If you are in the fortunate position of having a little money to invest, or if you are just curious about investing, here’s a bit on real estate as an investment. Before I get started, I’ll remind you that I am neither a financial advisor nor a tax professional. I am not advising any action; rather I am sharing my opinion and my rationale when I invest. This should not be your only education on investing before you go out to buy that 67-unit apartment complex. Take the time to learn about the pros and cons in more detail before you put up Junior’s college fund or your retirement.
Compared to other investment options with similar risk, real estate offers some excellent advantages. Real estate provides cash flow based on rent, and a tax shelter from depreciation. (A quick definition of depreciation is a measure of how much of an asset’s value has aged or has been used up.)
If you are the type to do your own improvements, maintenance, and repairs, you can spend relatively little to increase the market value of your investment property and/or the amount you can charge for rent. Even if you don’t do your own repairs, as long as you keep the investment property in good condition, real estate generally increases in value over time.
When I evaluate an investment property, I expect rents and market value to go up at about the same rate as inflation over the long term; bear in mind that real estate isn’t like trading stocks. Real estate comes with high transactions costs: you won’t find a broker willing to handle a real estate transaction for $39.95 and it also doesn’t happen this afternoon.
When I’m on the purchasing side of a transaction, I generally assume the transactions costs will be about two percent of the purchase price (i.e., loan fees, escrow fees, title insurance, and closing costs). If I’m on the selling side of the transaction, I expect to pay closer to seven percent of the sales price (i.e., brokerage fees and closing costs).
However, even with high transaction costs, I think real estate is a great investment. Once I own a property, I can leverage it (borrow a large percent of the purchase price). Rental income should be sufficient to cover the loan payments and other expenses including taxes, insurance, maintenance, utilities, and management fees. Depending on the property type, with a 20-30 percent down payment, you should be able to at least break even with cash flow.
Then, since depreciation is based on the purchase price of “improvements” (a real estate term that refers to everything except the land for a given property, so I’m talking about any structures, paving, etc.), you should have a tax loss of about two percent of the purchase price. That taxable loss creates a tax savings that will probably provide at least a four percent after-tax positive cash flow. To put that another way: usually you have to spend money to reduce your taxable income, right? So, with real estate, you don’t have to spend money to reduce your taxable income because depreciation does it for you. No cash outlay, but reduced tax burden. Win/Win.
If you went to the bank and purchased a Certificate of Deposit (CD), your return would likely be a tiny percent of the same money invested for the same period in real estate. However, unlike the CD, the real estate investment provides you with no guarantees. We’re talking about the risk/return tradeoff: the higher the risk, the greater the potential return. There’s also a risk to not investing: the opportunity cost of giving up the potential income.
When it comes to investing, you have to think about lots of factors. Is this a short-term or long-term investment? If you need this money for Junior’s college fund next year, I wouldn’t invest in real estate. Real estate is not a “liquid” investment (you can’t turn it into cash easily).
If you are interested in a long-term investment and real estate appeals to you, talk to your financial advisor and/or tax professional. Every property is unique. Every transaction is unique, and every person’s financial situation is unique. Two investment opportunities that appear similar may have different financial structures, tax structures, maintenance requirements, risk factors, and more. Be a careful shopper.
If you’re interested in acquiring a list of potential investment properties, call your realtor. Trust me, your realtor will be happy to help you.
Next time I’ll write about 1031 Exchanges. If there’s something you would like me to write about or if you have questions about real estate or property management, feel free to contact me at firstname.lastname@example.org or visit our website at www.realtyworldselzer.com. 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.