For many of us, today is the first day back in the office after our summer holiday. Just a few days ago, we were lying on the beach, enjoying the sunshine and the sea. Now we are sitting in front of our computers, with overflowing inboxes and seemingly endless to-do lists, feeling like we will never have enough time to get it all done.
Some of us are fortunate to be doing what they truly love, surrounded by supportive bosses and friendly colleagues. I am truly happy for those of you who are in this category.
Many others, however, are stuck in demanding, stressful jobs working 60, 80 or even 100 hours a week and wondering whether this is all there is to life.
They are forced to do this in order to extract a return on that expensive private education. As I look around the office, I see many people working with crushing intensity for years on end but not really getting anywhere.
There is, of course, a better way. It involves growing your net worth, creating passive income and reaching financial independence. And investing in real estate remains one of the most effective ways to build the kind of wealth that will allow you to live your best life.
Real Estate Is My Best Performing Investment
I previously posted about my experience buying and owning a real estate investment property. Over the past 10 years, this has been my best performing investment. As a result, I am actively looking to make more real estate investments over the next 12 months.
Last November, I refinanced my mortgage and have taken about $215k of cash off the table, which I will use to fund additional real estate acquisitions. My property is tenanted, so I have literally spent zero time and money on it since last year.
Having taken stock of my investment property over the weekend, I was pleasantly surprised to see that over the past 10 months, it has continued to grow my net worth.
Between property appreciation and a reduction in my mortgage principal, my equity has gone up $68k! Talk about making money while you sleep!
Grow Your Wealth With Real Estate
There are many different ways to invest in real estate – from buying homebuilder shares to investing in REITs to syndication.
The most effective way, however, is through direct ownership of a property. Whether it’s a flat, a house or a commercial property, these four key factors will create wealth for you through property ownership:
- Cash flow
- Mortgage paydown
- Property appreciation
Let’s look at these in turn:
This is the most important factor that will determine the success of your real estate investment.
Put simply, it is the difference between your total rental income and your expenses (which include taxes – more on that below).
If you bought a flat in London and rented it out for £2,000 per month and your expenses (including mortgage) are £1,500 per month, your cash flow is £500 per month. Simple!
In my example above, my rental income of about $2,300/month just about covers my mortgage payment, property taxes and property maintenance fees of $2,250/month.
My cash flow is $50/month or about $600/year. This basically rounds to zero and means I need to rely on some of the other factors in real estate wealth creation below.
While I generate very little ongoing cash flow from my property, a portion of my monthly mortgage payment (which is covered by my tenant’s rent payment) goes towards repaying the principal.
When I took out a mortgage in November 2018, my mortgage principal was $428k. Now it is $420k.
Therefore, over the past 10 months, I generated $8k of wealth through mortgage paydown.
Over the long run, real estate prices tend to grow slightly ahead of inflation. For example, if inflation over the past decade was 2.5%, you can expect real estate to appreciate anywhere between 3 and 4%.
It’s important to remember that this is only true over the long-term. In the short term, all kinds of things can happen and the value of your property can fluctuate up and down irrespective of what happens to inflation.
You need to be ready for long periods of price stagnation or declines followed by short bursts of strong growth.
For example, while my rental property has appreciated strongly over the past three years, the price has really gone nowhere during the 5 years between 2010 and 2015.
Over the past 10 months, I generated $60k of wealth through price appreciation.
However, looking at the graph above you will note that the price appreciation on the property was 5.6% over the past 9.5 years.
Because inflation hasn’t been incredibly high over the same time period, this means I need to be prepared for a period of price stagnation going forward. I don’t see a good reason why this (or any other) property should grow in value at more than 4% annualized over the long run.
This is one of the least well-understood aspects of real estate investments, at least by individual retail investors.
The bottom line is that property investment is much like running a small business. At the end of every year, you need to report your income and expenses to the tax authorities and pay the income tax due.
However, in determining your expenses you can include costs that you have reasonably incurred in managing the property. It can be the (properly allocated) cost of the car you used to visit the property, the cost of materials you used to refurbish the property, the cost of the phone you used to communicate with the tenant, etc.
These costs reduce your pre-tax profit and therefore lower your income tax bill.
Bringing It All Together
To keep using the example of my real estate investment property, I haven’t made any meaningful money through cash flow or the tax shield over the past 10 months. The $68k of wealth generation was primarily due to price appreciation ($60k) and mortgage paydown ($8k).
How To Get Started In Real Estate Investing
As mentioned above, there are many ways to play the real estate game. At the moment, I very much prefer direct ownership though over time I expect to explore crowdfunding and syndications as well.
When it comes to direct ownership, there are two key steps to follow.
Step 1 is educating yourself about real estate investing.
Step 2 is executing on your real estate investment strategy.
Step 1 – Learning About Real Estate Investing
There has never been more information available about investing in real estate. Most of it is free (or very cheap) and the key is to make sure you have a good understanding of the various aspects of investing in real estate. The key ones are summarized below.
For convenience, I have broken them out in three key categories.
Understanding the financials
- Leverage and financing
- Property appreciation
- Transaction costs
- Liquidity requirements
- Cash generation
- Investment horizon
Finding attractive investment opportunities
- Determining the macroeconomic prospects of your chosen location
- Understanding the relationship between price and rents
- Evaluating the demographic trends
- Determining the historical and current vacancy rates
Effectively managing the property
- Landlord responsibilities
- Finding appropriate, reliable, long-term tenants
- Property upkeep and renovation
I have had a chance to take finance and real estate investment classes in both my undergrad and my MBA. For those of you looking to quickly get up the curve on real estate investment concepts and terminology, I recommend this book.
Step 2 – Executing On Your Real Estate Investment Strategy
The best way to start building your real estate portfolio is to own the property you live in. You will be your own best tenant while paying down your mortgage and building equity at the same time.
So if you rent at the moment and look to live in the same city for the next 5 years or so, you should definitely look to buy a place. Over the long run, it is hard to go wrong owning your home in an area with a growing economy and population.
Saving for a down payment may be hard but there are many ways to do it – from finding a side hustle to sacrificing a holiday to borrowing money from parents.
You need to be creative and use whatever means you have got – you will find that starting out is the most difficult part but once you own one property (even if you’ve got a mortgage on it), things get much easier from there.
But I Already Own A Place
If you already own a place (even if its mortgaged), you are off to a great start and well on your way to financial independence!
However, just owning your primary residence will never generate the passive income you need to accomplish financial independence and freedom.
To keep building wealth, you will need to add more properties to your portfolio. There are multiple ways to do this:
1. Releasing some of the equity in your primary residence and using it to buy a new property.
2. Saving up for another down payment and buying a dedicated rental property.
3. Buying a new primary residence (perhaps to accommodate your growing family) and turning the existing one into an investment property.
Regardless of which path you follow, you need to make sure that the income from your investment property fully covers your monthly outgoings (mortgage principal and interest payments, taxes, maintenance and repairs).
Don’t have any illusions – building up a real estate portfolio is not going to be easy. Then again, neither is working in a demanding, stressful job for years on end. I am confident that if you truly focus on growing your real estate investments, a day will come when coming back from your summer holiday will be a much more enjoyable experience.