Followers of this blog know that we mostly discuss practical matters involving owning and operating residential real estate in the Dallas, Fort Worth, Denton areas in north Texas. While content in this blog could be relevant anywhere, when we get into numbers and recommend a strategy, the numbers mostly apply to the north Texas area. Now and then we digress and discuss broader aspects pertaining to US real estate in general. This article is one such digression. We are going to talk about realized vs unrealized gain.
Let’s define these terms to get on the same page. If I bought a property for X dollars and it’s current value is Y, then Y minus X, assuming Y is greater than X is unrealized gain. It is unrealized as I have not sold the property yet. When I sell it, I realize my gain. There is always a cost to realizing the gain, costs such as closing costs, commissions, taxes etc. So, now’s a good time to ask a question? What’s the biggest cost to realizing a gain?
Between seasoned investors, who are wealthy or on the correct path to becoming wealthy and those who struggle with the concept of understanding wealth, I see this marked difference. It is in how real they believe their unrealized gain is. The ones that struggle with the concept of wealth need to see the gain from whatever investment vehicle in their checking account as cash. Then they believe that investment vehicle worked. As long as their wealth growth is unrealized, then tend to see it as non-existent. The seasoned investor is precisely the opposite. They believe in the awesome potential of their unrealized gain. It is the unrealized portion that makes anyone wealthy. It’s the unrealized portion that has the thrust. Their attitude is: What good is realizing it when you don’t need it?
The wealthy understand that the biggest cost of realized gain is that it stops working for them. It’s over. It’s history. They understand that unless you need the cash for something bigger and better (and it’s not always about money), realizing is unwise and amateurish. In addition to not generating wealth, realized gain depreciates in value. Inflation, however small it might be now or however large it might get soon, shrinks your dollar. If you have a rental property producing cash flow every month, that will be inflation adjusted. If property taxes go up, either it is because your property value is going up (good) or your tax rate went up due to inflation and your rents will go up as well. Rent is a factor in CPI. Income from a rental property is inflation adjusted.
The correct question to ask about your bank account is not how much cash you want there but how much cash you need there. Rest must be working for you and in these blogs we believe that income producing real estate assets are a great place of work for your dollars. The key is income producing, not appreciation, not speculation. We don’t care if the goose gets larger – or smaller for that matter – as long as it keeps producing golden eggs. So, how much income should it produce? Again, the question is how much income do you have use for? Anything more than that is taking from the engine that creates wealth. For example, you would produce more income if you had a longer term loan than a short term loan. A longer term loan has smaller mortgage payments. So there’s more cash left for the investor every month. What does the investor do with that cash? Pay taxes? Exactly. With a higher payment on a short term loan, there is less income, rapid equity growth. With less income, you have lower taxes. Shorter loans enjoy a lower interest rate as well, so you are not giving your money away, it just goes back into your property as unrealized gain (that’s the good kind).
So here’s the mantra you need to learn: “Reduce your income; increase your wealth”. That’s so counter-intuitive and so very few grasp not just the techniques but the entire concept. Remember, income hardly builds wealth, it’s often the other way around.