Real estate is like a three course meal. The appetizer is the positive cash flow, always appreciated but not required (because breaking even is okay too). The dessert is the equity appreciation; like an appetizer it is always appreciated but not required for a meal or wealth creation. The main course is the mortgage pay down, month after month. The fact is: you will get rich and fat just on the main course.
Below we go into each course of this meal called real estate.
Main Course: Equity Creation Through Mortgage Pay Down
As you hold an asset, with or without cash flow, you will pay your mortgage down. But wait, it’s not actually you but rather your tenants paying your mortgage down since they’re paying the rent. The longer you hold, the lower the mortgage and after 25 years, the mortgage will be completely paid off. Just by holding on to your property longer it will prove to be a forced savings vehicle and that alone can make you very wealthy.
Real estate has heavy transaction costs: raising money, finding the building, realtor fees, legal fees, inspection fees, land transfer taxes (except in Alberta), mortgage commitment fees as well as inspecting 3-5 other candidates that are ultimately not even purchased. All these fees add up and often even a five-year hold is usually too short to make a high return due to these initial fees. That is why we always tell our investors to be prepared to hold AT LEAST 5-7 years or better yet 10+ years as it is the second five years when the true savings start as those initial fees for a 5 years mortgage do not reoccur if you hold 2 x 5 years.
Desert: Appreciation of the asset value is not a given but usually happens for three reasons:
A) Rents (usually or on average) go up with inflation, sometimes more, sometimes less. With inflation in the 2-3% range that is what you can expect in value increase if you do not spend a lot on property upgrades or even in normal markets with low to no in-migration.
B) Properties rise in value faster if they get upgraded, usually from the property cash flow or from reserves. We’ll touch on that further in another article, but let’s just say that an upgraded 2 BR commands higher rent than an ugly one. We make sure that all of our units are upgraded, giving our investor higher rent potential. That is why we call the firm “Prestigious Properties” and not “Sloppy Properties”. Anyone can make money as a slum landlord, but not nearly as much. We do not associate with being slumlords because it does not align with our beliefs of leaving the world a better place, both for ourselves as well as those less able.
C) In-migration into an area pushes rents up as the limited supply gets absorbed faster and new product has to be built at substantially higher costs to keep up with the demand. Rents of older apartments go up faster than they would with low demand, and continue to go up until they approach the rent prices of newer units (minus a discount for the year built). As you can see on our Facebook page, BMO Economic Research, has reported that real estate values in Alberta will continue to rise. Home prices are rising about 5-7% each year right now in both Edmonton and Calgary, so that should certainly be enough for most investors to stay put for the long haul.
Appetizer: Cash Flow
Your NOI (net operating income) is what you are left with after paying your operating expenses from the collected rent. With that you pay your mortgage. The leftover dollars are then used to payout regularly to investors in our LPs or, more typically, get re-invested into the asset for higher rents and thus, higher values down the road. As such, we do not operate like a REIT with low mortgages and extensive investor cash flow because 70-90% of our surplus cash flow gets re-invested into assets for higher asset values in the future, due to higher rents and more valuable, better looking, prestigious properties.
Aperitif / Benefit 4: Taxes
Taxes come in two forms: while holding and when selling. When holding a property there is usually no taxes payable since we amortize the building at 4%. This means that even in strong cash-flow assets like ours in Calgary, Red Deer or Edmonton we can deduct up to 4% of the building value from taxable income. We usually do not pay income taxes while holding except for one asset in Edmonton (Windsor Estates) that now, after 10 years of ownership, has such a surplus of cash-flow that despite the operating expenses, mortgages, upgrades and even 4% depreciation we still pay income taxes. Lastly, when the asset is sold after many years, only 50% of the gain is taxed because it treated as a capital gain. In Alberta, with a tax rate of 39% this means that not even 20% of the total gain has to be paid in taxes.
Tax advantages are the icing on the cake, or the aperitif if you will, of investing in and holding income producing real estate: it is tax deferred and tax preferred investing !
As you know, there are many investment vehicles available to you but few have the advantages of investment real estate and this is why we focus on using multifamily real estate as our preferred vehicle to creating wealth for our investors and for ourselves personally.
P.S.: Related video for those that prefer this story by video.
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