With Independence Day in the rear-view mirror, now is a great time to also contemplate our financial independence. The world of investing can be complicated and challenging to manage at times, but many of the wealthiest Americans got that way, in part, by investing in real estate.
All the great investors in history point to diversification of one’s portfolio as the key to risk management when investing your hard-earned dollars.
To achieve a well-diversified portfolio, real estate can be a great way to diversify not only cash flow, but also income tax profiles. Here are just a few reasons it may be a good idea to add real estate to your investment portfolio.
The first, most obvious reason is cash flow earned from leftover rental income after payment of operating expenses and mortgage payments. Cash flow can be used to reinvest in other properties, pay down additional payment of principal on a loan (if applicable), or to go out and buy a new Mercedes. Cash flow from real estate often can have more favorable tax treatment than ordinary income or other investment vehicles discussed in more detail below.
Inflation proof — well, mostly
Real estate, land, dirt — whatever you want to call it — is a precious commodity and no one is making any more of it. While the size of every space may vary, everyone needs a place to manufacture goods, manage their office services, purchase goods and services, and raise their families. All of those activities require real estate, and whether the economy is good or bad, they usually have to purchase it or pay rent to facilitate those activities. If you manage your real estate investments effectively and structure them conservatively, it can be a great way to hedge against the effects of inflation on your portfolio.
Appreciation through value and principal pay down
While values go up and down, generally speaking, real estate will appreciate over time, especially when utilizing the old investor adage of “buy low, sell high.” As rents increase, so do asset valuations. As long as you purchase in a stable or improving location, continue to reinvest in capital improvements and increase rents at a steady pace, your value should remain intact and even increase over time. Couple this appreciation with using rental cash flows to continue to pay down principal on mortgage debt (if applicable), and you will be surprised at how quickly your equity adds up.
As previously mentioned, cash flows from real estate investments have some unique tax benefits compared to other investment vehicles. When considering net cash flow after operating expenses, there are other items such as mortgage interest and depreciation expense that lower net income, and thus your taxable liability. Further, you may be able to take advantage of a 1031 like-kind exchange when selling an investment property, which may defer capital gains tax liability when you invest those proceeds in a like-kind investment asset.
You can always stand on it
My absolute favorite aspect of real estate investing is, at the very worst, you can always stand on it. In today’s age of investing, many of our stocks, bonds and 401(k) contributions have been reduced to an electronic, blinking, binary number on a computer screen. Having said that, these all are good investment options for a well-diversified portfolio. However, in challenging economic times, I take solace in the fact that we have some control over our investment performance. We can invest in physical capital improvements, raise rents, refinance with a new mortgage, or opportunistically sell a particular asset. While real estate can be an illiquid form of investing, it can also be a versatile tool for building long-term wealth.
There are no such things as “get rich quick” schemes regardless of what you hear on every HGTV show telling you real estate investing is easy. It is not. If it were, everyone would be doing it. They should know, however, that it is a long-term game: a marathon, not a sprint to the finish line. While there are no short cuts, real estate investing is an essential component to building long term wealth and creating financial independence for yourself and your family.