way real estate is profitable occurs through building equity. Equity is the difference between what the property is worth and how much owed to the bank. An old saying goes, you make your money from real estate when you buy it, not when you sell it. Pay too much and equity will build slowly. Acquire it at the right price, and watch that equity grow!

I know it sounds clichéd but real estate really is about location, location, location. Multi-family properties won’t increase in value as quickly as single family homes but will increase over time nonetheless. Rarely does real estate decrease in value but it can happen. All the more reason why location, location, location is paramount when shopping for that first investment property.

Sweat equity are those things an owner can do to improve the condition of a property thus making it more valuable. This can range from purchasing new appliances to building a small patio. Obviously the more sweat equity you do yourself the more return on the improvement.

Rent income and building equity are the two most obvious ways an investor profits from real estate, but there is one more “income stream”. It is a little more subtle and complex which warrants its own blog post. Tune in next week as I offer a layman’s perspective on the tax benefits of owning real estate.

The commentary provided in this blog is for informational purposes only and is not intended to be a source of financial or investing advice.

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