When it comes to real estate, you can invest in several types of properties. The question is, why would you? Well, because it can pay handsomely.
A reader asked, “If I were interested in investing in real estate, where should I start?” Well, there are several different types of real estate investments: single family homes, duplexes to four-plexes, residential buildings with five or more units, commercial real estate, raw land, limited partnerships, or notes secured by deeds of trust.
Today, I’ll talk about single-family homes. While many of the investment issues are common among all types, most folks start with single-family homes. Bear in mind, all consideration of buying a new residence applies to buying an investment property. Do your due diligence: complete all recommended inspections and listen to your realtor’s advice. Remember, lower priced properties will have a much better rent-to-price ratio. A $200,000 home will probably rent for $1,200/month, while a $750,000 home will likely rent for $3000/month. In addition to a better rent (income)-to-price ratio, you’ll probably have shorter vacancies with a less expensive property. More people are in the market for a $1200/month property than for a $3,000/month property.
For the purpose of this column, I’ll assume we’re talking about a $200,000 house in good condition. You should anticipate expenses in the neighborhood of 3-4 percent of the purchase price per year, or $6,000 – $8,000 per year. This includes taxes, insurance, and maintenance costs. Taxes alone are about $2,400. Now, you won’t spend the additional $3,500 – $4,500 every year, but the year you need a new roof, paint inside and out, and new carpet, you’ll make up for any money you didn’t spend in previous years.
On a $200,000 house with 20 percent down, your monthly payment will be about $800. I recommend that you treat the expenses mentioned above as a monthly bill. Take $550/month and put it in a separate “reserve” account, so you’ve got the money you need when that paint job or property taxes come due.
On the upside, you’ll have depreciation (a non-cash expense) as a tax benefit. Depreciation is a bookkeeping expense that allows you to deduct the value of improvements over time. As long as you take good care of the property, it will last many years past the “depreciable” life. Consequently, depreciation is only a taxable expense, not a cash expense. This means, you have the ability to save on your income tax expense to the tune of $150-200/month. This savings pretty much offsets your negative cash flow, and income tax savings IS a cash savings. You can reduce your withholding or your quarterly tax payments to provide cash to deposit to your reserve savings account for future property expenses.
So now, you own a $200,000 rental property that takes no significant time to manage or maintain, and that has about a break-even cash flow. You invested $45,000 (a 20 percent down payment plus $5,000 in closing costs), and your benefit is the potential appreciation in the value of this property. If values rise at three percent a year, that equates to $6,000 per year on a $200,000 house—that means you made $6,000 on a $45,000 investment or a 15 percent return. This is called leverage. Compared to other investment options, real estate looks pretty darn good!
In addition to the increased property value, over time rents will also increase. And while expenses go up with inflation, mortgage payment (your biggest expense) won’t go up over time. The bottom line is, if you can afford to buy a $200,000 rental today, by the time junior heads to college in 10-15 years, you should have an asset capable of paying for much of his education.
If you have questions about real estate or property management, contact me at email@example.com or visit www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.