Real Estate or Other Investments
Real Estate or Other Investments
Real Estate or Other Investments
Surely you’ve considered or heard about many different investments over the years. To help you appreciate and understand the unique characteristic of real estate, we compare and contrast real estate’s attributes with those of
other wealth-building investments like stocks and small businesses.
other wealth-building investments like stocks and small businesses.
Real Estate or Other Investments
How leverage affects your real estate returns
Real estate is different from most other investments in that you can typically borrow (finance) up to 70 to 80 percent or more of the value of the property. Thus, you can use your small down payment of 20 to 30 percent of the purchase price to buy, own, and control a much larger investment. (During market downturns, lenders tighten requirements and may require larger down payments than they do during good times.) So when your real estate increases in value (which is what you hope and expect), you make money on your investment as well as on the money that you borrowed. That’s what we mean when we say that the investment returns from real estate get magnified due to leverage.
Take a look at this simple example. Suppose you purchase a property for $150,000 and make a $30,000 down payment. Over the next three years, imagine that the property appreciates 10 percent to $165,000. Thus, you have a profit (on paper) of $15,000 ($165,000 – $150,000) on an investment of just $30,000. In other words, you’ve made a 50 percent return on your investment.
(Note: We ignore cash flow whether your expenses from the property exceed the rental income that you collect or vice versa, and the tax benefits associated with rental real estate.)
Remember, leverage magnifies all of your returns, and those returns aren’t always positive!
If your $150,000 property decreases in value to $135,000, even though it has only dropped 10 percent in value, you actually lose (on paper) 50 percent of your original $30,000 investment. (In case you care, and it’s okay if you don’t, some wonks apply the terms positive leverage and negative leverage.) Please see the “Understanding Real Estate’s Income- and Wealth-Producing Potential” section earlier in this chapter for a more detailed example of investment property profit and return.
Remember, leverage magnifies all of your returns, and those returns aren’t always positive!
If your $150,000 property decreases in value to $135,000, even though it has only dropped 10 percent in value, you actually lose (on paper) 50 percent of your original $30,000 investment. (In case you care, and it’s okay if you don’t, some wonks apply the terms positive leverage and negative leverage.) Please see the “Understanding Real Estate’s Income- and Wealth-Producing Potential” section earlier in this chapter for a more detailed example of investment property profit and return.
Returns
Clearly, a major reason that many people invest in real estate is for the healthy total returns (which include ongoing profits and the appreciation of the property). Real estate generates robust long-term returns because, like stocks and small businesses, it’s an ownership investment. By that, we mean that real estate is an asset that has the ability to produce income and profits. Our research and experience suggest that total real estate investment returns are comparable to those from stocks about 8 to 10 percent annually.
Interestingly, the average annual return on real estate investment trusts (REITs), publicly traded companies that invest in income-producing real estate such as apartment buildings, office complexes, and shopping centers has been about 10 percent. And you can earn returns better than 10 percent per year if you select excellent properties in the best areas and manage them well.
Risk
Real estate doesn’t always rise in value witness the decline occurring in most parts of the U.S. during the late 2000s. That said, market values for real estate don’t generally suffer from as much volatility as stock prices do. You
may recall how the excitement surrounding the mushrooming of technology and Internet stock prices in the late 1990s turned into the dismay and agony of those same sectors’ stock prices crashing in the early 2000s. Many stocks
in this industry, including those of leaders in their niches, saw their stock prices plummet by 80 percent, 90 percent, or more.
may recall how the excitement surrounding the mushrooming of technology and Internet stock prices in the late 1990s turned into the dismay and agony of those same sectors’ stock prices crashing in the early 2000s. Many stocks
in this industry, including those of leaders in their niches, saw their stock prices plummet by 80 percent, 90 percent, or more.
Keep in mind (especially if you tend to be concerned about shorter-term risks) that real estate can suffer from declines of 10 percent, 20 percent, or more. If you make a down payment of say, 20 percent, and want to sell your
property after a 10 to 15 percent price decline, you may find that all (as in 100 percent) of your invested dollars (down payment) are wiped out after you factor in transaction costs. So you can lose everything.
You can greatly reduce and minimize your risk of investing in real estate through buying and holding property for many years (seven to ten or more).
property after a 10 to 15 percent price decline, you may find that all (as in 100 percent) of your invested dollars (down payment) are wiped out after you factor in transaction costs. So you can lose everything.
You can greatly reduce and minimize your risk of investing in real estate through buying and holding property for many years (seven to ten or more).
Liquidity
The ease and cost with which you can sell and get your money out of an investment is one of the real estate’s shortcomings. Real estate is relatively illiquid: You can’t sell a piece of property with the same speed with
which you whip out your ATM card and withdraw money from your bank account or sell a stock with a phone call or click of your computer’s mouse.
which you whip out your ATM card and withdraw money from your bank account or sell a stock with a phone call or click of your computer’s mouse.
We actually view this illiquidity as a strength, certainly compared with stocks that people often trade in and out of because doing so is so easy and seemingly cheap. As a result, many stock market investors tend to lose sight of the
long-term and miss out on the bigger gains that accrue to patients buy and stick with its investors. Because you can’t track the value of investment real estate daily on your computer, and because real estate takes considerable
time, energy, and money to sell, you’re far more likely to buy and hold onto your properties for the longer-term.
long-term and miss out on the bigger gains that accrue to patients buy and stick with its investors. Because you can’t track the value of investment real estate daily on your computer, and because real estate takes considerable
time, energy, and money to sell, you’re far more likely to buy and hold onto your properties for the longer-term.
Although real estate investments are generally less liquid than stocks, they’re generally more liquid than investments made in your own or someone else’s small business. People need a place to live and businesses need a place to
operate, so there’s always a demand for real estate (although the supply of such properties can greatly exceed the demand in some areas during certain time periods).
operate, so there’s always a demand for real estate (although the supply of such properties can greatly exceed the demand in some areas during certain time periods).
Capital requirements
Although you can easily get started with traditional investments such as stocks and mutual funds with a few hundred or thousand dollars, the vast majority of quality real estate investments require far greater investments usually on the order of tens of thousands of dollars.
If you’re one of the many people who don’t have that kind of money burning a hole in your pocket, don’t despair. We present you with lower-cost real estate investment options. Among the simplest low-cost real estate investment
options are real estate investment trusts (REITs).
If you’re one of the many people who don’t have that kind of money burning a hole in your pocket, don’t despair. We present you with lower-cost real estate investment options. Among the simplest low-cost real estate investment
options are real estate investment trusts (REITs).
Diversification value
An advantage of holding investment real estate is that its value doesn’t necessarily move in tandem with other investments, such as stocks or small-business investments that you hold. You may recall, for example, the
massive stock market decline in the early 2000s. In most communities around America, real estate values were either steady or actually rising during this horrendous period for stock prices.
However, real estate prices and stock prices, for example, can move down together in value. (As happened in most parts of the country during the 2007–2008 stock market slide). Sluggish business conditions and lower corporate
profits can depress stock and real estate prices.
massive stock market decline in the early 2000s. In most communities around America, real estate values were either steady or actually rising during this horrendous period for stock prices.
However, real estate prices and stock prices, for example, can move down together in value. (As happened in most parts of the country during the 2007–2008 stock market slide). Sluggish business conditions and lower corporate
profits can depress stock and real estate prices.
Opportunities to add value
Although you may not know much about investing in the stock market, you may have some good ideas about how to improve a property and make it more valuable. You can fix up a property or develop it further and raise the
rental income accordingly. Perhaps through legwork, persistence, and good negotiating skills, you can purchase a property below its fair market value.
Relative to investing in the stock market, persistent and savvy real estate investors can more easily buy property in the private real estate market at below fair market value. You can do the same in the stock market, but the
scores of professional, full-time money managers who analyze the public market for stocks make finding bargains more difficult.
rental income accordingly. Perhaps through legwork, persistence, and good negotiating skills, you can purchase a property below its fair market value.
Relative to investing in the stock market, persistent and savvy real estate investors can more easily buy property in the private real estate market at below fair market value. You can do the same in the stock market, but the
scores of professional, full-time money managers who analyze the public market for stocks make finding bargains more difficult.
Tax advantages
Real Estate or Other Investments
Real estate investment offers numerous tax advantages. We compare and contrast investment property tax issues with those of other investments.
Deductible expenses (including depreciation)
Owning a property has much in common with owning your own small business. Every year, your account for your income and expenses on a tax return. For now, we want to remind you to keep good records of your expenses in
purchasing and operating rental real estate. One expense that you get to deduct for rental real estate on your tax return depreciation doesn’t actually involve spending or outlaying money.
purchasing and operating rental real estate. One expense that you get to deduct for rental real estate on your tax return depreciation doesn’t actually involve spending or outlaying money.
Depreciation is an allowable tax deduction for buildings because structures wear out over time. Under current tax laws, residential real estate is depreciated over 271⁄ 2 years (commercial buildings are depreciated over 39 years). Residential real estate is depreciated
over shorter time periods because it has traditionally been a favored investment in our nation’s tax laws.
over shorter time periods because it has traditionally been a favored investment in our nation’s tax laws.
Tax-free rollovers of rental property profits
When you sell a stock or mutual fund investment that you hold outside a retirement account, you must pay tax on your profits. By contrast, you can avoid paying tax on your profit when you sell a rental property if you roll over your gain into another like-kind investment real estate property.
The rules for properly making one of these 1031 exchanges are complex and usually involve third parties. Make sure that you find an attorney and/or tax advisor who is an expert at these transactions to ensure that everything goes smoothly (and legally).
The rules for properly making one of these 1031 exchanges are complex and usually involve third parties. Make sure that you find an attorney and/or tax advisor who is an expert at these transactions to ensure that everything goes smoothly (and legally).
If you don’t roll over your gain, you may owe significant taxes because of how the IRS defines your gain. For example, if you buy a property for $200,000 and sell it for $550,000, you not only owe tax on that difference, but you also owe tax on an additional amount, depending on the property’s depreciation. The amount of depreciation that you deduct on your tax returns reduces the original $200,000 purchase price, making the taxable difference that much larger.
For example, if you deducted $125,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $550,000 and $75,000 ($200,000 purchase price – $125,000 depreciation).
For example, if you deducted $125,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $550,000 and $75,000 ($200,000 purchase price – $125,000 depreciation).
Deferred taxes with installment sales
Installment sales are a complex method that can be used to defer your tax bill when you sell an investment property at a profit and you don’t buy another rental property. With such a sale, you play the role of banker and provide financing to the buyer. In addition to collecting a competitive interest rate from the seller, you only have to pay capital gains tax as you receive proceeds over time from the sale.
Special tax credits for low-income housing and old buildings
If you invest in and upgrade low-income housing or certified historic buildings, you can gain special tax credits. The credits represent a direct reduction in your tax bill from expenditures to rehabilitate and improve such properties. These tax credits exist to encourage investors to invest in and fix up old or run-down buildings that likely would continue to deteriorate otherwise.
The IRS has strict rules governing what types of properties qualify. See IRS Form 3468 to discover more about these credits.
The IRS has strict rules governing what types of properties qualify. See IRS Form 3468 to discover more about these credits.
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