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Your Wealth Creation Arsenal: The 7 Reasons Why Real Estate Is Your Essential Tool

May 24, 2008
Real estate (both residential and commercial property) is perhaps the best way for the average person to generate wealth. There are many reasons why real estate is such a brilliant way to fast-track your wealth plan and why it's so popular with those who want to become wealthy or are already wealthy. The key ones are:

1. Income and capital gain
2. Financial leverage
3. Low volatility
4. Below-market purchases
5. Add value
6. Ability to extract cash that is tax-deferred
7. Simple

Let's look at each of these advantages.

Income and capital gain:
Real estate offers investors the ability to gain on both income and price appreciation. Income comes in the form of rentals and investors' benefit from rental increases over times, which are usually in line with inflation or wage growth. This means that those who hold properties over the long term can experience significant increases in the income their properties produce, while mortgage payments remain constant.

Investors also benefit from the capital growth in the value of their properties over time, while their mortgage either stays the same (interest only) or reduces (repayment mortgage). This is usually a slow, constant growth rate that reflects increasing demand due to inflation and population growth. One of the wonderful things about capital growth is that it's unrealized income and as such you don't pay tax on it until you realize it...i.e. sell your property.

Financial leverage:

Financial Leverage, also known as gearing, allows you to control assets far beyond and much earlier than by using your own money. Real estate is quite unique in that those with money, namely banks, are more than willing to lend you their money for property investment. Turn on the TV, open up a magazine or walk down a main street, and you'll see ad after ad for financial institutions offering to loan you money for a home loan. When compared to all other asset classes, property stands alone. Why? Because banks consider property a low-risk asset.

The key benefit of gearing is that for every dollar you invest you control more assets...assets that are paying an income and growing in capital value.

Let's say you've managed to save $15,000 and you wanted to compare stocks and property as two investment alternatives to see how they stacked up. Well, for stocks your $15,000 would buy $15,000 worth of stocks as gearing is both difficult and fairly risky. For real estate however, it's quite simple to get 85% leverage on residential property, which would allow you to purchase a property worth $100,000.

Assuming that both stocks and property increase in value by 5% per year and the income from your property covers all your interest costs and running expenses (which it should if you've positively geared), how do they compare?

Both stocks and property have produced the same return on the invested capital. i.e. 5%. However, this does not represent the return that you receive on the cash you've invested. The return on your cash using stocks is still 5% as there is no gearing, but your return on your real estate is actually 33%. This is why a direct comparison of returns between stocks and real estate is totally pointless. You need to take into account the effects of gearing. Financial leverage is one of the key reasons why using property is so powerful since you can use OPM to multiply and fast-track your wealth plan.

Low volatility:

Volatility is generally considered the normal measure of risk. The wealthy do not agree entirely with this assessment of risk, but for the purposes of this analysis well stick with this version of risk (for the wealth creation view of risk visit the Risk category). If you were to compare the market index like the Dow, S&P, FTSE, All Ords, etc against property indexes over similar periods, property is far less volatile. But this hides the real truth...Firstly, what is the likelihood that an individual stock or property will follow their respective indexes? In the case of stocks, who knows! The average return of a market doesn't tell you anything about a particular stock's movement. Some individual stocks go up, while others go down. Compare this with property. If average prices of property have risen 5% over a year, it's pretty likely that an individual property will move fairly close to this average.

Secondly, prices in stocks can move every second the market is open. Again, compared to property, the prices tend to change far more gradually and consistently over time.

Below-market purchases:

Real estate is an incredible wealth building tool because it can be purchased below its market value. It's just not possible to buy below market value when you deal in bonds, stocks or commodities. There's just one market price.However, with real estate there will always be desperate sellers willing to sell their properties below market value. Why? The most popular reasons are:

* Need to sell quickly due to divorce or financial strain
* Tired and frustrated of the sales process
* Don't want the hassle involved in dealing with real estate agents and showing lots of people through their home
* Prior sale falling through
* Selling privately and lack of knowledge of their property's true value.

Add value:

Too many people walk into a property and are turned off by superficial problems. However, all often the problems are quite superficial and can be easily fixed resulting in enormous value and profit. You can visit your local paint shop and repaint the place or put in new carpet or wood flooring, replace the bathroom or kitchen, put in new lights and switches, clean and mow the yard, or any number of other things that will add far more value than the cost of the improvement. Property is quite unique in this regard. With stocks, mutual funds, commodities or bonds, it simply isn't possible to add any value to your purchase.

Ability to extract cash that is tax-deferred:

When a property increases in price, it's quite simple to re-mortgage the property and extract cash out of it to buy more assets to build your wealth. You don't pay tax on the money you've released because it's a loan (not income) and the interest on the loan is tax-deductible as long as it's spent on buying assets.

It's a common misconception that this is tax-free income. It's not tax-free but, rather, tax-deferred until you sell the property. If you don't sell, there's no tax to pay.

Releasing cash tax deferred is one of the most effective ways to build wealth quickly and efficiently. Thousands can turn into hundreds of thousands and hundreds of thousands into millions in a very short space of time. For example, if property were to double every 5 years and you had $15,000 in cash, then with 85% loan to value loans you could turn it into nearly $7 million in equity on a $45 million portfolio after just 15 years.

Simple:

Assessing and buying real estate isn't complex. We all know what makes a good residential property and what looks in need of some attention. Of course, things like structural surveys, etc. are for experts, but that's just a matter of hiring a surveyor. Local agents can give you the low down on what's in demand and what's not. Anyone can tell if a property is desirable to live in and as they say "practice makes perfect." With practice you'll begin to find not only the best properties to rent but also the ones that are being offered below market value.

Hopefully you'll agree that these 7 reasons make property one of, if not the, best method for the average person to generate enormous wealth
About the Author
Emlyn Scott is the founder of Rich1Percent , investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications and has amassed a multi-million dollar investment portfolio.
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