If you look at the story of the Titanic, it hit an iceberg and it sank, killing thousands of people. The captain saw a piece of ice extending out of the water and in an attempt to avert collision, he slammed the ship into the most massive piece of the iceberg – the submerged portion. In other words, he was looking at the obvious, ignored the most important piece of information (i.e. the majority of an iceberg’s mass is underwater), and the outcome was disastrous.
Jason Hartman, who has done thousands of real estate transactions across 11 states, compares income-producing real estate to an iceberg. There are obvious aspects of real estate that most investors focus on (i.e. the part of the iceberg you can see), but since income properties are a multi-dimensional asset class, there’s more to it than the money coming in and going out each month (i.e. the submerged part of the iceberg that makes up the most mass).
In our recent conversation, Jason explained the other dimensions of real estate investing that are not so obvious and why understanding of these added dimensions is a must if you want to ensure long-term success.
Is Real Estate Investing More Than Just Cash-on-Cash Return?
The most obvious aspect of real estate investing is cash-on-cash return. So, if this is the only metric you track, then it may seem as if your portfolio is performing worse than it actually is. “There are many other dimensions that are not apparent necessarily to investors that they realize later,” Jason said. “So if they just look at it from a cash-on-cash perspective, and if they have a couple of bad months, if they have a vacancy, if they have a big maintenance issues or a tenant that trashed the property issue, and they gotta spend a bunch of money, they wouldn’t be evaluating holistically.”
That’s why it’s important to take all dimensions of real estate investing into account and look at the big picture. “It’s important in real estate and in life in general to step back, like a painter from their canvas, and look at the big picture once in a while,” Jason explained. “Sometimes we have to be looking at the brush strokes, but sometimes we also have to step back and look at the big picture, and that is why real estate investors can feel like they’re losing when they’re actually winning sometimes.”
What are these other dimensions of real estate investing that come together to make the entire big picture? First, there is the value of leverage.
The Value of Leverage
One aspect of real estate investing that isn’t taken into account by the cash-on-cash return is the value of leverage. “That’s one of those things we love as real estate investors,” Jason said. “On most of our deals, [we] have a partner. That partner is called the bank, the lender, whoever finances the property for us. Well, we’re probably only putting in 1/5 of the cost of that asset, and they’re putting in 4/5 of it.”
What other investment allows you entrance at 20% of the asset’s value? Rather than put up $100,000 in capital for a $100,000 property, I can technically take that $100,000, spread it across five $100,000 properties, and control $500,000 worth of real estate!
Appreciation and Depreciation
Another often overlooked benefit of real estate is appreciation and depreciation. “We get appreciation over time, [although] appreciation is not always instant,” Jason said. “Sometimes we have depreciation, but the nice thing is, in those depreciating markets, typically rents will strengthen because people aren’t leaving the renter pool and entering the buyer pool because they don’t have any urgency to.”
Depending on your investment market, you can leverage either appreciation or depreciation by adjusting your strategy. “We can either be in a capital gain strategy, where we’re banking on appreciation, or we can be in a cash flow strategy, where we’re banking on upward price pressures on our rents.”
Income property is one of the most, if not the most, tax favored asset class in America. Since taxes are the single highest expenses in our lives, this is a very important and attractive benefit.
Jason broke down tax benefits into three major categories:
“If our properties are local, or especially non-local, we can deduct a lot of expenses associated with running our real estate business because it is a business just like any other business where we have business expenses. Maybe some of our travel expenses, maybe some of our cell phone expense, our internet service expense, software that we would otherwise use anyway in our lives. A lot of these things can be expensed off with the properties.”
“That is really one of the Holy Grails of tax benefits … where we can take and depreciate the property over 27.5 years if it’s a residential property and 39 years if it’s a commercial property. Residential has about a 25% faster depreciation schedule, and if we qualify for the depreciation benefit, it’s a non-cash write-off. As a non-cash write-off, we don’t have to actually spend money to get a tax benefit.”
“Every other area of life we have to spend money to get a tax deduction – donate to charity, or spend more money on our business. We get a deduction with income-producing real estate. We could have the property appreciating in value, we could have positive cash flow… In other words, everything could be going great, yet the IRS will still let us use a paper loss, a phantom deduction, to get a tax benefit, and that is an absolutely beautiful thing.”
“One of the ways that wealthy people can pay little or even no income tax [is] if they own enough real estate, and [they can] really benefit.”
“We can trade the asset all our life on a 1031 tax-deferred exchange and not pay any tax. If we have a business, if we own stock, and if we sell it, we gotta pay tax before we get to reinvest it. With income property, we can sell it, trade around, move around maybe to different geographies, different product types… A couple of times I’ve exchanged single-family homes for apartment complexes or a mobile home park – I still own those now – and that’s just great, that I get to reinvest everything – the government doesn’t take a cut – and reduce the amount that I get to reinvest.”
“I sold a business years ago, and when I sold my business, the government took a cut before I got to do anything else. There was no ifs, ands or buts about it. If I sell a stock, the government takes its share, and then I get to invest what’s left over… Not true with income property, using the 1031 tax-deferred exchange, which is a tremendous benefit.”
The Holy Grail: Inflation-Induced Debt Destruction
The final overlooked benefit is what Jason refers to as inflation-induced debt destruction. It is a fancy term to describe a hidden wealth creator that occurs behind the scenes (much like the submerged portion of the iceberg) – when you have financing on a piece of income property, that debt is constantly being debased by inflation.
Another advantage of putting debt on a piece of income property is that the tenants pay off the loan over time. However, this is minor compared to the big benefit of inflation.
Here is an example Jason provided to help explain how inflation-induced debt destruction works:
“Say someone buys ten single-family homes and they have one million dollars in leverage or debt against those single-family homes. Maybe the portfolio is worth $1.2 million when they bought it. Now, they will get their mortgage statements right after they buy it, and they can look and see that their loan balance today is one million dollars.”
“For easy math’s sake, and just say that if we look at an inflation rate of 5%, … then that million dollars, inflation is basically paying off $50,000/year of our debt for free, every year, in the background.”
Jason said, “Most people think they made money because the value of their property went up, but the property really doesn’t go up that much compared to inflation. It kind of keeps pace with it pretty well. The way investors beat inflation is they use leverage. If they have 4:1 or 5:1 leverage ratio, then they outpace inflation by 4:1 or 5:1”
However, there is another inflation-related benefit that comes from leverage. Jason said, “Inflation is also reducing the value of that debt because we pay it back in cheaper dollars every year.”
For more detailed information on how inflation-induced debt destruction works, listen to my first interview with Jason here: https://joefairless.com/podcast/jf38-dont-you-dare-lose-control/
Don’t be like the captain of the Titanic, overlooking the biggest and most important aspects of your business. In the Titanic captain’s case, he overlooked the fact that the largest part of the iceberg is submerged. As an investor, cash-on-cash return is just the tip of the iceberg. The often overlooked aspects of real estate investing that make up the majority of the benefits are:
- The value of leverage
- Appreciation and depreciation
- Tax benefits
- Inflation-induced debt destruction
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