[RWS #728] Real Estate Investing: Five Benefits of Owning Rental Homes

Picture of homes for Real Wealth Show Podcast Episode #728

Our guest today is a former athlete and family man who built a career on the corporate side of the solar industry. Along the way, he saw the value of owning rental property, and now owns 16 single-family rentals in seven states.

Nate O’Neil is a true believer in the financial power of long-term rentals and is here to tell his story on the Real Wealth Show.

Show Notes:

There are five really great benefits to holding financed properties over time:

1) Cash flow

2) Appreciation

3) Tax Shelter: $300 of monthly rental cash flow is like $460 of W2 income because W2 income is heavily taxed. This is significant over time, and with a number of properties. You can also depreciate the home over 27.5 years, which offsets taxable gains.

4) Mortgage Pay Down:   
A rental home owner’s net worth is credited every single month by the amount of principle their loan is paid. I look at is how much principle was paid down by the rent and how much my net worth increased from owning the asset. Again, the payoff grows over time and an expanding portfolio.

5) Inflation Hedge: 
People underestimate the power of a 30-year mortgage.  Due to inflation, a $600 monthly payment today, will actually go DOWN over time.  The value of that $600 in 10 years will be less, so therefore, in essence, the payment goes down.  Furthermore, with inflation, both rents and property values will increase.

Bonus: Over time, equity grows as the loan is paid down and appreciation grows.  This is money in the bank for further investing. For example, if you own an asset that is worth $200K and is paid off, you can do a cash-out refinance at 75% LTV, meaning you can take out $150K.  That $150K is TAX FREE.  I would have to earn $230K at my W2 job to take home $150K. And the original loan, at least in part, is paid back, not by me, but by the rent!  Current tax law allows my kids to inherit the property, at which point, the property steps up to market value. 


Podcast Transcript

Kathy Fettke: Nate welcome back.

Nate O’Neil: Thanks, Kathy. Great to be here.

Kathy: You have really jumped into real estate and what, over the last seven years?

Nate: Well, yes, I started in 2004, but really got aggressive back in 2009 and started really building the portfolio then. I’ve been in it 15 years but mostly over the last 9 or 10.

Kathy: Wonderful. You have a full-time job, tell me a little bit about why you started in real estate.

Nate: Our primary residence appreciated significantly and my wife and I were like, “Hey, we got to do more of this.” We started saving up and we live in California, the Bay Area which is pretty expensive and you can’t really cash flow unless you use down payments. We looked out of state and got our first property in Colorado. Then we were actually just passive landlords for five years, it worked out well. Then in 2009, when the market was low, I looked at my spreadsheet, and there was a lot of good numbers coming out of it so to me it was a great time to invest so we got aggressive between 2009 and I just love it. Again, I’ll talk today about all the benefits of holding long-term rentals.

Focus on Affordable Rentals

Kathy: Well, let’s talk about that because you bought in 2009, which was just probably the best time ever. There was so little competition and so much supply, but you also bought before that when prices were a little more normal. Those are two very different times in the cycle. Now we’re back where prices are back up. Does it make sense today as much as it did in 2009, or when you started?

Nate: I’ll say from my personal perspective, I’m definitely cautious. When we’ve seen this 10-year run-up of assets, not just housing but stocks and everything, it certainly makes you look at it. That being said, if you look at the fundamentals and everything I read about the housing market, the microeconomic information is very strong, just in terms of supply and demand. There’s a lack of supply of affordable homes, and that’s where I focus my investing is in starter home type of homes. Given the demographics of people coming into the homeownership market with the millennials and elder people staying in their homes longer, there’s demand as well.

Those two things are really what’s keeping me in the game right now, I’m certainly cautious. The concerns that I have are more macroeconomic like what could potentially happen with trade wars and geopolitical things and that kind of stuff. The last crash that we had was related to housing because we had poor loans, because we had over-speculation and that’s what led to the downturn. I don’t see that now in the housing market. My only concern really is what potentially could happen with macroeconomic things and national debt, et cetera like that.

Downturn Safety Net

Kathy: How are you protecting yourself from that?

Nate: I’ve been fortunate in terms of — my portfolio has appreciated very nicely, so I have equity in my portfolio. Even if there were to be a downturn, I’d be fine as long as rents still go down significantly because that’s really the risks to the long term buying old model is rent decreasing or vacancy and maintenance. Then just I’m actually going to be purchasing a couple of new build four-plexes here that are going to be finished in December, and just basically leveraging the equity that I have in my portfolio in a very conservative way, just in case, I had it built in my model if there is a downturn, I’ll be okay.

Again, the biggest risk is downturn in rents. Even if there is a downturn in home values, I’m a hold-forever type of guy, so I’m in a position where I could just ride it out.

Kathy: It doesn’t really matter, right? If you’re not selling it then who cares what the value of the property is, what matters is the rent.

Nate: Absolutely. That’s what I experienced with my first property when I bought it in 2004, it actually did decrease in value, but the rent actually increased so I didn’t need to sell and my cash flow increased and that’s really what gave me the confidence to really start to try and scale this thing.

Kathy: Yes, really where people got into trouble last time is they over-leveraged and weren’t able to make the payments. It wasn’t so much the loss of equity because as long as you can hold the asset, it usually comes back and over time, if you look at any graph or chart, you see that it does come back over time. The key is holding it. Unfortunately, in the last downturn, that was really tough because if you over-leveraged and your payments were high and your rents don’t cover the expenses or the rents go down or you have extended vacancies, that’s a big issue.

Nate: For sure. Then there was also these exotic mortgages more on the market as well, where you lock in payment for a year, and then there was a balloon payment and that was banking on continued strong appreciation. That’s part of the reason that we had a downturn.

Cash Flow vs Appreciation

Kathy: Yes. Now, you’ve got five reasons you think real estate can outperform other investments. What is that?

Nate: I see a lot of content out there that talks about cash flow and appreciation, or poses the question should you invest for cash flow or appreciation? I think it’s a great question. Those two things are certainly big factors that are making real estate investing so beneficial, but I think there may be a segment of the investing population or the general population that doesn’t realize all the other benefits to investing in long-term rentals and the acquire-and-hold model. I specifically choose the term acquire because it’s not really buy-and-hold because when you buy something, it implies that you consume it and it’s gone.

For example, you go to the grocery store, buy a gallon of milk, you drink and it’s gone. When you “buy a house” it’s still there, you’re just basically transferring your money from where it is to the home. The acquire-and-hold model, certainly, there’s cash flow, which is as long as the rent covers all the expenses, principal, interest, taxes, insurance, if there’s any HOA, that kind of stuff. Then, of course, appreciation. We have seen historically that homes tend to go up over time, so two great benefits.

There’s three other really powerful benefits. When you look at the government allows us to depreciate homes over 27 and a half years, that cash flow that you create is tax-sheltered. For example, if you make $300 a month in cash flow, you can take that depreciation to offset it and it shows a higher value. For example, for me like $300 in cash flow is like having to earn like $460 in my W2 job. It’s $160 difference, and you might think that’s not that big a deal, but when you think about that’s every month, and over the course of– Again, I’m a long-term guy, over the course of the years. Then if you scale it across different multiple units, it starts to really add up.

With depreciation, the government really allows you to have your cake and eat it too. You can depreciate an asset that’s actually appreciating. You got cash flow appreciation, and then you’ve got this value of being able to depreciate, so the tax benefit is there.

The Benefits of Depreciation

Kathy: Yes, it’s funny, it’s appreciation and depreciation at the same time. Even though your property’s increasing in value, according to the IRS, decreasing in value is depreciating and you get to write it off even if it’s making money, so it’s a wonderful law that makes no sense but I’ll take it.

Nate: Exactly. How cool is that? Thank your government for that.

Kathy: Right [laughs]

Nate: Another benefit, a fourth benefit is like I actually love getting my mortgage statements in the mail. I love getting the bills. The first thing I look at is, how much was the principal pay down on my loan because, at the end of the day, that money is not coming from me, it’s coming from the rent. Each month, the amount of principal that I get is paid down by the tenant. Again, it may not necessarily be significant on one property, but if you have every month that happening over the course of years over the course of many properties, it starts to be significant. Your net worth is credited every month by how much the principal is paid down on your loan.

Again, just the benefit of long-term mortgages as well and I’ll stress that this model that I’m talking about and the five benefits, play into the fact when you use leverage, so when you have a loan on the property. That’s the fourth one. You got cash flow, you’ve got appreciation, you’ve got tax-sheltered cash flow because of depreciation, and then your tenant is paying down your mortgage and your net worth is credited every month by that amount.

Kathy: That’s incredible. We have to share some violations on our old home because we built a deck in California and that triggered all these things. Apparently, we needed permits for that. Anyway, we haven’t been able to sell it so we’re renting it, but every single month that that renter is there, she’s paying $1,000 off towards our principal. It’s like “Okay, well, this is going to help pay for these violations we have to cure.” It is incredible.

Real Estate as Inflation Hedge

Nate: Yes. That’s four, the benefits. Then the fifth benefit is inflation hedge. Again, we talked about the mortgage and I think people may underestimate the power of a 30-year mortgage. Due to inflation like a $700 monthly payment, today will actually go down over time, and that’s because the value of $700 today, because of inflation, you’re not able to buy as much in 10, 15, 20 years with that $700. It’s a little bit nuanced thinking, but you’re locking in that payment today and the value of that is going down, and you want the value of your debt to go down, so another benefit. Then also with inflation, that drives up both home prices and rents. In real estate investing for the long term, when you leverage when you use debt, inflation is your friend.

Kathy: Inflation is not a friend for very many people. It’s really nice to be able to offset increased living costs. Cost of gas goes up, cost of food goes up, housing goes up, but here if you own real estate, your cost of your rent goes up so your rental incomes going up every month and generally speaking, and then the value of the house and yet that inflation eats away your debt. The asset value is going up while the debt is getting smaller. I’m so glad you’re reminding me. These are really the basics, but I forget to talk about them, but when people who don’t know real estate investing, but they see other people making money in real estate, they think the only way that happens is through flipping properties or buying in California and the property doubles in value.

That’s what most Californians think when they think of millionaires in real estate. What they don’t know is all this background stuff. You’re from California, and you get lots of people asking you questions about your portfolio as you’ve been building it because you took that leap, and you’re investing out of state and that’s real scary, the first time you do it. What are some of the questions that you hear people ask you or concerns that they say to you about doing what you’re doing?

Nate: The first thing is like, “How do you find the people? How do you find the people that you can trust?” For me, it was just a matter of getting on the phone and talking to people. I’ve got properties in different states, but I’ve talked to a lot of people and a lot of people that I ended up not doing business with, but it really comes down to asking the right questions, getting a feel for these people. I almost view it like a tennis match. You want to go out and play tennis with someone that’s going to hit the ball back to you. As you’re talking through different scenarios, different properties, you hit the ball over the net, and you trust that they hit it back.

You do that over the course of several times and the people that hit the ball back and you’re getting a rhythm, those are the people you want to work with. People that don’t hit it back or hit it back the wrong way, that’s who you don’t want to do business with. I think it’s just being able to identify the right kind of people to work with, and people are asking that question quite often.

Finding Good Property Managers

Kathy: You should ask the right questions, you talked to a lot of people and that helps you determine who to work with. What were some of those questions that you asked?

Nate: The basic property management things. What’s your monthly fee? What software do you use? That kind of stuff. Also, tell me your opinion, like, what do you think about this neighborhood? Do you think it’s going to appreciate? Do you think there’s risk of depreciation for any reason? That kind of stuff. Again, it’s not just the questions that you ask, but how they answer them and their responsiveness as well. For the people I would work with, I would send them property and tell me what would you put this on the market for? That’s just, well, Zillow says this or RentCafe says this.

“No, what would you if I were to get this property and you were my manager, what would you put on the market for?” Working with people that know and are willing to make that commitment says a lot.

Kathy: That’s great. Over the years, I’ve talked to a lot of people too, and boy, I’ve run into a lot of snakes, a lot of sharks in this business. Some don’t even know that they’re sharks, that’s how they operate. What we do at Real Wealth, just to go beyond even that conversation that’s important, but we will do the background checks because sometimes slicksters are the best conversationalists. I’ve been talked into some deals that I didn’t do my due diligence because I trusted the conversation and wow, that was a bad move. Now, we do start the conversation, ask the basic questions, but then we do background checks, we make sure that they’re licensed in those areas.

We want to talk to people that they’ve worked with, we definitely do Google searches to see if there’s any bad reviews. Everybody gets bad reviews, it’d be crazy to think that someone’s not going to get a bad review. You go to your favorite restaurant in the world, and you look them up on Yelp, and there’s going to be a bad review. It doesn’t necessarily mean it’s a bad company, it might be just during that month, they had a bad month, or maybe they had an employee out of town.

Two years ago, we had three syndications going that were like one was 13 million. We had to raise it in a month and then we had another one that was 4 million and another one that was 3 million. We were so busy, we couldn’t get back to people as quickly as we normally would, so we got a couple of bad reviews on that. I know we just went in and explained it, but doing as much background. Even beyond that, once you’ve decided, “I like this person”, that doesn’t mean that they know everything about a property. They don’t. How could they?

You’ve got to then also, make sure you bring in the right team to be your eyes and ears for you. Hiring the right inspectors to do a full inspection, not a four-point. I’ve seen some companies out there just doing these four-point inspections. That is not enough. You need a full inspection. Once you get that inspection back, and you want to see if there’s any issues at all, you get further inspections because you need to know what you’re buying from a third party, not the person selling it.

Nate: Sure. Yes, absolutely. The analogy is you got to play tennis with people a little bit, not just to have conversations.

Kathy: Yes. Throw them a curveball and see how they respond to you.

Nate: For sure. Actually, let me just kind of put up bow on —

Kathy: Yes, put a bow on it.

Nate: …the five benefits because there’s actually a bonus to this thing as well.

Kathy: Yes, talk about the bonus.

[laughter]

Nate: We talked about the cash flow depreciation, the tax-sheltered cash flow, mortgage pay down, and then inflation hedge. The other thing is like, over time as you build equity and you build equity through appreciation and your tenant paying down the mortgage, you have the ability to tap into that equity. For example, say you own a property for 20 years and it’s paid off and it’s worth $200,000, you have this $200,000 asset that you can go to the bank and say, “Hey, I want to do a cash-out refi. 75% loan to value, which is $150,000.”

That $150,000. Again, is tax-free, you’re not paying taxes. You’re going to get a check for $150,000 that you pay no taxes on. Again, like if you had to work a W2 job to make $150,000, you have to make like $220,000 and $230,000, so that’s another benefit. Again, two, remember, you take out this loan, who’s paying it back? The tenant is at least partially, depending on what the rent is at that time, you may have a little bit out of pocket as well, but you get this tax-free money that you can then if you’re smart, invest it in more cash flowing assets.

Kathy: It’s really amazing. Whenever rates go down, you can refinance, take cash out that cash is tax-free. If rates go down, you may not even change your financial situation in terms of cash flow. It might change just a little bit, but let’s say you knew that you had kids going to college in 10 years or 15 years or 5 years, this is the way.

Nate: Which is me. The next decade is going to be an expensive decade for me. I got two who will be in college.

Kathy: Is that part of your plan was to buy these homes and then refi at a later date or?

Nate: Yes, I’m evaluating a lot of different things but certainly that is an option for sure.

Power of Long-Term Rentals

Kathy: Wonderful. All right. Any other tips for our listeners, things you’ve learned along the way?

Nate: Again, the main message is don’t underestimate the power of owning long-term rentals, with smart loans, with smart debt. I wish I had started earlier, and the message really is to the younger people out there, if you can start this early, and just acquire one a year for10 years, and you get all those benefits for the rest of your life. Again, the beauty of this thing is if you decide not to sell these things, they’re going to be assets that you own, that have value that are going to pay you all these benefits every single month for the rest of your life.

Kathy: Now, what about the reality of repairs and vacancies, that’s going to eat into that profit?

Nate: For sure. You should definitely factor those in. Again, from my perspective, all of my homes were built this century, and I particularly targeted newer homes so we would have lower maintenance. At the same time, there is the maintenance and the longer I own this portfolio, the more maintenance there’s going to be. My perspective is, because you talked about flippers and rehabbers out there is I would rather rehab my own home because I know exactly what I have. I’ve owned it for so long, so definitely factor in that.

In terms of vacancy, yes, it’ll happen but then another thing that continues to encourage me is, we talked about the demographics is all the information I read out there is that rental demand maintain is very strong, and it’s expected to continue to be strong as well.

Kathy: Throughout the next decade.

Nate: Throughout the next decade and so that bodes well. My portfolio, I’m cash flowing in all my units, so if we were to even have like a downturn in rent, I could still cover the expenses.

Kathy: All right. Well, Nate, it’s really been a pleasure to have you here on the Real Wealth Show.

Nate: Thanks, appreciate it, Kathy.

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