Real Estate Investing Primer

I am a bonified, certified, genuine, real estate investment junkie. I have been fascinated by real estate investing since I was a teenager before I really understood how it worked. When I was very young my dad worked for a construction company. The owner of that company was an active real estate developer and investor. I saw how much money this guy had and even at that young age, I could appreciate the amazing wealth-building power of real estate.

As I got older and into my teenage years, I had a martial arts instructor who also worked in construction as a day job, was a licensed Realtor, and invested in real estate. I saw how fast his wealth grew as he added properties to his portfolio. From these early experiences, I was hooked.

Over the years as I actively sought out and got to know more real estate investors my early life experiences were simply reinforced. I believe this is one of the single best alternative investments a person can make.

In addition, it is a very accessible and simple investment class. Notice, I said simple, not easy. It is simple to understand and very accessible for just about everyone regardless of education level or financial means. I know people that only have a high school diploma and work in blue-collar jobs that own a portfolio of investment properties and are very wealthy. This is not to imply you don’t need to learn anything to be successful in real estate it just means that you don’t need to have an MBA in finance to do it well.

What is Real Estate Investing

To put everyone on the same page I am going to define exactly what real estate investing is. It is quite simply the buying and holding of real estate. This real estate can be single family houses, raw land, small multi-family properties, large multi-family properties, and commercial properties. Each of these sub areas of real estate can be very different and each one has further subgroups, but all of them share common traits if you buy and hold them for the long term. Notice I keep focusing on that word hold when talking about real estate investing. Know this one truth: Buying and holding property is how you become wealthy. I will discuss the benefits you get by buying and holding property and it will become clear why the holding portion is so important. As comedian Jerry Seinfeld once remarked it is really the holding that is the most important part here…

Real Estate Investing Benefits

While real estate may seem like a boring investment it comes with a plethora of benefits that accrue to the investor that buys and holds for the long term. In fact, it is the fact that you get so many benefits that make this such an amazing investment class for just about everyone. If some of these benefits vanished tomorrow for any reason this investment class might not be quite as lucrative, but for now, the danger of that seems remote.

The above diagram is a creation of Peter Fortunato, one of the greatest investors and finest teachers in real estate. He came up with this diagram years ago and it is presented in all his courses, which I would highly recommend everyone take. Peter teaches a handful of courses each year, which you can learn by visiting his website regularly to see when he posts new upcoming classes. This simple diagram shows all the benefits investors get by buying and holding property.

Income

The first major benefit to real estate investing is income. This generally applies to every subgroup of real estate except raw land, which is a special case I will talk about separately. To every other subgroup of real estate, you buy and hold you also accrue income. This income comes in the form of rents. If you have ever rented an apartment or house, you understand this principle perfectly. You lease out your property to someone that would like to live there and collect rent from them each month.

This income will generally rise over time for each year that someone stays and renews their lease. It *usually* keeps pace with inflation, but sometimes inflation goes through a bit of a rapid ascent and rents trail, such as right now when I am writing this in mid-2021, but over the long run, rents will generally pace inflation with no problem. This is a unique feature of the income stream from real estate. One caveat worth mentioning, if you live and want to invest in a very hot rapidly growing market your rents *may* not keep up with your expenses or give you positive cash flow. This often happens in various parts of California, Colorado, Texas, and Florida as I write this.

The difference between your income (rents) and your expenses (mortgage, taxes, repairs, maintenance) is called your cash flow. Don’t forget that word because it will be the concept that will eventually set you financially free. Once your total monthly cash flow exceeds your total monthly expenses you are essentially financially free.

This income component becomes especially powerful when you consider it in the context of leverage and OPM (Other People’s Money), both of which are discussed below.

Appreciation

The next major benefit of real estate is that it appreciates over time. While not all properties will appreciate at the same rate, over the long run just about every property will appreciate with a few rare exceptions. If you doubt this principle, ask your grandparents what they paid for their first house and then compare that to the value of that house today on Zillow.

My grandparents bought their first house in the late 1960s for $10,000 dollars with a $99 per month mortgage payment. Today that exact same house sells for over $100,000. While this appreciation took over 50 years to achieve, they didn’t do anything other than live there and wait. It just happened. Every market and even neighborhood is different, but appreciation will happen because we have inflation. Sometimes this appreciation is rapid and high and sometimes slow and long.

If you live in a particularly hot market like Austin Texas, Nashville Tennessee, or Denver Colorado the appreciation rate can easily hit double-digit rates over a single year and increase at a staggering rate. If you happen to own property in smaller mid-western states/cities that aren’t experiencing rapid growth this appreciation might be much more subdued.

An important note here. Don’t count on appreciation to make a bad deal a good one. In other words, don’t overpay for a property and expect that appreciation will make it far more valuable a year later. That might happen, but the real estate market could also slow down, or worse, crash, and that won’t happen. Buying real estate isn’t like buying Game Stop stock at $3.00 and having it shoot up to $495 per share 4 months later. It takes time and should be considered an additional benefit, not the sole benefit. I believe investors should have a single-minded focus and dedication to finding deals that cash flow first and foremost above everything else. If you do that, the appreciation, if and when it comes is a bonus.

In addition, remember that some areas of the country have very little appreciation because the population and local economy are stagnant or declining. If you are considering investing in a town with a single industry in it, think again. If that industry goes under or suffers a set back the value of your properties and appreciation could vanish overnight along with prospective tenants. You need to invest in areas that have a decent economy and a stable population at a minimum. Growing in both areas is even better. Also, make sure you have a diversified economy. North Dakota near the oil fields may be booming, but it is a single industry. A hit to the energy sector will really hurt real estate investments in that area.

Increase in Equity

The equity in a property is the difference between what you owe on it and what it is worth, i.e., your mortgage minus your current value is your equity. As you noticed above this equity will increase over time with appreciation, but I am referring here to the pay down of your loan on the property over time.

For example, let’s say you purchase a single-family house for $100,000. You put the typical 20% down payment down and get a loan for $80,000. For simplicity’s sake let’s say your fixed monthly mortgage payment is $381 per month (not including taxes & insurance). This is based on a 4% fixed interest rate for 30 years.

Each year you make the monthly payments the amount owed is decreased which increases your equity. Due to the way mortgages are amortized this equity (strictly from loan pay down) accumulates very slowly at the beginning of the loan period and increases through the years. For those of you that already own a house and are saying “well, duh!” stick with me on this.

Who is paying this monthly mortgage? You? Wrong! The mortgage is being paid by your tenants. In other words, all the equity buildup that occurs by paying the mortgage each month is paid by someone else, but YOU get the benefit of the equity build up. That is a beautiful component of real estate investing. You put the down payment down and then someone else finishes paying it off for you. If you own a property long enough your tenants will essentially buy it for you.

Leverage

Real estate is the only investment class where you can purchase an asset for a relatively (in comparison to the total value) small down payment and finance the difference. Remember you put 20% down and finance through a lender 80% of the purchase price at a 30-year fixed rate of interest. As I pointed out above this 80% you borrowed isn’t even paid by you! Your tenants are paying it off for you. The only money you have into this is the 20% down payment. Over time your rental rates will increase, but your monthly mortgage payment will stay fixed. If you start employing creative financing strategies you might not even have 20% in cash into the property. You might trade into it with a note, discounted mortgage, or option as your down payment!

To appreciate the beauty of this try buying $100,000 worth of stock in your eTrade account by putting $20,000 down payment at a fixed rate of interest for 30 years and then finding someone else to pay off the $80,000 for you. Meanwhile this stock appreciates and pays you dividends as if you owned the entire $100,000 of stock. Of course, this is absurd when discussing stocks, mutual funds, ETFs, etc., but is exactly how real estate investing works.

To you stock market enthusiasts out there that argue you can buy stock on margin it isn’t the same thing at all. First, it isn’t a fixed rate of interest for 30 years. Second, it isn’t 80% leverage. If your stock goes down in value, you will get a margin call, meaning you will need to kick in more money to keep your investment. In real estate if the market goes down the bank doesn’t give you a margin call. You simply keep making your monthly payment and wait for the market to improve. Finally, nobody else is paying off your margin loan on your stock, but in real estate investing my tenant is paying off my mortgage.

This is where I will also mention the concept of OPM (Other People’s Money) again. When you put the 20% down that is generally, though not always your money. The other 80% is the bank’s money, i.e., OPM. Real estate can also be purchased with private money from private investors who will lend you the money. While I don’t have time to go into it here, you can also trade real estate and utilize creative finance to purchase it. None of these are options with any of the traditional investment classes such as stocks, bonds, and mutual funds. It lives exclusively in the world of alternative investments and seems to be the most prevalent in real estate.

One final note, while leverage to purchase real estate is a beautiful concept it is a double-edged sword. It can easily wipe you out if you over leverage. Remember you will occasionally have vacancies in your property and rent could temporarily decline in a down market so if you have too much leverage you could find your financial boat gets swamped, at least, in the short term. I will cover over leverage issues in another article. For now, just understand it is a potential danger.

Tax-Advantaged Asset Class

The final benefit is real estate is tax-advantaged. You get a plethora of tax write-offs for owning real estate over the long term. You will get depreciation, which is an artificial construct created by the IRS that says buildings depreciate each year, so you should be able to write this depreciation off. As I pointed out above, real estate appreciates over time, but you get to write off depreciation against the income you generate each month. Depreciation isn’t cash coming out of your pocket. It is just a number you write off against the income you generate each month. It is a phantom expense that shields some of your rental income from income taxes.

You will also get tax deductions for expenses. These expenses are things like repairs and maintenance, but it can also be things like your cell phone, dining out, travel, education, mileage, and other items you would normally pay for in your everyday life with after-tax income.

 Finally, there are tax strategies that allow you to sell a property that has appreciated (1031 Exchange), it might be fully depreciated, completely tax-free, and roll it into another real estate investment! You can do this forever and leave it to your heirs tax-free at a stepped-up basis. 

Taxes and real estate is a complex topic, and I am not a CPA or a tax advisor. You will need to seek out and work with a competent CPA and spend time reading and educating yourself on how this works. I will simply say that depending on how you structure your real estate investments you could achieve some incredible tax benefits that don’t apply to any other investment classes. Finally, remember that taxes and tax policy is a VERY political topic, likely to change over time.

Real Estate Case Study

I will give you a real case study based on one of my own properties to pull all of this together. I once purchased a small house in a decent neighborhood for $68,000. It only needed a little painting and cleaning to get it rent ready. I put $10,000 down, which wasn’t quite 20% of the purchase price and negotiated seller financing on the balance. My monthly payments are $328 dollars for 15 years. I currently rent this house for $875 dollars per month. My expenses each month including taxes, insurance, repairs, maintenance, etc. leaves me a free and clear cash flow of $275 each month.

If you are having some trouble following my math, please understand this is a seller financed deal with some creative terms that make the monthly payment $328. These terms make the deal a little more profitable, but these are still realistic terms even if you are using a mortgage from a bank. Seller financing is an advanced topic I will cover in another article.

Cash Flow: $275 (per month)

Annual Cash Flow: $3,300 (before taxes)

Now, you may be thinking $3,300 isn’t super exciting and you would need a lot more properties doing this to become financially free. I acknowledge all of that. However, as I have said before I earn my living in entrepreneurship, specifically as a consultant. Therefore, I don’t need this monthly income to live off. I just save it and use it purchase more properties in the future.

Hence my cash flow, for now, buys more cash flowing investments. Again, a quick reminder, who is paying this cash flow each month? Tenants! So, my tenants are not only paying off my existing investment, but they are purchasing new ones for me! Someday when I have enough of these, I will live off this extra cash flow. Do you see why this is such an incredible investment class?

So, how does it do as an investment? To answer that we need to reference how much I invested to start, which was $10,000. How much free and clear cash flow do I generate annually? $3.300. If you divide $3,300 by my initial investment of $10,000 you get a 33% annual return! This is only in year one by the way. As my rents increase over time this rate will get even better. I don’t know about you, but a 33% annualized return year over year is an incredible rate of return that isn’t rivaled by many other investments, especially when compared to my risk level, which is low, remember I can always sell this house and get my money back for at least what I paid for it. Plus, consider this, once I get back my initial down payment in cash flow that means I don’t have any of my own money in the house any longer. My rate of return literally becomes infinite! However, it turns out this investment gets even better…

About 2 miles down the road the state just completed a new expressway entrance/exit making the main road that passes the neighborhood where this house is located a corridor road to our university and other businesses. This caused the entire area to appreciate considerably in only one year. Now, granted, we are also in a red-hot real estate market as I write this, but the house is now worth $99,000 and my tenants paid off $3,936 dollars of the note on the house. Total equity for one year: $34,924!

I put down $10,000 of my own money and earned $3,300 in cash flow and added $34,924 to my net worth in one year! Not a bad return for 1 year, wouldn’t you agree?

As if all of that wasn’t good enough when you tossed in my tax benefits, I paid a minimal amount of income taxes to my local municipality at the end of year one due to depreciation and expenses! This incredible investment boosted my wealth by an incredible amount in only a single year nearly tax-free! Do you see why I love real estate so much?

What is Not Real Estate Investing

If buying and holding property long term is investing what isn’t investing? The short answer is just about all the other activities that people call real estate investing but aren’t. Please don’t misunderstand me, I am not saying these aren’t good strategies to employ in real estate. In fact, I use them myself. I know people that are just getting started and do so by wholesaling to generate income and then move to flipping and eventually owning rental property. These can be amazing ways to generate large chunks of cash. It is just that I want to clearly distinguish between investing in real estate and running a real estate business. 

Flipping Houses

This is not investing. You might be buying property, but your exit strategy is very short term, typically 3-9 months on average. You are buying a house and adding money to fix it up. You quickly sell it at near retail price and realize a profit between what you paid for it and what you sold it for.

You get some forced appreciation from your renovation, but this is considered regular income with no tax advantages. In fact, it is even worse because if you get classified as a dealer by the IRS you will pay even more taxes. You get no passive income, long term appreciation, equity build up, or tax advantages.

You have one of the hardest jobs in real estate, finding deals, only to turn around and sell this great deal to someone else in less than a year. In short flipping houses is a job, much like being a contractor. It can be a great way to generate chunks of income if you are good at it, but it isn’t real estate investing.

Now that is not to say that I don’t see value in it and even do it myself from time to time to generate a chunk of income that I can use to purchase more properties, pay off debt, or simply take a vacation. I am not saying don’t do this. I am saying it isn’t real estate investing.

Wholesaling

This is also not investing. It is like flipping a house, but you usually aren’t doing any renovation. Instead, you buy a house at an incredible discount and sell it to another investor for a markup. The problem is you are generally making a small sum of money because you must leave a profit for the investor you are selling it to. If you ask too much and remove all the meat from the bone so to speak and leave nothing for the investor that is buying it from you, nobody will buy your inventory.

Again, you need to put a lot of work into finding properties that you can buy low enough that you can sell it to another investor at wholesale and still make a little for yourself. This is the hardest part of real estate investing, finding deals. You are finding them and instead of keeping them you are selling them for pennies on the dollar.

Just like flipping your income is considered regular income. You don’t get rental income, appreciation, equity build up, or tax advantages. Again, if you are new to real estate investing and you just need to make some money, like flipping, this can be a way to get started, but understand it isn’t investing either.

Again, as I said with flipping, this doesn’t mean you shouldn’t do it. It is a great way for beginners to start in real estate that are trying to build capital. It is also a way to still make money off a property you get under contract, but don’t want to own in your portfolio for the long run for some reason.

However, if you decide to mix flipping and wholesaling with creative financing techniques like wrap mortgages, options, and lease/options where you turn what would have been a one time fee into a monthly income stream it can be very powerful, contribute cash flow every month like rent and enter the realm of quasi real estate investing.

One of my mentors loves selling houses with an option to buy it back down the road. He describes this as being like a yo yo, where you sell and pull it back via an option later.

Investing in an ETF or REIT

Both are paper securities that you purchase on an exchange and can buy with your brokerage account. You are essentially buying a piece of a company that owns real estate just like any other stock. Most will pay dividends, but these dividends will never be equal to the rent you would receive if you owned the underlying assets, at least not for the dollars you invest into it. I once bought a REIT and put $10K into it, my quarterly dividends was about $100. About $33 bucks per month. In contrast I once bought a single family house by putting down $10K and financing the difference. My tenant paid off the mortgage. My monthly cash flow was over $275. See the difference?

You don’t directly own the real estate. Instead, you own a paper security. You have no say in what real estate is purchased, how it is run, or when it is sold. You have no control over it other than when you buy or sell the underlying security. If you go talk to a financial planner and express interest in real estate, he or she will likely point you to one of these and explain that it gives you exposure to real estate, but it isn’t like owning real estate directly and has none of the benefits other than a dividend, which isn’t equal to rent. You might get a little appreciation if the security rises, but this isn’t guaranteed, and you don’t have a lot of control over if it does or doesn’t.

Profile in Properties

I have repeatedly said buying and holding for the long term is real estate investing, but what type of properties should you buy and hold? Each individual investor may have a different outlook on this. Here is a brief discussion of the different types of property to consider.

Single Family Houses (SFH)

These are the simplest and easiest to understand. If you own your own home, you already understand this type of property class. It is easy to get into and easy to get out of because you can sell to other investors or prospective homeowners. These properties are generally more affordable as an entry point than the other types of property. The cons are that when it goes vacant you lose 100% of your income until you get a new tenant. I personally like SFH the best and this is what I focus on.

Small Multi-Family

This is the second simplest and easiest to understand. It is defined as 4 units or less. This also includes duplexes and triplexes. You can still use a traditional fixed rate bank mortgage to qualify for these properties. They are generally more money to purchase than a SFH, but not a lot more. The main benefit is you have multiple rents coming in, so a vacancy doesn’t end all your income. They are easy to sell and liquidate when you want. Your tenants may be a bit more transient, meaning they move more often than a SFH, but not necessarily a lot more. Overall a nice way to move into multi-family investing.

Large Multi-Family

This is 5 units or more and can go up to hundreds of units for a large apartment complex. These are complex and require a lot more capital to get into. You will also need a commercial mortgage to purchase and the management of the property depending on the number of units will be a lot more. People that operate in the space can create a staggering amount of wealth and create infinite returns as the property appreciates and they refinance to pull all their initial capital out. These properties will also be more difficult to sell. You need a larger investor with enough initial capital and ability to get a commercial mortgage to purchase. That could take some time. This is not for the beginning investor.

Commercial Property

This is property that houses a business. It could be a warehouse, self-storage, office, retail, or even industrial. It typically requires a lot more capital to get into and will also require a commercial mortgage. The management can be easier because many tenants will sign what is referred to as a triple net lease, which means they are responsible for all repairs, taxes, etc. You simply collect the rent and leave the rest up to them. This might sound great, but with every benefit there is a tradeoff. Tenants are sometimes quite specialized and once a tenant leaves you might have a vacancy for months or even years until just the right tenant comes along and leases it. Selling these properties is also difficult because you will need to find just the right kind of buyer that wants or needs the property, has a lot of capital, and can get the commercial mortgage it will take to purchase. Again, this is not for the beginning investor.

Where this class of real estate really shines is in future potential. If you know what you are doing and even get a little lucky you can buy a piece of land in the path of progress. This means you buy raw land that will be needed for future development. If that development comes you can make a staggering amount of money. If you owned some ranching land outside of Austin Texas 30 years ago you might easily be able to sell that to a developer today for millions of dollars. Again, this is not a beginning investor asset.

I have a friend and fellow investor that buys raw land around the country and resells it on seller financed notes. This is easy to do since most banks won’t lend on raw land seller financing is the easiest way to buy it. He is converting his intial purchase into a passive income generating note secured by the real estate. I also met another investor that buys up large tracts of raw land, subdivides them into lots and sells (or trades) them to other people for a huge profit. If you know what you are doing raw land can be a very lucrative investment.

Mobile Homes

This is a bit of specialized type of investing. Mobile or manufactured homes are considered personal property instead of real estate unless they are attached firmly to the ground, i.e., the axles removed and the ground under them is owned by the person that owns the mobile home. Also, if you mount them on a slab or foundation where they are “fixed” to real estate they become real estate.

It is generally considered the quintessential affordable housing option. These can be very lucrative investments if you know what you are doing. If you own a mobile home park, even a small one, you can make a lot of money. If you buy mobile homes, fix them up, and resell them to people you can also do very well. I have heard of investors routinely making 15-20% returns on their investment in this class.

Over the last year or so I have met several investors that specialize in buying, rehabbing, wholesaling, flipping and renting mobile homes. Most of these investors are located in warmer southern states where mobile homes are much more prevalent. These investors are absolutely killing it with their rates of return and the amount of money they make each month.

Conclusion

Investing in real estate is buying and holding property for the long term. It is semi-passive, but not entirely. You will either need to manage it or hire a property manager and oversee how they manage the property.

Buying real estate directly comes with some amazing benefits that you only get when you buy and hold property for the long term. It is a simple investment, but not necessarily easy. It does require you get some education, but you don’t need an MBA to buy and hold property.

It is a very accessible investment class that if purchased right is relatively low risk. It typically is considered an inflation hedge since rents and property values increase over time to keep pace with inflation. Quick short-term inflation may rise faster than these elements, but they usually catch up over the long run, which is another reason to buy and hold for the long term.

Real estate is the only investment class you can buy with leverage and finance it with long term, low cost, fixed rate debt. In essence you put in a small amount and can earn large returns while tenants pay off the house for you and provide you an income to boot. The IRS wants you to invest in real estate as well, which is why they encourage you with very generous tax advantages.