Rabbi Moshe Brown had no aspiration to the wealth of a Donald Trump, but he was in need of some extra income. He loved being a Rebbie, but it is a position with limited monetary potential. Shaindy Brown had a small insurance business, so they were managing financially, but with daughters facing shidduchim in a few years, it was time for some extra hishtadlus. Real estate investing seemed to be a favorite heimishe pastime and many had made fortunes in the industry. Rabbi Brown wondered what strategies did the rich use to be successful in real estate? Could he apply those strategies and build some wealth too?
Investor Strategy 1. Finding and Adding Value
Real estate is an exceptionally reliable and intuitive investment and owning “bricks and mortar” provides a sense of security that other investments can’t match. More importantly, every single piece of property is unique which enables diligent real estate investors to find and create additional value. Each share of Coke, Google or Walmart stock is identical, so it is tough to gain a buyers’ edge. It is much easier to become an expert in a neighborhood and recognize when anxious or lazy sellers are offering property at bargain levels. Real estate markets are localized so price inefficiencies can crop up, providing opportunities to astute investors.
In addition to buying bargains, property investors can use hard work and creativity to turn average investments into fantastic ones. For example, in Lakewood NJ’s bustling shopping centers, managers have brought in new tenants, added valuable rentable space on buildings’ fronts and sides and improved signage and parking. This hands-on approach increases the rental income and adds to the assets’ resale value. Even a novice like R’ Moshe can enhance the value and revenue of an investment. In a small house rental, adding value can be as simple as installing a new kitchen, nicer flooring and repainting the walls. These upgrades often allow substantial rental increases and help make real estate particularly lucrative to the active investor.
Investor Strategy 2: Using Mortgage Leverage
Just as a car jack enables an average person to lift a car, a small investor can buy a large amount of real estate by using mortgage leverage. Due to its stability, property is viewed favorably by banks who will lend as much 80% or more of the purchase value. With debt financing, investors can “lift” much larger deals than otherwise possible. In 2004, I attended a PCS course in Lakewood, where this concept was enthusiastically presented by the engaging real estate mogul/philanthropist, Dovid Lichtenstein. While his examples were of properties valued in the 100s of millions with leverage as high as 95%, the same principles apply to beginners as well. In fact, Mr. Lichtenstein founded his real estate empire in Lakewood using very modest sums borrowed on credit cards!
Say Rabbi Brown identifies a neighborhood where townhomes sell for $80,000 each. By sprucing them up (an additional $20,000), each home could achieve a healthy annual rental income of $10,000. After scratching together $100,000, he could buy, renovate and rent out one condo. Or he could choose to buy four units by using the $100,000 as a down payment and borrowing the rest (Down-payment of $25,000×4 =$100,000. Mortgages of 75,000×4=$300,000). By using debt leverage, he quadruples the size of his portfolio (from one unit into four). But this is just the beginning. The power of leverage can also turbo-charge a deal’s profitability.
In R’ Moshe’s case, with the unleveraged one home investment he would have an annual income of $10,000. With the mortgaged four unit portfolio, however, he could easily earn double that! Assuming typical house mortgage rates, the yearly rental income of $40,000 ($10,000 x 4 homes), would create a profit of $20,675 after annual mortgage payments of $19,325. Leverage had inflated a solid 10% return ($10,000/$100,000 =10%) to a spectacular 20% ($20,675/$100,000= 20.67%)! This effect is created by the fact that the mortgage interest rate (5%) is much less than the profit rate (10%). Rabbi Brown can use this positive leverage effect to create a dramatic wealth increase.
Investor Strategy 3: Avoiding Taxes…..Legally
Real estate also enjoys several significant tax avoidance benefits enabling real estate investors (such as Mr. Trump famously) to pay little income tax. For example, the tax on rental income can mostly be deferred thanks to a depreciation allowance. Regardless of the actual value of an investment building, the IRS allows owners to assume an ongoing (paper) loss to offset expected depreciation. In addition to sheltering current rental income, it is easy to roll over gains from the sale of property into the purchase of a better one, tax-free! This rolling strategy, known as a 1031 exchange, can be pursued indefinitely, shifting each property’s gain into a successor larger property pre-tax. On the property owners’ passing, all the accumulated deferred taxes are wiped out. Death may be inevitable, but taxes are not, for real estate investors at least!
Real Estate: Simple, But Not Easy
Each of these strategies: adding value, leveraging and tax management is powerful on its own, but when combined, they become extraordinary wealth builders. For this reason, real estate investment has minted many billionaires, and the very wealthy keep about 15-30% of their net worth in real estate. However, this does not mean it is an easy path to riches. Risk and reward are tightly related, and especially when debt is involved, real estate investment can cause substantial losses as well as gains.
Learn how to manage the risks of real estate investing here…. Managing The Risks Of Real Estate Investing