Why the Wealthy Invest in Rentals: 4 Key Reasons Explained!
When you hear the word "rentals," you might think of the single-family homes down your street. But did you know that "rentals" can mean much more? Rentals can be duplexes, multi-family homes, apartment complexes, commercial properties, office buildings, warehouses, or even storage units. The wealthy use these types of rentals to grow their wealth. By separating these 4 key reasons into quadrants, they can analyze their investment's potential. Plus, a bonus tip only the wealthy take advantage of.
Example:
Purchase Price: $100,000 (Home Value)
Down Payment: $10,000 (Initial Investment)
Mortgage: $90,000 (Principal)
Quadrant 1: Appreciation
Appreciation means that the value of your property has gone up over time. On average, property values in the U.S. go up by about 7% each year. Positive appreciation increases your equity, which is the amount of the property you truly own.
If the property value goes up by 5% in a year, the new value is $105,000. That’s a $5,000 gain from your $10,000 investment. This gain is tax-deferred or tax-free, making it a 50% rate of return!
Equity Gain: $5,000 from a $10,000 investment
Rate of Return: 50% (tax-deferred/tax-free)
Quadrant 2: Mortgage Reduction
When you pay your mortgage, you also pay down the principal balance, or the original loan amount. This is called mortgage reduction, and it increases your equity, and is more easily quantifiable than appreciation.
At the start of your mortgage, most of your payment goes towards interest, not the principal. Let’s say in the first year, you only reduce your principal by $2,000 making your principal balance $88,000
Equity Gain: $2,000 from a $10,000 investment
Rate of Return: 20% (tax-deferred/tax-free)
Quadrant 3: Tax Advantages
Like married couples and parents get more tax breaks than single or childless individuals, real estate investors get unique tax advantages. The main ones are depreciation and interest write-offs.
Even if your rental property makes money, these write-offs can create a “loss” on paper. This loss can lower your tax burden. For example:
W-2 Income: $100,000 (taxed at 20% = $20,000)
Real Estate Write-Offs: $10,000 loss (taxed at 20% = $2,000)
Your taxable income drops to $90,000, saving you $2,000 in taxes. That’s a 20% rate of return on your $10,000 investment.
Tax Savings: $2,000 from a $10,000 investment
Rate of Return: 20% (tax-free)
Quadrant 4: Positive Cash Flow
Positive cash flow is the money left over after all your rental expenses are paid. These expenses can include mortgage payments, property management, maintenance, utilities and more.
Let’s say after all expenses, you have $1,000 left at the end of the year:
Cash Flow Gain: $1,000 from a $10,000 investment
Rate of Return: 10% (tax-free)
Combining All Quadrants
Combining all four quadrants gives a total annual rate of return of 100% in our example. This means your $10,000 investment has grown to give you an additional $10,000 in ONE YEAR!
The Power of Leverage (Bonus Tip)
The secret to maximizing returns is leverage - using borrowed money to increase your purchasing power. Here’s why:
Faster Wealth Growth: You can save up for the first/next down payment faster and buy more properties sooner. For example, with a 100% rate of return, you could buy a second rental after just one year.
Higher Returns: Leveraging your investment means a higher rate of return compared to buying a property outright with cash.
Without leverage, your returns are lower. For example, if you bought the same $100,000 property with cash, your return might only be 10%. It would take ten years to save enough for another property. Plus, without a mortgage, you miss out on interest write-offs, increasing your taxes, and lowering your return below 10%.
The Wealthy would buy 10 of these example properties with that same $100,000 and have an additional $100,000 at the end of the year
Changing Your Mindset About Debt
It’s important to break out of the mindset that all debt is bad. When an investment, like a rental property, provides positive cash flow (income after all expenses), the leverage (debt) used to buy it should not be viewed negatively. This leverage (debt) helps you earn more money and grow your wealth. So, if an investment is making you money, its leverage (debt) can be seen as a useful tool, not a burden.
Equity and Taxes
Equity gains from appreciation and mortgage reduction are tax-deferred because you don’t pay taxes until you sell the property. If you never sell or use certain tax strategies, these gains can be tax-free.
Positive Cash Flow can be tax-free if your deductions exceed your rental income. However, if deductions don't cover all your cash flow, some of it may be taxed.
Final Thoughts
Investing in rentals can be a great way to build wealth, but it’s important to do your own research and understand the risks. Property values can go up and down, mortgages vary, and tax laws change. Positive cash flow can be affected by many factors, like vacancies and maintenance costs. Always do your due diligence before investing.
Disclaimer: This example demonstrates the four reasons the wealthy invest in rentals. It does not guarantee similar results for your investments. Market conditions, mortgage details, tax rates, and cash flow can vary widely. Always consult with a financial advisor before making investment decisions.
