Ideally, your financial plan includes real estate, which offers the kind of attributes that will often take the pressure off the rest of your portfolio to perform. Having the right allocation of real estate in your portfolio provides enhanced diversification and non-correlation, (assets behaving in different ways, not related to the general markets at large) not to mention certain tax advantages, cash flow, and equity appreciation.
Cash Flow & Leverage – Double Edge Sword
Real estate can be costly to acquire and as a result, it begs for leverage, which is directly related and impactful to cash flow. Fortunately, in the US there is an abundance of capital, and if you have good credit, you can obtain a mortgage to acquire real estate. If you don’t have good credit, chances are you will still find a mortgage but it will cost you more to service.
The goal of any real estate investor is to produce positive cash flow each month. Think of your mortgage like a partner who put up a big chunk of cash and reduced your risk, but you must pay them one month at a time until your loan is paid off. If you want to reduce your costs of financing, you may have to put more of your own capital at risk. In turn, this may reduce the allure of a real estate investment, as it becomes riskier.
CAP Rates = ROI
Cap rate is just another term for ROI or return on investment as applied to real estate. Cap rates allow you to compare the relative economic benefits of different real estate investments. It will indicate the efficiency of that investment. The calculation is Net Operating Income (without regard to depreciation – see next section) of the property divided by its Purchase Price. Sort of the equivalent to the P/E (Price/Earnings) ratio in the case of a stock.
As an investor, the more you have to pay for leveraging the investment, the less attractive the CAP rate of a real estate investment is, indicating a higher risk to obtain a reward.
Depreciation has the effect of reducing or sometimes eliminating otherwise taxable income. Since investing in real estate provides significant tax benefits in the form of depreciation write-offs, the theory is you can amortize the economic benefit of the long term investment over time, allowing you as an investor to recover due to its long term features. Real estate is the only investment that offers this benefit.
If properly positioned, real estate can offer attractive features to investors and belongs as an asset class in every portfolio.