Hey everyone, it's Marco from Whiteboard Finance. In this video, I'm going to show you how to build wealth with real estate. Let's get started.
Before we get started, I want to announce that Whiteboard Finance University is now live. We have four pillars of wealth building: money management, increasing your income, stocks, and real estate. So if you're interested in any of these topics, please check out the link in the description below.
Real Estate Appreciation
The first way to build wealth with real estate is through appreciation. Appreciation is when your property goes up in value over time. This is very relevant in commercial real estate, which is what we're going to be talking about today.
We're going to be using multifamily properties as an example throughout this video. Multifamily properties are basically apartments with five or more units.
So there are two ways that your property can appreciate:
Supply and Demand: If there's a lot of demand for your property and not a lot of supply, the value of your property will go up.
Forcing Appreciation: You can force appreciation by increasing the Net Operating Income (NOI) of your property.
So what is NOI? NOI stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's basically the income that your property generates minus all of its expenses except for debt service.
So let's say you have a property that generates $100,000 per year in income and has $50,000 per year in expenses. That would give you an NOI of $50,000 per year.
If you increase the NOI by either increasing the income or decreasing the expenses, you can increase the value of your property.
So let's say you increase the income by $10,000 per year and keep the expenses the same. That would give you an NOI of $60,000 per year. If you divide that by a 5% cap rate (which is basically the return that investors want on their money), you would increase the value of your property by $200,000.
So if you bought a property for $1 million and increased its NOI by $10,000 per year, you would increase its value to $1.2 million.
The second way to build wealth with real estate is through depreciation. Depreciation is when your property goes down in value over time according to the IRS tax code.
This is actually a benefit because it allows you to take a tax deduction on something that isn't really losing value.
Multifamily properties are typically depreciated over 27.5 years for tax purposes. However, there are ways to accelerate this through cost segregation and bonus depreciation.
Cost segregation allows you to break out certain assets within your building and depreciate them over shorter periods of time. Bonus depreciation allows you to take a large deduction in the first year that you purchase a property.
I'm actually going to have a guest expert called "the car wash guy" come into Whiteboard Finance University and teach us all about cost segregation and bonus depreciation.
So let's say you have a $1 million building that you can depreciate over 27.5 years. That would give you an annual deduction of about $36,000 per year.
If you did cost segregation and were able to depreciate $500,000 worth of assets over seven years instead of 27.5 years, that would give you an annual deduction of about $142,000 per year for seven years.
Cash Flow Importance
The third way to build wealth with real estate is through cash flow. Cash flow is basically the income that your property generates minus all of its expenses including debt service.
If your property has positive cash flow (meaning it generates more income than it has in expenses), then it can service its debt and potentially increase its value through forced appreciation like we talked about earlier.
Leverage in Real Estate
The fourth way to build wealth with real estate is through leverage. Leverage means using other people's money (OPM) to control a larger asset with only a fraction of its total value as an investment.
You can obtain leverage through bank loans or syndication (which is basically pooling money together from multiple investors).
Let me explain this concept using an example:
Let's say you have two properties:
- Property A costs $100k and generates $10k per year in pre-tax cash flow.
- Property B costs $500k and generates $50k per year in pre-tax cash flow.
If you buy Property A with 100% cash ($100k), then your pre-tax cash flow would be 10%.
If you buy Property B with 20% down ($100k) and finance the rest ($400k) at 4% interest for 30 years, then your pre-tax cash flow would be 10% on your invested capital ($50k / $100k = 50%).
As you can see from this example, leveraging OPM allows you to control larger assets and generate higher returns on your invested capital.
Cash on Cash Returns Explanation
The concept of cash on cash returns is basically taking your pre-tax cash flow divided by how much money you have invested in the property.
So if I invest $100k into a property and generate $10k per year in pre-tax cash flow, my cash on cash return would be 10%.
If I invest $100k into another property but use leverage so I only have $20k invested into it and generate $10k per year in pre-tax cash flow, my cash on cash return would be 50%.
As you can see from this example, leveraging OPM allows me to control larger assets and generate higher returns on my invested capital.
Real Estate as an Inflation Hedge
The fifth way to build wealth with real estate is through inflation hedging. Real estate has historically been a great hedge against inflation because properties typically keep up with inflation rates over time.
This means that if inflation goes up by 3% per year on average over time, then so will the value of my properties as well as my rents (which means more income).
This also means that if I lock in a low fixed-rate mortgage today while inflation is low but interest rates are high (like they are right now), then I'm essentially hedging against future inflation because I'll be paying off my mortgage with cheaper dollars while earning higher interest rates elsewhere as inflation goes up over time.
Conclusion and Call to Action
In conclusion, those are five ways that real estate can help build wealth:
- Cash Flow
- Inflation Hedging
If any of these concepts interest you or if you want to learn more about how to build wealth with real estate or any other topic related to personal finance or investing please check out Whiteboard Finance University using the link below:
Use discount code "REI20" for 20% off membership!
Thank you so much for reading!