In this Episode, David and Mike talk about why they love investing in Rental Property. They break down all the advantages of investing in Rental Property and real estate in general. Some of the items that are discussed are the tax benefits of owning Real Estate. How Leverage can help you acquire more assets faster. The difference between good debt and bad debt and how rental properties are good debt if managed properly. Value of Real Property and how over time you can expect some appreciate on your real estate. The extra money that is left over at the end of each month which is called Cashflow. And last but not least wealth creation AND Freedom!
David: Alright guys, welcome back Discount Property Investors, this is David Dodge, and co-host--.
Mike: Mike Slane, hey guys, been a while. Dave and I have not been super consistent on the podcast, but we are looking forward to our next topic, we are going to dive in pretty extensively into what we have been up to. You guys know us as wholesalers, and we love that you guys know us as wholesalers, and we love that you guys know us as wholesalers, we are happy to share that information and help you guys do wholesale deals. Obviously you can check that out at freewholesalecourse.com, that is our favourite little baby I'd say, that we have put out there for the world. We have got how many people? 5000 or so? Hundreds of positive reviews, and again-- when somebody asks us out to coffee, it's our way of saying check this out first, then I am happy to chat with you. You want to get them up to speed on what this wholesaling thing is. So anyways, we love wholesaling, but we also-- we see it as a job. What we are passionate about now is-- well wholesaling real estate in general, but we are building a portfolio of rental properties for ourselves. We are really excited about the way that we are doing it. We did not invent this, we are just following the model and we want to share that with you. So today we are talking about, Dave, diving into BRRRR.
David: Diving into BRRRR. Why rentals?
David: So everybody gets into real estate, and everybody finds out there is no freedom in real estate. They get into real estate because they want the freedom I should say, then they start doing real estate and it's hard work. You are constantly busting your ass to get a deal and make money. So why rental property? Rental properties allows you to invest in real estate and get the freedom, okay? Most people don't get that, there isn't a connection there. But you get freedom through rentals, and it's maybe not freedom today, but it will give you freedom later in life. If you get enough rentals you can have freedom today. It's all about the cash flow and everything else.
Mike: The freedom aspect of it is what's really funny, because we actually-- we are refining some of our rentals. One of the bankers was-- he is happy, he has done 10 or maybe 15 loans for us. But he said, yeah you guys are not getting rich off this one. I just kind of sat there and smiled. I was like, you are absolutely right, but we have 40 of them or whatever.
David: You are absolutely wrong is what I was thinking.
Mike: I was--.
David: Rich is the wrong term.
Mike: I am not trying to get rich off this.
David: You might get wealthy over the next 15 years off this thing.
Mike: It's just that mind set, like people just don't quite understand that 300 bucks a month that we are going to cash flow on this property, it is going to make us rich, it is going to buy us that freedom. Like that is-- 300 bucks every month forever just about. Then way more once we pay off that loan. So it's pretty exciting and we love-- yeah we just love rentals. So again, that's your freedom. It's not one rental, it is probably ten. Ten paid off and you are going to be rocking. Again, I don't know what your freedom number is, and we can delve into that later.
Let's talk a little bit more about why rentals? One, that freedom right, Dave? We love that freedom. Let's talk about the tax benefits, right?
David: Multiple tax benefits.
Mike: You don't get those tax benefits necessarily when you are wholesaling.
David: That's true.
Mike: Wholesaling you are generating a good chunk of change, which is awesome, everybody loves a good pay day. But you are going to have to pay income taxes on that for the most part. So again, what are some of the deductions Dave that we see-- when we own rental properties? Let's talk about that.
David: Let's talk about the deductions and the tax deductions. So--.
Mike: How the tax benefits you.
David: How it benefits you. So you have deductions. The biggest deduction is going to be your interest on your loan. Most people are buying rentals with mortgages on them. That's what we teach our students to do as well. All the interest that you pay to the bank, the mortgage company, you can write that off as a deduction on your taxes. All the repairs that you make on that home you can write those off. If you are travelling to and from that property, you can write that off. You can write off a small portion of that home that you live in to have a home office. Then the biggest deduction in my opinion is kind of a hidden one, and it is called appreciation. So in the State of Missouri where we live we can depreciate the property one over 27 and a half years. The reason why it is one over 27 and a half is because two law makers argued how long it should be, one said 25, one said 30, and they said let's meet in the middle.
Mike: I did not know that. Is that national or is that just Missouri?
David: It could be national, we will look into that. But I know for 100% fact it does that in Missouri. So that's what you do; you take the value of what you paid for the property, not the value I should say, you take the cost of what you paid, what you have invested into that property, and you divide that by 27 and a half, and every year you get to deduct that from your taxes. So why is that important? Well, this benefit-- let's say you buy a rental for example. You get to do all these new deductions, alright? For having this rental, and you have interest, repairs, travel, a home office, depreciation etc. Let's say the income on the property was less than those deductions. Well you can then offset other income that you make by owning real estate. So having real estate can actually save you money in taxes versus increase it. So that is an asset that you buy that not only makes you wealthy over time, we are going to get into the how right next, but it can actually save you money every year on your taxes just by owning it.
Mike: It's pretty cool.
David: Very cool.
Mike: That brings up another thing that Dave reminded me of, which is one of the coolest things about it, or two of the coolest things about it rather. When you pass away--.
David: More tax benefits.
Mike: You are able to transfer this to your heirs.
David: So it doesn't matter if you have the home in a trust, doesn't matter if you have it in an LLC. Anytime you own a piece of real estate, and you die, and you pass that real estate on, I believe that the way that it works with the current laws of inheritance are-- you own that property and the new value of it is the basis, the basis resets. So whatever the current value is-- that is what you start your taxes as. You only pay taxes when there is a gain. Let's say you bought a piece of property, and you owned it for 30 years but you depreciated over the first 27 and a half years. At the end of that 27 and a half years you can not longer depreciate that property on your taxes, because you depreciated it to zero. If you were alive and wanted to sell it, your new tax basis is a lot lower. So your profit would be zero to that number, it wouldn't be what you paid for it plus that number. So that is the only down side to depreciation.
Mike: All this tax stuff, we are talking about all these tax benefits. You definitely want to have a CPA help you with this. We are not professionals in this, we have CPA's.
David: We have multiple CPA's.
Mike: -- with all of our taxes because-- again we are just talking in general what-- why we like real estate and what they help us do.
Mike: So the [00:08:36.17 - inaudible] to that though is the 10-31 exchange.
David: Yes! I love me the 10-31 exchange.
Mike: Again, completely forgot about this one, so a 10-31 exchange essentially-- let me pull up a little cheat here. It's a way to defer your recognition of that capital gain. So you buy the property-- or you sell that property that you depreciated, and if you invest that income into another property, you are able to defer that gain. That is essentially--.
David: Let me say one thing. This is a law that the IRS wrote, so they are basically telling you how not to pay taxes. The tax law, look up how many pages in the United States tax law.
Mike: A lot. Do you want me to do it?
David: Yeah please. I want to say it's 27,000 or something like that. Here you go.
David: 73,954 pages of tax code. Here's a little secret, guys. A little secret, alright? Only about five of those pages tell you when you need to pay and where, okay? Everything else is a law to defer tax or to avoid it, okay? That's all these pages are, alright? So, back to--.
Mike: The 10-31 exchange is what we were talking about.
David: Oh the 10.31. So this is created by the government. What it does is-- it allows you not to pay taxes on a gain. So back to what I was going with was all this tax code, right? Well taxes are written by the rich to protect the rich, okay? That's the only reason you have taxes. Now, taxes are something the government takes from you to help support the infrastructure, right? So they tax income, this is very important, they tax income. They do not tax wealth, okay? So if you are able to create wealth, you don't have to pay any tax. If you want to sell that wealth and realize it you get income. That's taxed, so income is taxed, okay? That's-- I wanted to go with that. So to avoid getting taxed on your income, you can use a 10-31 exchange. Essentially a third party holds your money, a title company, a lawyer, or a 10-31 exchange company will hold your money, then you can go buy another asset with it, and not pay those taxes. So it's a way to defer it, love it.
Mike: Pretty clever. Yeah so those are some of the tax benefits of owning real estate or rental properties essentially. The next topic would be leverage. So why do we like rentals so much? You can leverage them.
David: Mike, when was the last time you walked into a bank and said, I want to borrow 100 grand and I want to invest it into Microsoft and Apple stock?
Mike: I've tried and they pretty much say no every time.
David: They say no.
Mike: It doesn't happen.
David: Doesn't work that way.
Mike: Again, you could get a credit card maybe, get a cash advance.
David: That is a pretty significant asset, owning a share of stock in a major Fortune 500 company.
Mike: Banks are not going to lend you the money.
David: Banks don't care about it, but banks lend on real estate which is good for us.
Mike: Why is that? I think it is because it is a real asset, there is something tangible there. It's what they do, right?
David: It's very unique. These companies can issue more stock, you can't create more land unless you like in Dubai. Then they build--.
Mike: Or we make it to Mars. We might be there--.
David: But in our current state you can't build more land. There is only so much United States of America. Can't really make more of it, okay. The banks will use that as collateral and they will loan to you, and they will give you loans, sometimes up to 100% of what you have invested.
Mike: How do you leverage your money though, Dave? The way that you do that is-- well let's talk about a conventional mortgage. So a conversion mortgage let's say the property is $100,000, jusr for easy math, and you wanted to buy that, well if you put all $100,000 into that property you could do that, and you would have zero leverage on it, zero-- you would have all your money tied up, and none of any one else's. But a conventional loan, let's just say it's at 20%, you have to bring 20% to the table. Of that $100,000 house, then you only have to bring $20,000. So that means you still have $80,000 in your pocket to either spend or to invest. So with that same $100,000--.
David: You can acquire an asset for a small percentage of what you would actually have to pay. Somebody else will help you pay it.
Mike: Let's just use the $100,000 example. I could then go out and buy four more houses. I could buy five houses with that same--.
David: -- 80% financing on each one, absolutely, love that.
Mike: How much asset do I control at that point? I control half a million dollars worth of assets with my 100,000, leverage that out. Yeah that's essentially what you want to do with real estate, especially when markets are going up. Everybody loves it.
Mike: Leverage out that money, it's cheap money, get as much of it as we can. Our goal--. Nice, that's right. Yeah again, so you want to leverage out your money as far as possible right now, that's what we are doing, we are trying to get as much debt as we can.
David: But it's good debt, absolutely, it's not bad debt. So let's get into why it's good debt. So-- let's come back to this one. We have good debt and we have bad debt, so let's talk about this. Bad debt is debt that you have to pay, that's how I look at it. Good debt is debt you have but you don't pay it, someone else pays it for you, alright? So you are paying it off, but you are not going to have to work for that money to pay it off, you are just waiting. So you are trading time for wealth. Again, we talked about this earlier, you are only taxed when you have income, you are not taxed whenever you create wealth. So the name of the game is to create wealth.
Mike: Yeah baby. Wealth is where it's at. You don't-- I'd rather be wealthy than rich.
Mike: Wealthy is the way to go. So wealth creation. Dave mentions this so we talk about real estate in this, and it is one of those-- gosh I wish I remembered the quote. Real estate is like the number one asset that has created more wealth, more millionaires than anything else. Do you know what I'm talking about?
Mike: That's why real estate is very exciting to us. So you have an asset that typically is going to depreciate, and if you leverage that asset you are going to have a loan on it. But, if it's a rental property you are going to have someone else paying down that loan for you, and on top of that you are going to make cash flow. So they are going to pay that note down for you, I mean obviously they are paying you and you are going to pay the mortgage. But they are paying down that mortgage for you, and you get to keep a little extra money for that privilege of owning real estate.
David: That extra money is called cash flow, that's awesome.
David: Absolutely. So let's come back to cash flow. What about the value of these properties that you're buying? The whole deal here is buying rentals. So we are going to go out and buy a rental, we are going to get tax benefits, we are going to use leverage from the bank, then we are going to talk about depreciation now. This asset in theory is going to be worth more at a later date. It's not guaranteed, and you are going to have to upkeep the property to keep it in the same condition if not better when you sell it to get depreciation. You can't let the house fall apart, it doesn't work that way.
Mike: That's a really good point.
David: You have to keep the maintenance up for depreciation to even be a factor. However, if you maintain the house properly, one could say that over time the value of that house will increase, and it will increase for several reasons. One being just inflation in general. When your dollar has a lower buying power, typically things cost more and they have more value. That's one way, alright? Another way is again like we talked about earlier is scarcity of land. You can only build on so many feet until there is no more left, alright? So over time you have depreciation. Mike, jump in and tell us a little about depreciation.
Mike: Absolutely. So I wanted to touch on NAR, the national association realtors. They published some data about the rising prices. This was from 1968 until about 2004, the average price increase was about 6.5% during this period. They said there was not a single year of decline. So again, historically housing prices go up. We all know what happened in 2007-2008, we had that bubble and a big crash. Well since then we have seen-- we saw the real estate market stumble, then it picked up again.
David: Did you say it increased 6.5%?
Mike: Yeah annually.
David: From 1968-2004?
Mike: Yeah, a 36 year period, 6.5% gain. Again, we plan on our assets depreciating, but to us the cash flow is first, that is our favourite part of it. The depreciation is really just icing on the cake, and that's a shout out to Jason Hartman, I like his creating wealth podcast. So I am going to throw him a little plug there. That's what he says, he says, cash flow is key, depreciation is the icing on the cake. I couldn't agree more, that is the way I look at it as well, I really couldn't even care about depreciation, because it is not guaranteed.
David: It's not guaranteed. However-- and you have little control over it. But another thing too, don't forget in order to even have a chance as depreciation, you have to maintain that house. That house needs to be in good condition when you sell it. If it is falling apart or deteriorating from lack of maintenance, you should not expect any depreciation. That is why we buy houses all the time that--, they are not any depreciation because they have let those houses go. That's how we find deals, by finding people who have let houses go, they get none of that. What's next on that list then?
Mike: So the next one on the list-- the cash flow. So cash flow, we want to talk about a couple of things. How we calculate cash flow, and how other people do it.
David: There are a lot of ways to calculate cash flow.
Mike: Again, I think we just like [00:19:39.03 - inaudible] method, keep it simple. Again there is no reason to over complicate thing. When we look at our cash flow, we have a little formula and we can share this with you guys. But we basically look at what the property is going to rent for, what our mortgage is, and I include our insurance and taxes in that. What our property management is, and then we include a little vacancy and maintenance, usually about 10% for that for reserves. That's how we calculate cash flow, that's what is important to us.
David: That's exactly right.
Mike: I don't know, do you want to add anything?
David: That's all there is to it. To look at the 10,000ft view, all cash flow just means the difference of what you have to pay, and what you receive. So you just can't forget to include all those things you have to pay, because sometimes those costs might not even be a cost, but they will just be a lack of income, hence vacancy. So yes, Mike, I love it, you nailed it, man.
Mike: It's pretty easy, so then-- how do other people do it? So there are all sorts of phrases, and we are going to talk about each of those a little bit. The cash on cash return. So, Dave?
David: Cash on cash is awesome. Your cash on cash return goes up with leverage. That's beautiful, okay? So leverage is tied to cash on cash return. So if I invest $100 into an asset and I sell it a year later for $200 with no loan, okay? I have 100% cash on cash return on that example. Now if I get a loan for $80, and I invest $20, so I am getting a loan like I would on a house, and I have an asset worth $100 now but I am only in it for 20, and a year later I sell it for $200, and I am only in it for 20, I pay back that 80 and I now have 120. So I didn't just got from 20 to-- lost my train of thought.
Mike: It's all good, we get the concept. Again, the other way you can look at it is-- your annual cash on cash return if you calculate looking at the rental income. So say same example, if we put the 20% into it, and we are realizing say 5000 annually from that property. That would be 5000 over that 20,000, or 25% cash on cash return.
Mike: So different ways to look at it. So that's your cash on cash return.
David: A lot of people use cap rates too, man. Cap rates are big in multifamily or commercial properties.
Mike: So let's talk about cap rates, man.
David: I am not a big fan of using cap rates.
Mike: I don't like them.
David: But people use them, they use them a lot.
Mike: The big boys use them.
David: Yeah I guess you would say that.
Mike: I am just a small fish, you know?
David: I guess if you're dealing with a lot of money, really you are looking for just a simple ratio. I think this is a pretty simple ratio. But the capitalization rate, or cap rate for short, is commonly use in real estate and refers to the rate of return on a property based on the net operating income that property generates. In other words, a capitalization rate is a return metric that is used to determine the potential return on investment or payback of capital. That's that the cap rate is. So, your cap rate basically equals your net operating income over your current market value of the asset, a small ratio. So cap rate equals NOI, net operating income over the current value of that asset. I think it's kind of silly, man. People are always saying, oh it's 14 cap, it's an 18 cape
Mike: The problem is that--.
David: Some of these big firms will buy out a six or an eight cap, the lower percentages.
Mike: Well there is different-- they care--.
David: They just don't need that higher return.
Mike: They have different goals. I would say ours is wealth, conservation or preservation as opposed to creation. So again, when you are looking to invest assets and maintain them, then yeah those lower caps rates and steadier more stable investments make sense. When you are like us and you are trying to create wealth, it is definitely time to maybe kick the cap rate to the side and focus on your cash flow. Just makes more sense for somebody that is starting out, again like I said, I'm a small fish, it's the way I like to see myself, and I like to focus on cash flow. I understand it, it makes sense to me.
David: Cash flow is easy.
Mike: That's cap rates again, we pretty well ignore them, it doesn't make it the right thing to do, but again, as a single family investor-- I wouldn't get caught up in cap rates, I wouldn't focus on that, I think that's-- you're spinning your wheels. Focus on the cash flow you are going to make from that asset day one.
David: Let's recap, guys. Why rental properties? We have tax benefits and lots of them, we can use leverage with the bank to buy properties that we might not be able to afford because we can get a loan from those banks or those institutions. The value of this property, assuming you don't let it go to shit is going to depreciate over time, and as Mike said, it's icing on the cake. So there are a couple of things that go wit that, but over time-- time is the biggest variable there. You should expect some depreciation. You can use the real estate, the rental to create income by renting it, and you charge a higher rent than you owe on all of your bills, and you create an extra or an overage. Boom! That's your cash flow, okay? Then there is wealth creation. We talked about wealth creation by all of these factors. You are not taxed on wealth creation, you are only taxed on income. So you are deferring these payments, essentially someone else is paying down a debt that you have, versus them just paying you. So it is a guaranteed way to save. Each house is essentially a small piggy bank when you buy it. Over 10 or 15 years if you can pay that down, that piggy bank is big as a car filled with hundred dollar bills. It's awesome, okay? Everyone of these reasons all leads-- it all flows downhill into the wealth creation. The tax benefits are parts of that, the leverage increases your cash on cash return, it's part of that. The value of the property is going up, it's part of that. It is creating extra money that is part of wealth creation, all of this is part of wealth creation. Which leads us to freedom which we started with.
Mike: That's right, I love it. I was going to say, freedom, man. That's what the name of the game is. Dave and I-- well I know personally I started out--.
David: I can't wait to have 150 piggy banks the size of cars, man.
Mike: That's right, man. That's the direction we are headed.
David: It's going to be cool.
Mike: We will, we are going to share some of our stories with you on what we are doing with this BRRRR method, and how we are building our rental portfolio.
David: I think a lot of our episodes moving forward are going to be about BRRRR, because that is truly where you get freedom, guys. We love wholesaling, we are going to always be talking wholesaling, because that is how we find the deals to turn into rentals. We like to buy them direct from the seller, we like to-- buy them, add a little value with a short small little rehab, then we refinance it out, that's how we buy our rentals, it is the BRRRR method, we love it. Right now we have how many rentals on the board? How many doors?
Mike: 14, 18, 28, 38, about 43, 45, something like that. We have about 6 or 8 in the pipeline.
David: Keep listening, guys. We are going to be talking a lot about this in future episodes. We are going to get to 150 in the next two years, mark my words, we can't wait. Anything you want to end with, Mike?
Mike: Wish we could do it by the end of this year, baby.
David: Got three or four under contract right now as we speak, so we are going to be doing good.
Mike: Alright, thanks for listening, guys. We will catch you on the next episode.
David: Thank you