The Rich Person’s Guide on How to Build Wealth Through Property Investment
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Originally Posted On: https://www.dohardmoney.com/the-rich-persons-guide-on-how-to-build-wealth-through-property-investment/
I may be biased, but I firmly believe that there’s no better way to build long-term wealth than through real estate. Investing in real estate provides multiple profit paths and the incredible benefit of using debt to finance deals. Having said that, people considering this path often ask me how to build wealth through property investment.
With money, investing in real estate is easy. But, the challenge for most investors is building that initial capital. By following a series of investment strategies, new investors can raise money and increase experience. Next, you can purchase your own properties to start building long-term wealth.
In the rest of this article, I’ll explain how – even without a ton of money – investors can build serious wealth with real estate. Specifically, I’ll dive into the following topics:
- An Overview of the Wealth Building Aspects of Property Investment
- The Challenges of Traditional Financing
- Hard Money Loans as a Partial Alternative to Traditional Financing
- Step 1: Save Cash and Gain Experience by Bird Dogging and Wholesaling
- Step 2: Grow Your Capital and Rehab Experience by Flipping Houses
- Step 3: Build Long-term Wealth Investing in BRRR Properties
- Step 4: Building Wealth through Private Lending
- Tax Planning Considerations and 1031 Exchanges as a Property Investor
- Final Thoughts
An Overview of the Wealth Building Aspects of Property Investment
Before getting into the nuts and bolts of different real estate investing strategies, I want to first provide a broad overview of different real estate profit paths. When investors understand how real estate creates wealth, they arm themselves with the knowledge to build the best investing strategy for their unique situation and financial goals. With that said, here are the major ways that investing in real estate builds wealth:
Property Investment Profit Paths
- Cash flow from rents: With a properly analyzed deal, investors will collect excess cash flow from a rental property every month. Depending on your wealth-building priorities, you can use this excess cash flow multiple ways. For example, to build your rental property portfolio, you can set this money aside every month until you have enough for another down payment. Alternatively, you may want to diversify your savings and use this cash to invest in stocks, bonds, and mutual funds.
- Loan amortization: When investment property tenants pay rent, that money pays your mortgage. With an amortizing loan like a mortgage, a portion of every payment reduces your loan balance. As your loan balance decreases, your equity – or ownership – in the property increases, building your overall wealth.
- Property appreciation: Property investors also benefit from long-term property appreciation. While home values may fluctuate in the short-term, if you hold for an extended period, you’ll likely benefit from property appreciation, or increases in value. As the values of your property investments increase overtime, your net worth builds with them. This relates directly to a wise saying related to property investments: don’t wait to buy real estate; buy real estate and wait.
The Wealth Building Advantages of Leverage
In addition to loan amortization, the concept of leverage (i.e. borrowing money to purchase a home) also significantly increases your return on investment. I’ll demonstrate with a basic example.
Assume you can buy a rental property for $250,000, and it generates $15,000 in net operating income every year. If you paid all-cash for this property, that would translate to a 6% return on investment, or ROI ($15,000 / $250,000). But, what if you instead used a mortgage with a 20% down payment to purchase the property? That would mean you invested $50,000 in cash and a $200,000 loan to buy this property.
Now, your loan payments would cut into your cash flow. But, you’d also increase your ROI. Assuming a 3.5% interest rate and 30-year term on that $200,000 mortgage, you’d have annual debt payments of ~$10,900. As such, your annual cash flow would now be $4,100 ($15,000 NOI – $10,900 in debt service). This translates into an 8.2% ROI, 2.2% higher than an all-cash deal! ($4,100 / $50,000 down payment).
And, in addition to the higher ROI with a leveraged deal, you also gain two other great benefits. First, you gradually build wealth through that loan’s amortization, as outlined in the above profit paths. But, more importantly, you can now use the remaining $200,000 for other deals. Instead of buying one property for $250,000, you can buy five $250,000 properties, each with a $50,000 down payment. With this approach, you’d then own $1.25 million in real estate!
Yes, these are simplified numbers, but the important takeaway is the concept: using debt to buy real estate increases your ROI. And, by extension, this leverage speeds up the process of building long-term wealth.
The Challenges of Traditional Financing
Having explained how property investments can build wealth, I need to throw a wrench in things. Unfortunately, the above approach of using traditional mortgages includes three major challenges. First, investment property mortgages require a down payment – typically 20% to 25%. From the above example, you’d need $50,000 cash to finance a $250,000 rental property. That’s a lot of money! And, most new investors just won’t have that sort of cash sitting in the bank.
Second, to qualify for traditional mortgage financing, you need to have solid financial health. In particular, you need to have a strong credit score, regular income, and a low debt-to-income ratio. Once again, many new investors won’t meet these criteria.
Third, traditional financing comes with specific property requirements. Due to the fact that a home serves as collateral for the associated mortgage, lenders will want to confirm that the home is in good condition. In other words, it can’t be a distressed property in need of major repairs. But, many real estate investors purchase homes that do need these major repairs, meaning that these target properties wouldn’t qualify for a traditional mortgage.
Bottom line, before investing in properties with traditional mortgages, you’ll need to have A) cash, and B) outstanding financial health. And, with respect to the properties themselves, only ones in good condition will qualify for these mortgages.
Hard Money Loans as a Partial Alternative to Traditional Financing
Fortunately, an alternative financing path exists for investors who don’t meet the above requirements for traditional mortgages: hard money loans.
Hard money exists as an alternative to the above traditional financing. And, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional lenders require minimum standards with the borrower’s financial health. Hard money lenders don’t concern themselves with this. These lenders look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
This system provides real estate investors two key advantages. First, you can secure a hard money loan even if you don’t have a great credit score and/or enough cash for a down payment (but, lenders likely won’t work with you if you have bankruptcies or judgements in your credit history). Second, you can use hard money loans for distressed properties, making them ideal for fix & flip investors.
Traditional lenders want to confirm that, if foreclosed upon, a property will cover the loan balance now. Hard money lenders assume more risk. They lend based on what they believe the property will be worth in the future. While each hard money lender offers different terms, at Do Hard Money we’ll lend up to 70% of a property’s ARV. As such, if a borrower fails to successfully rehab a property, hard money lenders need to recoup their outstanding loan balance with a distressed property sale. And, selling a property in the middle of a repair likely won’t pay off the outstanding loan balance, as the loan was based on what the property would become.
Due to this increased risk and the shorter term nature of hard money loans, they have higher rates than traditional mortgages. Depending on your investing history and the quality of the deal, you can expect an interest rate from 7.99% to over 15%. However, investors can also close these loans extremely quickly. Traditional mortgages typically require 30 to 45 days to close. You can close a hard money loan in 10-15 days.
How to Build Wealth through Property Investment
Eventually, successful real estate investors will need access to traditional financing. If you want to own a rental property while getting the above ROI advantages of leverage, there’s just no avoiding this fact. But, hard money serves as an outstanding tool for A) getting your foot in the real estate investing door, and B) financing the rehab of properties that don’t initially qualify for traditional mortgages.
And, during the journey from novice to wealthy investors, I recommend taking a certain progression. As stated, you need cash and good financial health to eventually own rental properties. By following the below steps, you can put together enough cash to buy rental properties while taking the time to gradually improve your credit score and overall financial health.
Step 1: Save Cash and Gain Experience by Bird Dogging and Wholesaling
From a wealth-building perspective, bird dogging and wholesaling will help in two main ways. First, you can use the proceeds from these deals to put together cash for future property investments. Second, when you act as a bird dogger or wholesaler, you learn how to analyze deals, a skill that will be critical to successful property investments.
Bird dogging offers an awesome, low-risk way to get your foot in the real estate world. And, it doesn’t require any capital. To make money, you’ll absolutely need to work hard and learn a lot. But, if you make a mistake on a deal, you won’t lose tons of invested money in the process.
Here’s how it works. A lot of real estate investors make money through wholesaling, which I’ll discuss next. But, in a nutshell, wholesaling requires investors to find deals to bring to other investors. While the wholesalers themselves can certainly do this searching legwork, they often pay other people – bird doggers – to do it for them.
Bird doggers spend their time looking for a certain sort of deal. They want to find distressed properties that won’t qualify for traditional financing. In other words, traditional mortgage lenders want to make sure a house is actually habitable. Bird doggers look for properties that don’t meet this standard. Next, the owners of these properties need to have A) some equity in the property, and B) some reason for wanting to sell – often to turn that equity into cash.
As bird doggers find leads on situations like this, they pass them along to wholesalers for a fee. They may receive a fee for every lead, or it could be a contingent payment based on the lead actually converting. It ultimately depends on the relationship you have with a particular wholesaler. But, regardless of payment structure, bird dogging provides you an outstanding opportunity to gain some real estate investing experience with little to no barrier to entry.
Once you’ve bird dogged for a while, you can make the jump into wholesaling properties yourself. This investment strategy lets you make money without needing to actually purchase properties. As a result, it represents a great approach for new real estate investors working on gaining experience.
As stated, with wholesaling, you don’t purchase an investment property. Instead, wholesalers find off-market properties, and they enter contracts to purchase these properties. Rather than close on the purchases, they assign the contracts to a third party, typically a fix & flip investor. And, they assign these contracts for a fee. As such, wholesalers find deals, connect the sellers with investors, and collect a fee in the process – all without dealing with the headaches of doing any rehab work themselves.
When you wholesale, you learn very quickly how to spot good deals for fix & flip investors. If you don’t find good deals, you won’t be able to assign contracts to these people. Simply put, you learn what to look for in a property. Additionally, you have to work closely with house flippers. This gives you the added benefit of learning from them. Pick these people’s brains. They have tons of experience, and you can learn from it. Lastly, wholesaling puts money in your pocket. If disciplined, you can allocate a portion of these funds for a down payment to purchase your own fix & flip property.
Step 2: Grow Your Capital and Rehab Experience by Flipping Houses
The above strategies will give you the cash and experience to make the jump into house flipping. That is, as a fix & flip investor, you need to understand everything wholesalers do about finding good deals, and you need to have some cash (though not as much as a traditional down payment would require). But, you also need to understand how to rehab and sell these properties. Broadly speaking, the fix & flip strategy works like this:
- Step 1, Find a distressed property: Investors need to find properties that need rehab work to qualify for traditional financing. And, these properties need to make financial sense. That is, the purchase price and all rehab-related costs need to be less than the projected final sale price to make a profit.
- Step 2, Rehab the property: After purchasing a distressed property, house flippers need to renovate it to a standard that A) qualifies for a traditional mortgage, and B) appeals to potential buyers in that particular market. This requires an in-depth understanding of renovations, working with contractors, and creating accurate rehab budgets.
- Step 3, Sell the property: Finally, house flippers need to sell the property. Typically, these investors sell to primary homebuyers. That is, they sell to people looking to buy their home – not an investment property. This requires an understanding of sales and pricing strategies, and a solid analysis of the local market.
The above provides a simplified overview of the house flipping system. However, it should be clear – this strategy takes far more knowledge and experience than bird dogging or wholesaling. But, it also provides investors far greater returns. And, during the house flipping process, you’ll inevitably make mistakes. As you work through a few deals, you’ll quickly gain a tremendous amount of experience.
But, there’s also a major flaw to the fix & flip strategy when it comes to building long-term wealth. Once you stop flipping houses, you stop making money. In other words, this strategy doesn’t provide investors access to the three primary profit paths in real estate: 1) regular cash flows, 2) loan amortization, and 3) property appreciation. As a result, building wealth through property investment depends on taking the cash and experience from flipping houses and jumping into the next strategy.
Step 3: Build Long-term Wealth Investing in BRRR Properties
After gaining experience in the fix & flip world, investors who want to truly build long-term wealth usually make the jump into the BRRR strategy. This requires all of the experience and knowledge of flippers, but now you also need to understand property management and permanent financing. Here are the steps that make up the BRRR strategy:
- Buy: Investors buy distressed properties – ideally at a deep discount – in need of major repairs. As such, BRRR investors largely look for the same properties as fix & flip investors.
- Rehab: Investors then rehab the property. However, they don’t rehab it to sell it. Rather, they do their renovations with an aim to appeal to renters. Rehabbing a rental property usually means picking far more durable materials than if rehabbing for sale. You’ll need materials that can handle the wear and tear of multiple tenants. And, you don’t want to have to complete repairs every year. This rehab leads directly into the next step of the strategy.
- Rent: Once you’ve completed the renovation, you need to market the property for rent and secure quality tenants. You can certainly hire a property manager to do this. This saves you a ton of headaches, but it also costs money. And, from an experience perspective, I recommend investors manage at least one of their own properties. This provides you a solid understanding of the leasing and property management process, and you’ll be better positioned to hire and supervise property management companies down the line.
- Refinance: Once you’ve rehabbed the property and signed a tenant lease, you can refinance the property. Typically, BRRR investors (and flippers) use hard money loans to finance a property purchase and rehab. However, these loans have high interest rates, as they’re designed for short-term investment use. Once a property meets traditional mortgage quality standards and is rented out, you’ll want to refinance into a traditional mortgage. This new loan will pay off the outstanding hard money loan.
As these steps illustrate, BRRR investing requires all the experience and knowledge of flipping homes, with two additional wrinkles. These investors need to understand property management, and they need to have a better grasp of real estate financing. The success of the strategy hinges on refinancing, so that’s crucial knowledge.
However, while requiring more experience, this strategy also provides more profit. With a house flip, you have one-and-done profit. That is, once you sell a property, that’s how much you make – for better or worse. BRRR investing creates long-term wealth. In addition to profiting up-front by pocketing a portion of your refinance proceeds, you continue to make money in three ways.
First, you pocket any rent payments in excess of operating expenses and debt service. Second, you gradually build equity in the property as your tenants’ payments pay down the amortizing mortgage. And, third, houses appreciate over time. While they may fluctuate in the short-term, over time (especially a 30-year mortgage horizon), home appreciation historically has outpaced inflation.
Step 4: Building Wealth through Private Lending
I’ve known many investors over the years who have built a tremendous amount of wealth by focusing on the BRRR strategy. But, if you’d like to continue building this wealth – without the rehab and tenant hassles of BRRR deals – another, more advanced strategy exists: private lending.
This final step in the real estate investing progression requires expertise in all of the previous strategies. Once investors understand these systems, they often decide to become hard money or private lenders. Of note, both of these lenders function similarly, but hard money lenders act as formal businesses, whereas private lenders act as individuals.
At face value, lenders appear to do far less work. And, in some ways, they do. Lend money, sit back, and profit. But, to do that successfully, you need to have an in-depth understanding of how to analyze deals. Lenders only make money on successful deals. If you lend to anyone for any deal, you’ll fail. As such, before issuing loans, these lenders need to fully analyze a deal – the same way they would as a fix & flip or BRRR investor. However, now the loan interest is their income not expense.
But, lenders need to know more than just analyzing deals. They also need to understand the legal, administrative, and financial requirements of originating and administering loans. And, unfortunately, part of this means understanding the foreclosure process, as well. Proper up-front due diligence mitigates the likelihood of a borrower foreclosure. But, sometimes a series of unfortunate incidents leads to borrower default. As a lender in this situation, you need to be prepared to execute foreclosure procedures to recoup as much loan principal as possible.
Tax Planning Considerations and 1031 Exchanges as a Property Investor
In a discussion about building wealth with property investments, I’d be remiss to not mention tax planning considerations. That is, savvy investors don’t just analyze investments – they also analyze the tax impacts of those investments. This is particularly true with rental properties.
When investors sell a property they’ve held longer than a year for more than they purchased it, they trigger a capital gains tax. Assuming they sell after a year of holding a property, the profits will be taxed at long-term capital gains rates (0%, 15%, or 20%, depending on income levels). These taxes can take a huge chunk out of your profits – and overall wealth.
And, these investors will also have to pay a tax known as depreciation recapture. Every dollar you deduct via depreciation over the life of your property will be taxed at a 25% depreciation recapture rate on sale. For instance, if you’ve deducted $100,000 on a property during your ownership, you’ll need to pay a depreciation recapture tax of $25,000 – in addition to the capital gains tax on any proceeds above your original cost basis (normally the purchase price plus rehab costs).
However, the IRS offers an opportunity to defer – or delay – these taxes. Using a technique called a Section 1031 Like-kind Exchange, investors can sell one property and roll the taxable basis into another property. This means you don’t need to pay these taxes until you sell that next property (or defer them again by doing another exchange).
NOTE: Section 1031 Exchanges come with strict compliance requirements. If you don’t follow them, you will likely trigger a current tax bill. Be sure to work with a 1031 expert if pursuing this strategy.
Real estate is an outstanding path to building long-term wealth. And, even if you don’t initially have a ton of extra cash or a great credit score, following the above steps will allow you to reap the wealth-building benefits of property investment.
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