Photo:
Getty
I was recently talking with a close friend who wanted to start investing in real estate. However, he still had debt. What debt? Beyond the typical mortgage and car payment most Americans have, he had the dreaded student loan debt. It’s debt that affects 44 million Americans. But we’re not here to talk about that.
The complication that was presented to me was, “I can’t rationalize investing in real estate while I still have so much debt.” My reply to him was the question that changed the direction of our conversation: “What debt do you have right now that pays you monthly?”
First, let’s address debt: It’s not always bad. Yes, I said it. There are many gurus out there who profess for you to pay everything off and live completely debt-free. Cut your credit cards. Pay off your house as early as possible. And for some, that may work. However, for those wanting to leverage money to make money and build wealth, that is the furthest thing from the truth.
There is a large difference between good debt and bad debt. Bad debts are things like credit card balances (specifically for everyday purchases where you allow a balance to roll over month to month), loans for elective medical procedures, payday loans and more. What is good debt? Mortgages, student loans (yes, student loans), debt invested in appreciating assets and more. The first step is to clear your mind of the thought that debt is always bad. It’s not.
Second, let’s look at some simple numbers and why it may good for my friend to consider investing in real estate. I asked him how much he had to invest in real estate right now. He said he would at least have a down payment for a buy-and-hold rental property of around $15,000. Certainly not a small amount, but not an overwhelming amount either. What I did next was illustrate how three different investment strategies would yield much different results from that same $15,000 investment.
Savings Accounts
Most of us have had one of these at least once in our life, right? However, it is not the best savings or investment avenue. Not in the least. Right now, average savings account rates are around 0.9%. For the purposes of our calculations, I’ll use 1%. If we took $15,000 and placed it in a savings account, after five years, we would have a whopping $15,769 when applying a monthly 1% interest rate. That doesn’t even keep up with inflation. Unless you’re simply setting aside cash for a trip, home remodel or other goal, a savings account is a terrible place to put money.
401(k)
I am positive that almost everyone reading this right now has some knowledge or experience with a 401(k), 403(b), Roth IRA or some other income deferred investment program. Although 401(k)s have been around since the late 1970s, only about half of Americans are investing in a company retirement plan. Many factors may play into this but one of the biggest is the ability for many Americans to set aside additional funds to invest. Whether it is poor personal budgeting or low wages, it’s not a popular choice. If you’re interested in hearing more about 401(k)s, directly from the creator Ted Benna, I recommend his interview on Keith Weinhold’s podcast.
Now let’s evaluate investing $15,000 in a 401(k). For the ease of comparison, I won’t figure in any pre-tax benefits as there are some with a 401(k) investment. The average annual return on a 401(k) is between 5% and 8%. If we invested that $15,000, using a generous 7% annual return, after five years our 401(k) account would be worth $21,264. That is nearly $6,000 more than a savings account. There is a clear winner between the two investment strategies. However, we’re not done yet.
Buy-And-Hold Investment Properties
Real estate investing is diverse. There are multiple ways to invest, from flipping houses to wholesaling properties and more. One of the best strategies to produce monthly cash flow and build wealth at the same time is through buy-and-hold investing — more commonly known as owning rental properties.
To be transparent, this is what I do. I provide rental properties to investors looking for a turnkey solution. The average returns of properties that I work with are somewhere between 9% and 17%. There have been some lower and some much, much higher. If we look simply at numbers, using a 14% return, the $15,000 we could use to invest would be worth $30,084 in five years. However, that may not be the best way to view this type of investment. I’ll break it down a bit more.
Whereas savings accounts and 401(k)s don’t provide you a monthly paycheck, real estate can. Using $15,000, you could secure a loan on a property worth $75,000. For all you large-market readers, yes, those unicorns do exist in real estate — I promise. After accounting for reserve items like maintenance, vacancy, management fees, your mortgage, insurance and more, you will receive a monthly payment from your investment of $200 per month. After five years, you’ve collected $12,000 from your monthly income. You’ve almost made your entire investment back.
In addition to that, the property has appreciated. Considering a minimal 3% appreciation, your investment property is now worth $86,946. If you sold it and took out some fees and closing costs, you could make somewhere between $20,000 and $33,000 after paying off your mortgage. Add all that profit up and you’re now sitting at $12,000 in monthly income, plus $25,000 from the sale, for a total of $37,000. Subtract your original $15,000 investment, and you’ve made $22,000. Clear winner? Yes.
There were some other points made in the discussion with my friend, but I believe I was able to illustrate my stance. Even with looming student debt, my friend could take the monthly income and put it toward those student loans which would in a sense be using a solid investment property to pay down your debt and build appreciation in an asset. It’s a win-win-win.