Investors Build Wealth through Real Estate Investment

On being ‘rich’ (or maybe we mean ‘wealthy’)

Most ambitious young people set out on their careers determined to do their best, work hard, and enjoy the benefits of diligent pursuit of excellence. This is the American Way. But too soon lifestyle expectations and what we perceive as an ever rising ‘cost of living’ combine to lock us into growing personal debt and, for most, apparently narrowing prospects for financial independence. A financially secure Retirement is becoming an uncertain view of the future.

When we talk about ‘wealth’ and ‘financial independence,’ some of us fantasize about Bill Gates (‘more money than God’) or the late Sam Walton, founder of WalMart, or Donald Trump (‘lots of money,’ and ‘trophy wives’ with exotic names). That’s being rich. More interesting to many of us is the notion of Wealth.

Build ‘Passive Income’ for long term wealth

Robert Kiyosaki, in his best selling Rich Dad/Poor Dad (Warner Books, 2000), defines wealth as that moment in time your passive income from investments is sufficient to meet your living expense. The day we recognize that if we  were to just stay home, and not go to work, there will be enough investment income coming in to pay the bills and at least ‘get along’–that realization is one’s Declaration of Independence! from the Rat Race, from the stress and dissatisfaction of less than ideal employment. Perhaps, as Joseph Campbell once described it: with this happy turn of events, one is truly freed to ‘follow one’s Bliss,’ to pursue our dreams, to undertake all those other agendas in our lives put aside early on in deference to conformity and the work-a-day world.

It is assets that count in the long run

If this proves to be a universally accepted definition of Wealth as it should, how might we all achieve such a desirable condition? Kiyosaki, a successful self made millionaire, suggests first of all that we recognize the sometimes subtle difference between assets and liabilities. Assets, he says, are investments that result in real tangible, monetary returns– assets make money. Assets work for us,  all the time, rain or shine. Liabilities are items or entertainments that we purchase (homes, cars, wardrobe or vacation cruises) that may contribute to our sense of living the Good Life but nevertheless diminish in value over time and contribute nothing to Passive Income, the true Index of Wealth.

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Investing in Real Estate, Securities & Savings

Historically real estate investments have proven comparable to investment in securities (stocks and bonds), “whole life” insurance, and systematic savings programs where interest compounds. The stock and bond market for nearly 75 years, beginning in 1926, yielded a pretax 5-12% annual return where income was left to compound (the difference being the specific investment vehicle. Terry Savage (The Savage Truth On Money, John Wiley & Sons, Inc., 1999) provides a useful comparative table:

Investing in Securities for the Long Term 1925-2011

(download Ibbotson Report)

All of these investment vehicles generally increased in value faster–or at a higher rate–than inflation, and will grow even more quickly when additional contributions are made periodically over time.  As governmental taxation policies change, advantages sometimes shift from one investment vehicle to another as policy makers seek to encourage one form or another of savings or investment; recent examples include IRA, Roth IRA’s and 401k tax deferred accounts, and changes in capital gains tax rates favorable to investments

Home Owners enjoy long term Investment Benefits as well.

The real estate market for single family homes has not lagged behind these sometimes sophisticated investment strategies. Indeed popular wisdom has it that the single most important investment one may make is in the purchase of one’s own home. For many, home ownership is their primary estate building opportunity, especially given the likely inadequacy of personal savings as a contributing factor. Across the country, homeowners in particular have enjoyed steady gains in the market value of their homesteads for sixty years or more, since the nation’s recovery from the world wide economic depression of the 1930s (See "100-Year Housing Price Index History").

While the midwest may have trailed other more heated regions of the country in recent decades, the statistics for the year ending June 2009 are noteworthy:[2] The numbers demonstrate that the upper midwest is not subject to wide swings in value: Neither on the up, or the down cycles.

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In the end, Why Invest in Real Estate?

Liquidity. When compared with other investment and savings opportunities, holding real estate for long term appreciation merely keeps pace with more liquid assets. Assets such as cash savings accounts, Treasury bills, stocks and bonds, may be readily retrieved (by going to the Bank) or sold “over the counter” by calling your broker. Real estate, on the other hand typically takes weeks or months to sell or “liquidate.”

(Sophisticated real estate investors, on the other hand, appreciate that where there is “equity” available in a piece of property, it is generally possible to pledge that equity as collateral for a loan and thereby raise needed funds. Other alternatives include: simply refinancing the property, the sale of a partial interest in the property for cash, or the “sale and lease back” of the property to a passive investor, among others.)

Security and Long Term Growth. Liquidity is only one attribute looked for by an astute investor. Security and long term growth are also important. The long term growth attributable to real estate equities has already been discussed. To be sure, all investment markets are somewhat cyclical. And in the event of economic catastrophe, such as the Great Depression of the 1930s, which few if any can be fully prepared for, all markets will turn “down” for some period of time. Securities analysts suggest the stock market historically has experienced roughly 10-year cycles of “bull” and “bear” markets, sometimes punctuated by sudden and often unpredicted rises and declines (remember “tech. stocks”?).

Real estate is arguably cyclical by nature as well. Housing starts (new construction) will increase and decline, often as a function of interest rates. Office building is chronically subject to over building in times of rising rents – due to low vacancy rates – and economic prosperity, only to slow in the face of increased vacancies due to “over building.” Low interest rates beginning in the late 1990s encouraged renters to buy their own homes or condominiums (It became “cheaper to buy than to rent”), resulting in rising vacancy rates in multifamily investment properties and apartment complexes; as interest rates rise in future, this condition too will reverse.

In the end, all investment strategies should be long term to be successful.  Securities analysts cannot agree on whether those who actively trade – buy and sell frequently based on one “market timing” technique or another – come out ahead in the end. Indeed, the preponderance of evidence suggests simply buying and holding solid “blue chip” stocks works best in the long term, yielding an average of 11-12% annual yield or growth.

Leverage. Leverage, or the ability to control a large amount of capital with a lesser amount of cash, is one way to enhance yield on an investment. In the stock market, this is generally referred to as “buying on margin” and is accomplished by borrowing the additional funds from the broker. When one is convinced of the immanent increase in market value of a specific company's stock, using this margin account – in fact borrowing –   it is possible to purchase many more shares, which become collateral for the margin account loan. Using this technique, even a small increase in value may equal or even exceed the actual funds initially put at risk (for a 100% or more profit).

For example a 5% increase in value of a thousand shares valued at $100 each would be a gain of $5,000; if purchased using $90 thousand borrowed, this would result in a gross profit of 50% before interest and transaction costs.

Speculators in stock options and commodities employ essentially the same arithmetic in their dealings, gambling on both price increases and decreases. The common denominator, once again, is Leverage, the use of limited funds to control substantial assets subject to price fluctuation. The problem is: that while leverage creates opportunity for exceptional gains or profits, the consequences of wrong predictions are proportionately just as great. To have the values go against the investor or speculator is to risk loss of the investment, and liability for additional losses should price declines exceed the “equity” committed.

Risk Factors of Leverage. In any event this use of Leverage is inherently high risk and generally left to the realm of speculation rather than investment. In real estate the corollary is (non income earning) vacant land or, possibly, the recent phenomenon of speculators purchasing homes and condominiums in rapidly appreciating markets with the intention to resell in the near term – say, 1-3 years. The vacant land seldom generates income sufficient to cover carrying costs, and gains value only when deemed attractive for development.

Similarly, homes purchased in a rising market for speculative purposes rarely enjoy “positive cash flow;” it’s likely one will have to contribute to whatever rental is realized in order to meet all the costs of ownership. Should the market “flatten,” or worse yet decline, the mere transaction costs may seriously compromise (even eliminate) potential profits if sold within the first year or two. Such short term purchases are best understood as speculative real estate plays, rather than investments.

Leverage is nevertheless central to understanding the benefits of long term real estate investment in income earning assets. With traditional lenders prepared – if not, indeed, anxious (they’re looking for the business!) – to lend 75-100% of the capital required to purchase and own an investment property, leverage is built into the equation. Like any other form of leveraged investment, increases in the value of the entire asset ( appreciation ) magnify the yield on the funds actually invested. Loan reduction paid down over time out of rental receipts also contributes to equity growth and yield.

Government ‘Incentives’ make real estate attractive. Governmental incentives, including depreciation, the deductibility of interest and operating expenses, and the availability of long term capital gains tax treatment on the long term profit, all serve to enhance the incentive to invest in real estate.

Conclusion

This combination of rising demand and increasing market values, and the ready availability of conservatively managed leverage, combine to create an exceptional opportunity for those committed to a long term savings and investment program. For those investors who “pay themselves first,” practice personal thrift and disciplined investment, real estate offers an accessible path to long term wealth and personal well being.

- Philip Elmes, Investing In Affordable Housing, pp. 3-14

[1] Terry Savage (The Savage Truth On Money, John Wiley & Sons, Inc., 1999), p 81.