It’s funny how real estate gets treated as an investment. Like Rodney Dangerfield, it gets no respect. While stocks and bonds get the Wall Street Journal and Financial Post, do a search on “how to invest in real estate” and you’ll find millions of no-money down schemes that seem designed to market books and tapes instead of real estate. On television there is Report on Business TV, but for real estate you’ll see infomercials or decorating shows. It strikes me as sad that such a steady investment vehicle gets such poor treatment.
It is possible to purchase with no money down, but it involves arranging a 100% (or more) mortgage, and for investment property you’ll only do that if you have equity in other properties. For example, if you already have one property free and clear its not difficult to arrange a line of credit at prime. A $100,000 condo might cost about $400 per month, plus taxes and maintenance of about $200. In short, it would carry and give you money to feed the debt.
A more common method to buy income real estate is with a down payment of some sort. Generally is you can make income real estate itself with less than 40% down its worth buying. These types of properties are much more common in stable markets.
There are lots of reasons to own investment real estate.
Reason #1 to own investment real estate is because the renters buy it for you. Even if other advantages didn’t kick in, that alone would make it worth it. The fact is, there are other advantages to buying rental property
Reason #2 is leverage. The most effective description of how leverage works comes from the book Buy, Rent, Sell, by Lionel Needleman (Needleman is not a huckster; on the contrary, he’s a very accomplished author and professor with many published books and articles on property in the UK and Canada. His assumptions and math is a bit simplistic, and should be adjusted for your local market, but the book is worth looking into).
Needleman explains leverage in the following manner: John and Mary each buy a rental house $100,000. After one year both properties have risen 10% in value. Both investors sell their properties and compare their profits.
John put in $100,000, and after a year he has $110,000, meaning he has earned 10% on his purchase. Mary, on the other hand, put $10,000 down on her house, and financed the rest for$90,000. When she sells she clears off the mortgage and totals everything. She too got a $10,000 profit, but as she only placed $10,000 in the income property, she’s made a 100% return on her down payment. And of course, the real kicker is that while John bought one investment house, kept it for one year and then sold it with a $10,000 gain, Mary bought 10 rentals, held them the same time, and then sold them for a $100,000 profit. They both started with $100,000, but after the same amount of time John has only got $110,000 while Mary almost twice that. The math is simplified in Needleman’s example, but they clearly demonstrate the power of leverage.
Reason #3 is taxes. In most tax jurisdictions the expenses incurred on investment property is deductible. What’s more, you can generally incur depreciation costs on the house that in effect are paper losses that reduce the tax load. Depreciation functions like this: we agree that the value of durable items, like a structure, decreases with time. Even if the property is maintained perfectly, an old building is not worth the same amount of money as a new house. This loss in value is termed depreciation, and you can use that loss to decrease the taxes.
Of course, when we buy investment property we usually hope that it will go up in value, and over the long term it often does. What do you see with the depreciation in that case? The taxman was told the structure decreased in value through depreciation, but at the end of the process we sold with a profit. The tax agency will generally say that you’ve “re-captured” the depreciation and levy tax.
Re-capture is no fun. Its like finding that you’ve already spent the profit that you intended on spending in the future.
There is a remedy. When you purchase the investment you divide the purchase price between the house value and the land value. Without cheating you value the land as low as possible and the building as high as possible (do the math and you’ll see it pays to be reasonable on your valuations). When the property increases in value and you sell, you tell the taxman that you didn’t recapture any depreciation since the building did depreciate, while the land appreciated in value. This profit is capital gain, and capital gain is generally taxed at better rates than income like…rent. You depreciate the money you make when you get it as rent, and pay tax on it when you get it as capital gain.
Owning income producing property also allows you to write off the costs of things that you may have purchased anyway, from office supplies to a trip to see the property.
Reason #4 is capital gain. Capital gain doesn’t always happen, but it often does. As we’ve seen with leverage, the capital gain can be leveraged. Even better, the capital gain can, sometimes, be greater than what some folks earn in a year of work.
Reason #5 mixes everything together by combining cash, leverage, and tax planning. Investment property create cash flow. To start with the cash flow might be neutral or even negative, but given time it will usually becomes positive. When it does you must pay income tax on excess rental income. The solution to that is to re-mortgage and incur additional interest cost, reducing your tax load. You also re-leverage your original property. The next step is to take that money and buy another income property. You won’t pay income tax, get more depreciation, and get a capital gain. Even better, with two properties you can spread your risk, and when it comes time to sell you can stretch out the timeline and sell the properties in different years to minimize taxes.
It can’t be stressed enough that you must buy investment property wisely. You need to know all about the location and the potential tenant. Properties that are desirable and are in a desirable area stay rented. “Desirable” doesn’t have to be “mansion”, but warm, clean, dry and well priced are key. Whether you buy a small apartment or a three bedroom house with a suite isn’t critical.
Metrics are critical. The first is price-to-rent ratio. What that means is that you take the price, say $100,000, and divide the rent, say $1000/month, into that. In this case the result would be 100. Results between 75 and 175 are great, but never forget that projected capital gains and interest rates impact what numbers you make use of. Low interest rates lead to higher numbers, and solid capital gain projections will demand higher numbers. Over 200 is no good in almost every location unless all you want is dependable income, don’t care about capital gain or don’t plan on ever selling.
Another excellent metric is the break even rate. This is the percentage of the purchase price required as down payment in order for the realistic rent to carry the property. The rent has to be a) market rent, not “promised” rent, and b) net rent, not gross rent. If the property will carry itself at less than 45% down its worth examining closely. Obviously, if interest rates are low the net rent will carry more, meaning the break even rate can be high. Don’t forget that low rates don’t last forever, so unless you can lock in very long term you must assume that the break even rate should be low in low interest rate environments, and can be higher in higher interest rate environments.
If you find an income property that has an acceptable price to rent ratio and a good break even rate (and is in a good area and isn’t a inferior proeprty), its worth the effort to put the numbers onto a spreadsheet and calculating the internal rate of return (a real estate investment metric that combines various income streams) and projected cash on sale. There are spreadsheets and programs that can calculate this, but the key is “GIGO” – garbage in, garbage out. Put in realistic taxes, the correct interest rates, your projected income tax rate, and realistic estimates of annual appreciation and maintenance. Income property in urban often go up in value more than properties in depressed or rural areas. They can also have what seem to be worse metrics – a downtown condo may have a much worse price to rent and break even point than little house in a small town. But, capital appreciation in rural areas is likely more uncertain. Measuring mortgage pay down and tax benefits on a detailed spreadsheet permits you fairly evaluate how competing investments compare.
It would be wrong to ignore the problem of a property bubble, or market crash. Buying on metrics both helps and hinders. It helps because if you are strict with break even rates and rent multipliers you won’t buy overpriced investment real estate (underpriced investment property doesn’t really exist in a bubble, and it doesn’t crash in value). It hinders because you can’t buy on metrics in a bubble, no matter how much you want to, because metric compliant properties can’t be found.
The result of this is that when a market crashes there are plenty of metric compliant properties, but generally little financing and plenty of reluctant buyers and stressed sellers.
At the end of the day, a balanced market is the best for buyers, although purchasers who invest on metrics and exit the market near the peak sometimes think they’ve hit the jackpot.