Most people know that real estate creates wealth. But what makes real estate different from other investments is that it happens in four distinct ways. Today we are going to discuss the four different ways real estate generates wealth for the investor.
The first wealth generator from real estate is cash flow. Cash flow, or more specifically net cash flow after debt service, is the cash flow from operations that is left when all revenues have been collected and all operating expenses have been paid, and all debt service has been made. Whatever's left over, the net cash flow to the investor is the first generator of wealth.
The second wealth generator from real estate is appreciation. Appreciation is the amount that the asset has gone up in value, which is determined by, of course, the sale price minus the original purchase price. Appreciation can be significant in many cases, and is often the greatest driver of wealth out of the four.
The third generator of wealth in real estate is principal paydown from leverage. Principal paydown is when the loan that is used by the borrower to acquire the real estate balance is paid down by the cash flow from operations. Effectively, the investor receives more money at the beginning than they owe at the end, and the difference adds to the investor's wealth.
Finally, the fourth generator of wealth in real estate, which can be quite significant, are the tax benefits. Deductions for interest expense, non-cash expenses such as depreciation and amortization can be extremely beneficial; especially to investors who are looking for ways to offset other income. When all four of these wealth generators from real estate are combined, it's not uncommon to see internal rates of return well over 20-30% in real estate.
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Trevor T. Calton, MBA is the founder of Real Estate Finance Academy and President of Evergreen Capital Advisors. Since 1997, he has analyzed, acquired, or sold more than $5 billion of commercial real estate assets, financed over 500 commercial investment properties, and overseen the asset management of over 6000 units of multifamily housing.