Real Estate Investment
Why 5% Cash is Not King
Several colleagues and investors have recently asked, “Why should I invest in real estate when I’m earning 5%, risk-free, on my cash?" On the surface, this is a great point: Why take any risk when the most risk-less asset, US Treasuries, are paying similar returns to real estate? In this blog post, I'll explain why.
The Impact of Inflation
Holding Treasury bonds and federally backed money market accounts is considered risk-free because the US government backs them. The problem, however, is that inflation erodes the return. For example, when inflation was running at 10% annually, holders of 5% bonds were losing 5% of their real purchasing power; they were losing money. Now that CPI is +/-4% in San Diego (as of Sept 2023), and money market yields are in the 4.5% - 5% range (same as T-bills), investors are earning a paltry 0.5% - 1% in real dollars.
And there is no upside. Treasury bonds are locked until maturity, and money market yields will move with the market, but the principal invested will remain the same.
Real Estate as an Inflation Hedge
Let's explore why real estate can serve as an effective hedge against inflation. When you invest in a real estate asset, such as a rental unit or apartment building, during a high inflationary period, the value of that asset tends to increase along with inflation. This situation means you are earning a cash yield on your investment, and your equity is growing.
Let me give you an example. Imagine you buy a property for $1 million, utilizing a $500,000 loan and a $500,000 down payment. The property is cash-flowing at a 5% cap rate (yield before debt service). If inflation increases by 10%, the property's value could rise to $1.1 million within a year. As a result, your $500,000 investment would turn into $600,000 of equity. That's a 20% return on your investment and the 5% yield you're earning.
In addition, rents tend to increase faster than inflation (at least in San Diego). That 5% cap rate could turn into 6% - 7% - 8%+ yields over time.
Comparatively, Treasuries locked at their coupon yield have no opportunity for increases to keep up with inflation – of either the cash flow or the principal (equity) invested.
Let’s Talk About Leverage
The previous example shows one of the benefits of a leveraged investment (leverage in this context is another word for debt). The property’s value went up 10%, but because the investor’s down payment was 50% of the total purchase price, the return to the investor was double that – 20%. The bank doesn’t benefit from the appreciation in value; only the equity investor does.
All investors need to be aware of the downsides of leverage. For one, current mortgage rates are higher than the cap rate yields.* This results in negative leverage of the cash flow. That’s a more complex discussion, but essentially, it erodes annual return because the loan’s interest rate is higher than the cap rate yield of the property.
This is also why current loan-to-value amounts cap at +/-50% of the property’s purchase price, whereas in a low-interest rate environment, investors could get loans at +/-70% of the purchase price. When those loans had lower rates than the cap rate yield, the investors saw a boost in their cash-on-cash yields, and it was positive leverage.
Tax Advantages of Real Estate Investments
Another significant advantage of real estate investments lies in the realm of taxes. While Treasury yields are federally taxable, further eroding their after-tax real income returns, real estate investments offer various strategies to minimize or eliminate tax liabilities. For instance, cost segregation study allows for accelerated depreciation, and even simple straight-line depreciation can significantly reduce your taxable income. Depreciation is a non-cash expense used to offset the property’s income. It’s essentially a deduction on your tax returns.
Additionally, options such as 1031 exchanges allow for the deferral of capital gains taxes upon the asset’s sale. This means that even with a 4% or 5% yield on your real estate investments, your after-tax return can surpass that of Treasury investments. The tax advantages of real estate can significantly enhance your overall returns.
Is There a Place for T-Bills and Money Market Savings Accounts?
Simply put, YES. A well-diversified portfolio should include holdings of cash and equivalents, plus bonds, stocks, and other types of investments. Personally, I think of cash and bonds not as “investments” because they have no chance of equity appreciation -- they are safe havens currently paying an attractive yield compared to the <1% yields of the last several years.
Inflation decreases the real yield on bond and money market savings, whereas real estate participates in inflation, and investors may even benefit from inflation with enhanced returns. This, coupled with the potential for equity growth and the tax advantages offered by real estate investments, make real estate a far greater investment than high-yield savings accounts and bonds.
Remember, real estate investments are not without risks and require careful analysis and due diligence, particularly in a high-interest rate environment. We help our clients analyze these impacts to offer a pathway to long-term wealth accumulation and financial security. So, instead of 5% cash, explore the potential of real estate as a valuable investment opportunity.
*Cap rate can be defined as cash flow before debt service, divided by the purchase price. More precisely: Net Operating Income / Purchase Price. If one buys it without a loan, it is the measure of a property’s yield. The interest rate of the debt will then either positively or negatively impact the investor’s cash-on-cash return (cash flow after debt service, divided by the down payment amount).
Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial or investment advice. It is essential to consult with a qualified professional before making any investment decisions.
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