Building Wealth with Real Estate
why homeowners have greater net worth than renters
I’ll tell you right now – what I share in this blog about building wealth with real estate is not a guide for how to get rich quick with real estate (although that’s not to say if you timed the market right or got lucky that couldn’t happen). Rather, building wealth through real estate is about making strategic investments to benefit you over the long term. Owning property has proven to be one of the best investments and opportunities for people to build wealth. The earth isn’t making any more land, so don’t take lightly the chance to get a piece of it.
What is wealth and how do you measure it?
According to Investopedia, wealth “measures the value of all the assets of worth owned by a person, community, company, or country”. There are a variety of ways to build wealth with real estate. Simply by owning your home, most of the time the value of the home increases in value in the long run. The wealth of an individual person is usually calculated by their net worth, not by their income. Net worth is the total sum of what you own (ie: your assets) minus what you owe (ie: your liabilities). Pretty plain and simple. It is not the measure of your income. Why not? Here’s an example: Tom might have an income of $200k per year. But if he consumes $201k per year and invests $0 per year, then he will be $1,000 in the negative. This means his net worth, or his wealth, has actually gone down.
How do you build wealth (ie: increase your net worth)?
There are three main ways to build wealth:
Save money
Build an asset of value (e.g. a business or invention
Invest money
Let’s break these down.
1. Save Money
You don’t need me to tell you this, but I will say it anyway: Saving money is a good idea. There are many different ways to save money (which I’m not going to get into in this blog), but as we talk about building wealth, it’s worth pointing out that simply putting money in a savings account is fighting an uphill battle when it comes to wealth building. Why? Because a savings account (or nearly any other account that’s holding your money) typically only returns a small percentage, if anything at all.
Furthermore, every year inflation erodes the purchasing power of those dollars. Inflation is nothing more than the cost of goods and services increasing year over year. If inflation is 3% per year, that means goods and services that cost $1.00 last year cost $1.03 this year. If your money was sitting in an account that earned 0% interest, you will still have $1.00 in the account, but you’re able to buy less with that dollar. Hence, the uphill battle of trying to simply sock money away without investing it. Yes, there are plenty of reasons to have a pile of money sitting in a savings account but that’s a conversation for another blog.
2. Build an Asset of Value
Starting and building a business or coming up with a unique invention are examples of building assets of value. If you have a unique perspective, voice, experience, skill set or invention you can use or apply to provide goods and services in the marketplace, then you have an opportunity to build an asset of value. If you can do so in a way that earns you more than it costs then you, then you have a profitable business. If you build the business in a way that makes it attractive to other potential investors or business owners, then you have a valuable asset to include in your net worth.
However, most folks don’t have the time, desire, or wherewithal to start a business – let alone develop the business into a saleable asset. So this isn’t a realistic or desireable way for many people to build wealth. Or even if it is, it’s unlikely you want to put all your eggs in one basket and rely on this one asset of value (business or invention) to be how you count on building wealth long term.
3. Invest Money
Another way to build wealth is to work an income producing job and put a portion of your income into investments. This can take the form of stocks, bonds, commodities, currencies, real estate, etc. While you have many options for ways to invest your money, we know that 90% of the world's millionaires got there by owning real estate (*Source: The College Investor). Since real estate investing seems to be the path most traveled to millionaire status, we’re going to pop open the hood and see how and why real estate is such a powerful wealth building tool. Keep reading.
Renting vs. Owning a Home
As human beings, we have a few basic wants and needs, one of which is shelter. In order to have a place to call home, we usually go to work, earn an income, and dedicate a portion of that earned income to the consumption of shelter. This typically manifests itself in one of two ways: 1) rent paid to a landlord, or 2) mortgage paid to a lender. There are other cases besides these two, but since they are the main avenues of consuming shelter in this country, we’ll focus on them for the sake of this discussion.
Let's look at the differences between renting and owning a home. Data shows the average homeowner net worth is almost 40x that of a renter (*Source: Keeping Current Matters). But why? Let’s dive in and find out.
Downsides to Renting
Renting is essentially borrowing a space owned by someone else in exchange for money. Although you have certain rights to use of the property/space, you have no rights in the ownership of the property. You don’t get to decide how the property gets used, maintained, upgraded or downgraded. You are simply paying the property owner for the right to use the space.
Renting is problematic for wealth building for several reasons:
Increasing Property Values
As the demand for housing increases through the years due to population growth, divorce, migration patterns, the increasing amount of dollars (demand) chasing a relatively limited number of homes (supply) causes the home’s value to increase. However, if you are just borrowing the space in the form of renting, you don’t get to participate in the asset’s increasing value.
Increasing Rent Fees
As the demand for housing goes up, rent tends to increase as well. Landlords regularly raise rent in order to cover their increasing costs (and frankly, to experience more profit for themselves). So there is an inherent instability to renting in the long term because even as your household income increases, the owner/landlord will be constantly positioning themselves to earn more of YOUR income by ever increasing rents. Check out the graph below demonstrating this fact.
So as you can see (and likely have experienced in real life), when you are renting, the property owner is literally transferring your ever increasing income to themselves in the form of rent hikes.
Between the siphoning of your income and their experience of the increasing value of the property which you are living in and paying for, it’s easy to see why property owners net worth is exponentially higher than renters.
Now, for the record, renting isn’t ALWAYS a bad idea. There are several legitimate reasons to rent for short seasons of life:
While you’re getting financially prepared to buy a home
If you’re only living in an area for a short period of time
If the funds available to you are invested in something that gives you a greater opportunity for higher returns than investing in housing
Just know that in the long run, owning the shelter in which you live is generally a better financial move than renting. Now that we’ve explored why tenants have a harder time building wealth than homeowners, let’s take a look at some of the advantages homeowners have.
Benefits of Homeownership
There are several reasons why homeowners have greater net worth than renters:
Homeowners get to participate in the appreciation of their asset
Real estate tends to appreciate because of the ever increasing demand for housing. This demand can take several forms, which can be described in a term called “household formation”. Here are some examples of household formation:
A young person buying their first home
A married couple getting divorced where at one time they only demanded one home and now the same two people demand two
People moving to a new location from other parts of the country (i.e. migration patterns)
Wealthy people flocking to an area to buy second homes
Foreign buyers purchasing assets in a location as a way to diversify their investment
A corporation buying up homes to hold as rentals.
So if there are new households forming in a given area, that is demand going up. For example, in my area, San Diego, it’s not uncommon for wealthy people, celebrities, political dignitaries and other high net worth people to have vacation homes here. They might not even live in San Diego, however, the attractiveness of our great city drives up demand. Add-in the factors of population growth rates, economic opportunities with companies like Amazon and Apple moving here, and the demand keeps increasing.
However, the supply of new houses hasn’t kept up with the increase in demand (*Source: Keeping Current Matters). Thus, like we learned in Economics 101, we have many dollars (demand) chasing few goods (supply). This drives prices up. So if you are an owner of a house in San Diego, you will notice your house value has historically tended to go up, increasing your net worth. At the same time, as you make payments towards your mortgage in MOST cases your mortgage balance is going down. So the property value (what you own) goes up and the mortgage balance (what you owe) goes down, further increasing your net worth. You're doing the same thing as a renter, using a portion of your income to consume housing, but you’re doing it in a fashion that doesn’t cause your net worth to increase (aka: increase your wealth).
2. Leverage
Per Investopedia, “leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project”. Most people use mortgage debt to finance their home purchase. In doing so, the buyer puts down a percentage of the price and the lender funds the rest. In 202, the average down payment for a first time home buyer was 7%, for a repeat buyer was 20%, and the overall average was 12%.
So how does getting a mortgage amplify your investment returns? Here’s how:
Let’s assume two people have $40,000 to invest, we’ll call them Albert and Brenda.
Albert decides that his favorite investment is stocks. He has heard of an investment that returns 10% per year. So he invests his $40,000 and after one year he has $44,000. (40k X 10% = $4k in returns).
Brenda, however, decides she’d like to buy her first home with her $40,000. Brenda decides to buy a $400,000 condo. So she puts 10% down and gets a loan for $360,000 from her bank. After one year of happy home ownership, the value of her home has increased by 5%. Now, this might seem like she made a worse financial move than Albert. However, the 5% increase is on the value of the $400k home, which she has a 100% ownership stake in. So now her home is worth $420k, increasing by $20k (400k x 5% = $20k). So by investing her $40,000 into real estate, she earned a $20,000 return on her $40,000 investment in year 1, a 50% return on her cash investment.
So as you can see from the paths chosen by our two friends in the story above, Brenda’s net worth increased much faster than Albert’s, on the same amount invested. By using debt, she was able to experience 100% ownership gains even though her “skin in the game” was only 10%.
3. With a fixed mortgage, a home buyer protects themselves from ever increasing housing payments.
Your mortgage payment is not going to change for the term of the loan in a fixed rate situation. So unlike our tenant friends, who have the landlord constantly raising rents, our payment is fixed. This is a very important part of the wealth building process because we have stabilized what is, for most people, the highest expense in our personal budget. With your highest expense stabilized, you get to keep more of your income.
As you get raises at work, you can take the extra money and invest it further, instead of giving it to the landlord. If you get a $200/mo raise at work and you don’t have a landlord raising your rent 200/mo, that means you have $200 extra dollars a month to do as you wish. If you chose to keep your lifestyle the same and invest that extra $200 into an investment making 10% per year for the next 30 years that $200 would grow to $434,264.22! So you have the home increasing in value, your payment dropping what you owe, and a stable payment allowing your income to go towards further wealth building activities.
4. Cash flow
Let’s say you’ve been in your house a while and now it’s time to move. You decide you don’t want to sell your house, and you’re going to rent it out. Well, you are now the landlord as described in our story above. You continue to experience 100% of the appreciation, but now you have a tenant paying down your mortgage and in many cases, you’re earning some cash on top of that.
If you use that cash flow and your increased income to go buy another home or make other investments, now you have multiple streams of income going on and a large portion of it is being paid by your tenant. Now you are the one transferring their income to your bottom line, increasing your net worth. This process can continue ad infinitum as long as you can find the funding to make it happen.