The Benefits of Buy-and-Hold Investing
Hey Everyone, today we’re going to talk about Buy-and-Hold investing. Buy-and-Hold investing is a strategy that many investors use wherein someone buys a piece of property with the goal of keeping it for an extended period of time. This contrasts to flipping properties where a property is improved in some way and immediately sold.
Either strategy can be successful and apply to any asset class, but Buy-and-Hold investing has many benefits that flipping doesn’t offer. It all depends on your end goal. Let’s examine in depth some of the benefits that one could expect to see with a Buy-and-Hold investment.
Cash Flow - Recurring cash flow is one of the greatest benefits of investing in real estate. With a Buy-and-Hold investment, owners can expect their asset to produce a stream of income in regular intervals, usually monthly or quarterly. Most stocks and bonds by contrast don’t give out regular dividends and the ones that do typically offer a much lower yield than what one would typically expect from a real estate investment.
Equity - Equity as a benefit actually comprises two separate pieces. In this section we’re going to talk about one part of it, principal paydown. Principal paydown only applies if you use leverage to purchase a property. An investor that utilizes a bank loan to purchase a property is expected to pay off a portion of the principal, the original borrowed balance, every month. The amount of principal that is paid off is yours and builds over months and years. Over time your share of equity in the property grows, and the portion that the bank owns decreases. If the property in question is a rental property, the rent received should cover the entire monthly payment. Equity in a property isn’t cash in your pocket like cash flow is, but it is an asset that can be accessed via a refinance event.
Appreciation - Appreciation is the second part of the equity portion. If the value of a piece of property goes up over time, we say that the property has appreciated. The additional value gained by appreciation belongs completely to the owner of the property. This is value that has been created simply by owning the title to the property. This appreciation can be tapped into through a refinance or HELOC (Home Equity Line Of Credit) at a later date and pulled out in a lump sum. This lump sum that is pulled out must be repaid, the refinance is simply a loan with the equity in the property acting as collateral, but it can be used for anything the investor wants. Savvy investors often use refinance events to purchase additional property by using the equity they pulled out of their property as the down payment on an additional property.
Leverage - We touched on leverage above in the sections about equity but I’ll go into it further here. A common way to leverage in real estate is to use a mortgage or loan to buy a piece of property. The benefit of leveraging is that an investor can purchase more property than if they had only used cash. By leveraging a rental in this way, investors utilize the rent they receive to pay down the mortgage allowing them to hold property with no out of pocket cost aside from the upfront down payment and fees. Additionally, properties tend to appreciate in percentages of their original value, as opposed to specific dollar amounts. This means that a higher valued property will put more dollars in the investor’s pocket over the same time period while keeping the out of pocket cost to the investor the same.
Tax Benefits - There are certain tax benefits that investors gain by holding property long term. One of the biggest benefits, and the one I’m going to address in depth today, is depreciation. Depreciation is a term used in taxation to refer to a loss in value over time.
Let’s backtrack for one second. The price of a piece of real estate consists of two pieces. The price of the “property”, which includes improvements such as houses or other buildings, and the price of the land, which is the dirt underneath said buildings. The IRS allows investors to write off depreciation of the “property” but not the land. This writeoff happens over a set number of years(27.5 for residential, 39 for commercial).
Back to the main point: Let’s say for example an investor purchases a house for $600,000. The house is worth $550,000 and the land it’s sitting on is worth $50,000. The investor can’t depreciate the land, but can depreciate the house. Over 27.5 years, the house is scheduled to lose $20,000 in value every year. Now if the investor makes $20,000 in cash flow every year from the property, he or she doesn’t pay any taxes on that amount, because his or her property lost value according to the tax code. Now let’s say that the investor made $0 in cash flow from the property. He or she still can claim the same $20,000 in depreciation and use that to offset his or her W2 income, thus lowering his or her overall tax burden. The ability of depreciation to offset W2 income is one reason why passive investment in real estate syndications is a favored investment of high W2 earners like doctors and software engineers. In addition to depreciation there are other tax benefits like the 1031 exchange for capital gains tax and the mortgage interest deduction. I’ll dedicate another post at a later date to exploring tax benefits in depth.
Buy-and-Hold investing can apply across just about every asset class in real estate. There are investors that Buy-and-hold single family homes valued at less than $10,000 and investors that Buy-and-Hold multi-billion dollar industrial warehouse properties and everything in between. There are also different ways to do Buy-and-Hold investing which do not all include every benefit listed above. A couple of other Buy-and-Hold strategies are:
Raw Land - Buying raw land on the outskirts of a major city for example, would not necessarily grant monthly cash flow. Instead the value of such an investment could be realized by selling the property to a developer after holding for ten or twenty years when the land has appreciated to a high degree. An investor buying raw land can still benefit from appreciation, principal paydown, and leverage, but may not receive regular cash flow or depreciation.
Timberland - Timberland is another great example. With timberland, an investor typically clearcuts all the trees on their parcel and sells the lumber to a mill. They have to seed new trees and then wait ten to twenty years for the new trees to grow before repeating the process. A timberland investor may benefit from equity, appreciation, and leverage, but would not benefit from regular cash flow or depreciation.
Overall, Buy-and-Hold investing is a great strategy and one that we focus heavily on here at IronGall Investments. As always, if you have any questions or you would like to learn more, feel free to contact us.