Advantages of Real Estate Investing
A brief discussion of some advantages of investing in residential rental real estate
Real Estate must be part of any well balanced portfolio. Why have real estate as part of your portfolio? Is it better to invest in real estate trusts or funds or just buy few rental properties? What are the advantages of owning investment real estate.
I am going to explain why everybody should consider some investment in real estate as part of their savings or investment portfolio. This article is geared towards the small regular investor and not institutional investors, therefore our focus will be residential investment real estate, although several institutional investors started to navigate the residential real estate investment area after the 2008-2010 downturn.
When thinking about investing in real estate you have several options. Investment in land, commercial income producing properties or residential rental properties. You can do this directly or through investment trusts. The advantage of investing in your own properties is that you have full control, you are the decision making person, you are at the helm controlling expenses, setting goals and policies, etc., contrary to a totally passive investment in a Reat estate trust. In this article we will talk about the 5 major advantages of investing directly in income producing single family homes for the average investor.
1- Appreciation: Even though property values may go up and down for several reasons, in the long term properties tend to increase in value overtime, being a good hedge against inflation. This is crucial for accumulation of wealth, setting up a retirement nest or just increasing net worth over time to achieve financial independence. Other investment vehicles such as stocks also tend to increase over time but the risk associated with the financial markets is a lot higher so it is always wise to balance any investment portfolio with some real estate which is less volatile while still offering long term asset appreciation. Long term value of properties is directly associated with the time value of money. Cost and materials tend to increase over time, more in inflationary periods, so the replacement cost of properties increases as time goes by, pushing values up. Also real estate in good locations have many other desirability factors such as schools, proximity to working centers, airports, leisure, etc that provide additional value to properties over time.
2- Income: Unlike many other investments, rental properties provide current income, net cash flow every month after paying for expenses. Many other assets provide a return on the investment only when you sell them but rental properties provide monthly cash flow and in most cases not only good cash flow but a good return on the investment. Especially those seeking financial independence, rental properties is a good way to achieve income that can supplement or even replace employment income in many cases.
3- Tax Advantages: Real Estate offers many tax advantages. The information I provide here is not tax counseling, tax consulting or tax advice, which can only be provided by a CPA or tax professional. Each investor must consult with their CPA, Attorney and Tax Advisor his/her specific tax and investment situation in order to properly analyze tax advantages and implications. But here we can discuss things that may be an advantage for most people. First real estate can be depreciated, excluding the cost of land, the total acquisition cost of the improvements can be depreciated over time. Depreciation is deducted from the net Operating Income of a rental property before calculating tax liabilities. Another advantage, until the tax law is changed, is that investors can use what is called a 1031 exchange of like kind properties. There several restrictions and considerations but in basic terms if you exchange your property for one of equal or higher value, meaning you sell your property and purchase another one of greater value within a specific time period, you do not have to pay tax on the net gain of your existing property. This process can be repeated time over time deferring capital gain taxes to the future when the last property is sold and not replaced. This can be an advantage in deferring taxes to be paid with a less valuable money in the future and reinvesting today to generate additional returns more valuable funds, remember the time value of money. One dollar is more valuable today than in 10 or 20 years.
Another advantage is that over time equity in the property increases as the mortgage is paid down. One can do a cash out refinancing, taking out, tax free, a portion of the equity that has been building up over the years. If the cash flow of the property permits the additional financing, this may be a way of getting a portion or all of the initial investment back to buy another assets or go into another venture.
Again consulting with your tax advisors is essential for the correct planning and structuring of your real estate investment.
4-Financing and Possitive leverage: In tax advantages we touched on the possibility of refinancing and cashing out a portion of one’s equity into a property. This is another advantage of real estate investing, you can use other people’s money to invest. Banks and other financial institutions offer real estate mortgage loans to investors nationwide and with many different programs. Therefore you can control a large, more valuable property with less cash requirement or you can divest your investment in more than one property by financing a portion of the acquisition cost. For example if you have $300,000.00 to invest you can can buy one property with $500,000 putting down 30% or $150,000 and at the same time buy another property worth also $500,000 putting down the balance of your total investment of $300,000.00. With this you now control $1,000,000.00 in real estate value rather than just $300,000 if you would have bought a property all cash. If properties are appreciating at an annual rate of 3% for example no the total value of your investment is growing $30,000 a year (3% of $1 million of real estate) instead of just $9,000 if you would have bought one property with the $300,000. So your net worth is increasing faster. Another considerations that now you have two locations and two assets, diversifying risk, rather than buying one $1 million property with leverage (financing) or just putting all the money into one $300,000 property. The key si that the Net Operating Income of the property (Rental Income minus Operating Expenses) is sufficient to service the debt or in other words pay for the mortgage. Not only we look for the Net Operating income being enough to pay for the mortgage but being 20% to 50% more than the mortgage payment. This situation will provide not just a cushion for the debt service but also Possitive cash flow and a good return on the investment due to Possitive leverage. We can talk in another blog in more detail about Possitive leverage but in simple terms happens when the cost of money borrowed is less than the Capitalization rate or Return on the Investment if bought for cash with no financing. We can explain tis as follows: less say that we buy a property for $200,000 cash and the net return 9after all expenses ) is $12,000 a year or 6%. Let’s say now that e finance $140,000 with an interest only loan at the annual rate of 3%. We now have to pay from the Net Operating Income of $12,000 the amount of interest we have to pay the bank which is 3% of $140,000 = $4,200. Now the net Income and Cash Flow after financing is $7,800 ($12,000 in Net Operating Income minus $4,200 in Interest Payments) but we only invested $60,000 because the rest of the purchase was financed by the new loan from the Bank. Now the Return if we would have bought cash was 6% ($12,000/$200,000) and now the return on the investment is 13% ($7,800/$60,000). Not only we increased our return on our investment but we still have $140,000 in cash to buy two more similar properties and do this again, diversifying risk and accelerating wealth creation by controlling at least $600,000 of real estate instead of only $200,000. This is part because we have a Possitive leverage situation which is what investors should always do in real estate investing.
One of the disadvantages that many people cite about real estate is that is not liquid, which is true but as long s there is mortgage financing available you can, in most cases, mortgage the property and cash out a portion of your equity, providing all other factors align.
5- Professional Property Management Available and Total Control of the Asset: The fifth major advantage of investing in real estate is that you can hire a profesional management company to manage and administer the property and deal with the daily routine. This cost should be part of the Operating Expenses when analyzing a property to purchase. Therefore you do not have to put time resources or go through a learning curve to operate your properties, you can hire a seasoned professional to do so and you can just meet every now and then to review reports, set policies, etc., while keeping your current job, occupation or lifestyle. You also have total control of the asset, making all the decisions unlike stocks and corporate bolds where the decisions of the executives and Directors affect their performance and outcome beyond your control.
In other blogs we will go in more detail into the advantages of real estate investing and financial and investment analysis of investment properties as well as what types of properties and in which locations are the best for the small real estate investor.
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