How Do Real Estate Investments Create Wealth?

Individuals have a multitude of investment options to choose from to boost and preserve their wealth, ranging from the stock market, to treasuries, to new speculative assets like cryptocurrencies. Real estate is one of the oldest and most reliable investments an individual can have and offers owners an easy-to-understand, relatively predictable stream of income in the form of rents. from an asset that is easy for them to wrap their heads around through their rents.

Tax Benefits

When it comes to taxes, real estate is very tax efficient. One way real estate investors benefit is the ability to deduct depreciation from the net income generated by properties, minimizing your taxes paid—sometimes to the point where you are paying no taxes on the net income.

In a recent podcast episode, Drew Breneman walked listeners through an example of how depreciation works:

Let’s say you purchased a property where the building improvements (excluding land) were worth $2.75 million, which after paying expenses, debt service, and interest deduction leaves you with $100,000 of net income. Without depreciation, you would then have to pay an income tax on this income—but since this is a residential property, you are depreciating it over 27.5 years. Because of this, $100,000 of net income is eliminated in that year.

What is particularly powerful about this is that any unused losses are carried forward into future tax years and will be available to offset future net income at the property (or other properties you own).

Eventually, when you sell there will be depreciation recapture, but you can avoid depreciation recapture and capital gains through a 1031 tax-deferred exchange. If you are interested in learning more about the additional tax benefits of real estate through other means, such as cash-out refinances and 1031 tax-deferred exchanges - we have covered them in a previous 1031 tax-deferred exchange article.

Low Correlation To Other Common Investments

Finally, while not directly creating wealth, it is important to know that real estate has a low correlation with traditional investments such as the stock market and treasuries. The private real estate index NCREIF has a 0.14 correlation with the S&P 500, and a 0.05 correlation with treasuries. All of this means that it is a fantastic way to diversify your investment accounts to protect the wealth you already created while simultaneously growing it at a consistent rate and reaping the unique benefits.

Principal Paydown

Principal paydown is another way that assets can generate wealth. When you pay down a loan balance from your rental income, you are essentially creating future wealth once you sell the asset. This is because any amount of principal that you pay down reduces the total loan balance, therefore increasing your equity in the asset. This method of wealth creation slowly increases wealth but is notable for investments where you plan to buy and only sell after a long hold period. The power of principal paydown starts to become noticeable when combined with the next way real estate can grow your wealth: appreciation.

Appreciation

Real estate assets appreciate over time, typically following market trends. To illustrate how this works, take the following example. Suppose you purchase a property for $100,000 with a $20,000 downpayment. If you assume that the asset appreciates 3% per year, then after year 1 the property is worth $103,000—and your initial $20,000 investment is now worth $23,000 upon sale—a 15% return in one year.

Now, this is a simplified example, but it illustrates the power of purchasing with leverage and how appreciation can generate wealth.

Cashflow

Lastly - this is why when people invest in real estate they think of cashflow. During operations, properties will generate revenues that will cover expenses and any debt service. The money that is left over is now considered cash flow, which is typically distributed to investors directly.

Some businesses and asset classes generate more cash flow than others, simply due to the way the assets are priced or how they are expected to appreciate over time. For example, laundromats and ATMs generate more cash flow than owning stocks or multifamily investments, but they don’t appreciate nearly as much. That said, these assets don’t come near to real estate when it comes to total returns relative to the amount of risk taken while operating those assets.

About Breneman Capital

Breneman Capital is a private real estate investment management firm specializing in the multifamily property sector.  Breneman Capital employs a deliberate investment approach, leveraging data analytics and proprietary technology to generate superior risk-adjusted returns for investors.

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