First Stage Investor

Real Estate’s Unfair Advantage

Real Estate’s Unfair Advantage
By Andy Gordon
Date August 6, 2020

Note: This is a guest post from our friends over at MillionAcres. They’re at the frontier of helping individuals like you and me invest in alternative asset classes. And while we’ve urged you to invest in startups and crypto, MillionAcres believes in the investing power of real estate. And they make a compelling case for it here. — Andy Gordon

Early 20th century comedian and real estate investor Will Rogers probably put it best when he advised: “Buy land. They ain’t makin’ any more of the stuff.” 

Rogers was right of course. There is only so much land — accessible, habitable and buildable land, that is — on Earth. Every human needs a place to live, and every business needs a place to operate, farm, manufacture, store, market and distribute goods or services. Land and location are especially critical for businesses like hotels and resorts that want to be near beaches, mountains, national parks, and other top destinations. Retailers and restaurants want to be near high traffic areas. Offices want to be close to customers and rich employee talent pools. Industrial operators want to be close to transportation lines and distribution hubs. 

To add an additional twist to Rogers’ famous quote above: Invest in great locations. There are even fewer of those. 

Moreover, zoning and building ordinances vary from state to state and city to city. In Washington, DC where I live, strict height restrictions make it impossible to construct buildings higher than 10 stories in most places. In-demand cities like San Francisco and Seattle have put a virtual freeze on new office and condominium construction in many neighborhoods. That puts a hard cap on the amount of supply that is available to meet what is, in many cases, frenzied demand for square footage. 

Egregious tax benefits 

I’m sure all of us are familiar with some of the enormous tax advantages Americans get from owning a primary home — most notably the deduction of mortgage interest and property taxes (up to a certain amount and income level). That can sometimes make the after-tax cost of owning a property far lower than the cost to rent it. 

Meanwhile, owners of income-producing rental properties can deduct all a property’s operating expenses, plus annual depreciation, a big non-cash expense. Adding depreciation expense often results in an overall net loss on the rental, even though the landlord’s cash flow could be positive. How’s that for a tax loophole? And by the way, real estate usually retains its value or appreciates over time, making depreciation like an annual tax credit for landlords. 

Real estate’s tax advantages last beyond ownership. Did you know that capital gains of $250,000 ($500,000 for married couples who file their taxes jointly) are excluded for primary residences as long as the owner lived in the property for two out of the last five years? Yep, buy a house for $500,000, sell it five years later for $700,000 and boom, no tax bill from the IRS. Don’t you wish your stocks were treated the same way? 

But here’s where things get even more egregiously advantageous for the real estate investor. Under certain circumstances, capital gains on real estate can be deferred for years — and these days, even reduced in size. Thanks to what’s known as a 1031 Exchange, real estate owners can exchange, or transfer, their equity to another “like-kind” property of equal or higher value. Fortunately, the IRS is quite lax when it comes to determining what qualifies as a like-kind property, meaning almost any type of real estate can be exchanged for another, as long as it’s also a real property. For example, equity in a single-family rental can be exchanged for equity in a commercial property, such as an apartment building or shopping center. Capital gains taxes are then deferred until the sale of the new property, unless the owner elects to do another 1031 Exchange in the future. And here’s the ultimate kicker, thanks to the recent creation of “opportunity zones,” investors now have the ability to not only defer capital gains on their real estate, but reduce them and earn tax-free returns by reinvesting them in specialized zones. 

Leverage (the safe kind) 

Because of real estate’s stability relative to other asset classes, banks and mortgage lenders have been comfortable lending up to 80% of a home’s value (and sometimes up to 100%) to borrowers with good credit histories. And home loans often come with long-term, fixed rates. Where else can an investor borrow 5-1 against his or her equity and pay a potentially low, fixed-rate for up to 30 years? It’s unheard of with other asset classes. 

The same dynamics play out in the commercial real estate (CRE) world. While loans aren’t quite as generous as they are in the conventional residential mortgage world, well-heeled CRE developers often have their choice of lenders looking to lend between 50% and 80% of a property’s value at rates that are often fixed over the first few years of the loan. That’s because, unlike other investments, real estate prices and income streams are far less volatile and far more predictable than they are for your average publicly traded equity. Most of the time there’s a real business case behind every real estate deal — the renovation of an apartment building, the construction of a new hospital or senior living center — that’s supported by existing demand. And tenants usually sign long-term leases (5-plus years) with built-in rent escalators and renewal clauses. No wonder banks are eager to get in on the action. 

And what does leverage do for the CRE investor? Well, like buying good stocks on margin, leverage can seriously enhance returns — if used wisely. That’s because the cost of debt financing is usually lower than the unleveraged returns from a property investment. When that’s the case, real estate investors can use leverage smartly to increase their returns. All of a sudden, a property with a 5% cap rate turns into a double-digit IRR opportunity using leverage. 

A natural inflation hedge 

Finally, as if real estate investors didn’t have enough going for them, they can also rest assured that their real estate portfolio has a natural moat protecting it against the inflation bogeyman. While inflation erodes the purchasing power of an investor’s dollars, it usually leaves real estate assets unscathed. That’s because as prices move up, so do the costs of lumber, copper, drywall and other construction materials needed to build, renovate or replace homes and commercial buildings — not to mention the labor costs associated with real estate contractors and service providers. Thus, for all but the least desirable of locations, real estate prices tend to naturally increase at the rate of inflation over time. 

At the same time, rental income also tends to go up as rising wages and higher costs for utilities and maintenance push landlords to demand higher rents. In the commercial world, it’s standard for leases to come with built-in escalators that automatically raise the rent on a periodic basis to account for higher costs in the future. This gives most real estate — especially quality homes or buildings in desirable locations — some element of long-term pricing power. 

Just think about the advantages for the real estate investor. Not only is the investor’s biggest cost, the mortgage or commercial loan, generally fixed over some period, but the value and cash flow of his or her property is, at the very least, growing alongside inflation over time — a double whammy! Investors in other asset classes could only dream about a scenario like that. 

The Mogul Bottom Line 

Solid returns with low volatility. An essential resource with limited supply. Egregiously favorable tax treatment. The ability to use leverage safely to enhance returns. And an asset with natural pricing power to combat the ills of inflation. Real estate isn’t just playing an unfair game, it may be the most unfairly advantaged asset class on the planet. Here at Mogul, we want to help you master it. 

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