Real estate can be one of the best ways to build long term wealth.
As investors, we must be aware of the potential benefits and consequences of an investment. There are numerous potential benefits of real estate investing, such as tax breaks, financial stability, appreciation, and storage of wealth.
With many investment choices available, real estate is just one of our options to build long-term value. Real estate is unique, and in certain areas, exclusivity and lack of additional space to build has driven prices higher. For example, prices for a Manhattan apartment in the last decade have risen faster than stocks or gold.
Larry Fink, the founder of BlackRock Inc., says:
“The two greatest stores of wealth internationally today is contemporary art…and I don’t mean that as a joke… and two, the other store of wealth today is apartments in Manhattan, apartments in Vancouver, in London.”
Holding property in the right market can be an extremely lucrative investment. These are just some of the many benefits of being a real estate investor.
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1. Real Estate Can Offer Passive Income
Many real estate investors agree that the passive income generated from their investments is the most beneficial aspect of real estate investing.
The cash flow, which is the amount left after all of the bills have been paid, allows them to spend time doing other things like building a business or re-investing into more real estate.
The cash flow that is generated from real estate rental income has the potential to be relatively stable. Some will argue that real estate investing is not completely passive, and they are correct!
However, those looking for a 100% passive investment could invest in crowdfunded real estate or simply hire a property manager.
In addition to generating income from rents, investors can potentially gain from the appreciation of the property itself. Over the last 60 years, real estate has generated around a 2.4% annual return.
Owning real estate as a passive partner within a portfolio can also be a great way to earn passive income. Investors have a wide variety of options to invest in such as public REITs, private or non-traded REITs, real estate partnerships, or crowdfunded real estate platforms.
2. Real Estate Gives Tax Benefits
In the United States investors have a variety of tax benefits available for real estate investing. There are allowable deductions available for both your main home as well as a rental or investment property.
Individuals who purchase a home can write off their interest on their mortgage and property taxes if they itemize their deductions on Schedule A.
For rental property owners who report their rental activity on Schedule E, there are various deductions. Income that is generated by the rental property is offset by any allowed expenses, reducing the net profit of the rental activity.
The IRS allows property owners to take losses on their rental properties. Up to $25,000 of passive losses can be used to offset ordinary income.
Investors whose income is too high (over $150,000) will be subject to passive activity loss limitations, and will not be able to claim losses in the year they accrue. Rather, they will carry these passive losses forward and realize them when they go to sell the property.
Another tax benefit is the cash flow received from rentals is not included in self-employment tax. Self-employment tax is a tax you must pay if you are self-employed and consists of the employer and employee portion of payroll taxes (Social Security and Medicare).
Many real estate investments will be able to take advantage of long term capital gains rates. These are lower tax rates than ordinary income tax rates. This gives investors even more of an incentive to purchase real estate.
Another tax benefit is the ability to defer taxes through a 1031 Exchange, which is a provision that enables real estate owners to sell a property and buy another one while deferring capital gains. An investor can continue to buy and sell properties without having to pay taxes on the gains for years.
3. Rental Income Allows for Faster Loan Payoff
When you purchase an investment property and take out a mortgage, the rental stream may be able to cover the loan payments.
This makes operating the property much more manageable. When the mortgage is completely paid off, the investor owns a valuable asset almost completely paid by the rents the property generated.
Having the ability to pay down your loan faster can be a huge advantage when trying to invest in real estate.
If you can generate positive cash flow and have the property pay for itself through the rents, you will have a greater chance for a successful investment.
4. Real Estate Can Be A Hedge Against Inflation
Another benefit of real estate investing is the store of value and the natural hedge against inflation. Inflation occurs when prices increase due to the decreased value of a currency.
Inflation has averaged around 2% per year over the last 50 years. This means the value of the dollar reduces by 2% each year. Real estate is an asset class that provides a hedge against inflation.
For example, this means real estate generally can hold its value better than the value of the U.S. dollar.
Real estate is a unique asset as it has a personal use factor. People are always going to need a place to live, and real estate will always have an intrinsic value. Even if the entire monetary system were to collapse, real estate would maintain its value fairly well because of its useful characteristics.
Many real estate investments provide income from rents, which tends to increase with inflation. As the cost of living goes up, rents do too, meaning more cash flow for the investor. Real estate values also typically increase with inflation.
As inflation erodes the value of the dollar, it takes more dollars to purchase the same property. Real estate usually appreciates over time, particularly during times of high inflation.
5. Real Estate Appreciates
Another benefit of real estate investing is the fact that it appreciates over time.
While the market can have its up and downs, housing values generally rise over the long term. Although there are certain periods when the market value goes down, over the long term, real estate, in general, appreciates and goes up in value.
This makes real estate an attractive investment as it can be a relatively safe store of wealth.
The scarcity characteristics of real estate will aid in its appreciation over time. For example, there are only so many apartments in New York City.
This makes the supply limited while the demand continues to increase.
This will help drive prices higher for buying an apartment or land in New York City.
Real Estate vs Other Investments
With so many options for investing money, an investor might be wondering how real estate stacks up against other investment possibilities.
Real Estate vs Stocks
Investing in the stock market can be a great way to build wealth.
Over the long term, a diversified stock portfolio should earn respective returns. The S&P 500, an index that tracks the largest 500 companies, has returned around 12% over the last 50 years.
However, if you are a risky investor, you may be able to earn higher returns, but only by taking on more risk. Stocks can depreciate just as easily and are not always a sure investment.
Real Estate vs Bonds
Bonds are less volatile than stocks, but they generally have lower returns.
Because they many times offer lower risk, the rates of return are lower than stocks and real estate. The safer the bond, the lower the interest returned to the investor.
Careful real estate investment can provide the same safety as bonds, but investors must do their due diligence to find such investments.
Bonds pay a fixed interest rate for the life of the investment and can be subject to inflation risk. Inflation is always negative for lenders because they are getting paid back in dollars that are worth less than their original principal amount.
Rental properties can potentially pull in higher rents and appreciate with inflation.
Real Estate vs Gold
Many people choose to invest in gold, simply for its history and popularity.
It is a safe commodity, often considered to be a hedge against inflation and a good store of value. But, gold has no potential to generate cash flow. It is a commodity nonetheless and can not be used to generate income.
This is why Warren Buffett does not like gold as an investment.
Real estate investing carries many benefits for investors.
As long as all factors are considered before investing, real estate can prove to be a sound investment. The passive income generated by real estate investment can help build up an income stream to re-invest in other properties, to pay for living expenses, or to be able to retire early.
Tax advantages, faster loan payoff, and the long term store of value make real estate a potentially attractive investment.