Creating Wealth through Real Estate

Investment vehicle drift in and out of fashion over the years. There are years when stocks are generating better returns than other investments. We’ve seem commodities stand out as the place to be and of course real estate has had some amazing gains over the years before it suffered the major correction that we are still dealing with today.

We need to recognize:

·        every investment has an element of risk

·        we are susceptible to being pulled by the momentum created when “everyone else is doing it”

·        the sources of information available to use aren’t as neutral as we believe

·        there is no truly passive investment

We’ve been lulled over the years to think that real estate is the perfect investment. It was never a question of if there is going to be appreciation, it was a question of how much. The last few years have served as a wakeup call. We’ve seen real estate prices drop. We’ve been exposed to new terms, underwater mortgages, modifications, buy and bail, etc. All the assumptions about real estate have been proven wrong. 

Anything we read in the newspaper or on the Internet regarding real estate has been negative. If we are to believe what we’re being told then we have to conclude that buying a house ranks up there as one of the top 10 biggest mistakes a person can make. You could easily be tempted to rank it as number one.

We are being lead into new form of bubble; call it a reverse-bubble. Instead of a common attitude driving the price of something up to unsustainable levels, the attitude today is to avoid real estate at any cost because prices will not recover in your lifetime.

For an investor to be successful he needs to develop his own opinion from the facts at hand and minimize the pull to be a part of the crowd. You need to analyze the potential gains and the risks of loss to determine if real estate should be a part of your assets.

Real Estate is a Long Term Investment

One of the largest contributing factors to the development of the real estate bubble was that real estate was expected to appreciate over a time frame measured in weeks instead of years.

Real Estate investing is based on a long term timeline, just as most investments are. Speculation on the other hand is the intention to generate short term gains. Professional speculators recognize the high level of risk involved in what they’re doing and are willing to expose themselves to that risk because of the magnitude of the potential gain.

We saw many people speculating in real estate though property flipping fooling themselves by thinking they were investing in real estate. This blinded them to the potential risk of the deals they were getting involved in.

If you are considering investing in real estate you need to plan on being in the deal for 10 years. If you’re not prepare to commit yourself for that length of time either recognize that your investment is going to be carrying a speculation component to it, yielding a higher exposure to risk or rule out real estate as an investment vehicle.

Another issue was that people were looking at their primary residence as an investment first and a home second. This effectively made their home a speculative investment. Can it be? Sure, as long as you recognize the magnitude of the risk involved. You are not only putting your capital at risk but the quality of life of your family. Is the profit potential great enough to warrant that kind of risk?

Your Primary Residence fills 2 Roles

When purchasing a property to live in you are doing 2 things. First, you are leaving the rental market where you can easily move from one address to another. Once your lease is up, you’re free to either sign a renewal lease or pack up your family and your belongings and move on. This freedom works both ways. Your landlord is under no obligation to offer you a lease renewal and is free to offer the renewal on different terms, such as a higher rent.

Once you move into an ownership position moving becomes more complicated. You not only need to find a new place to live but you also have to sell your current home. This comes with its own demands on you time and attention as well as the associated expenses. While you are living in your own property you are not exposed to the demands of a landlord. Although you can’t control your utility or maintenance costs, you don’t need to be concerned about the income a landlord wants to earn or worry about when he wants to sell the property. In making this decision to buy a home to live in you are committing to staying put for a number of years and you are taking better control of your housing costs.

The second role this purchase fills is that during the time that you own this property any appreciation in the value of the home is yours, not your landlord’s. In addition, the mortgage payment you are now making is also reducing the money you owe on the property. As the years progress, this becomes a substantial buildup in the equity in your property not the landlord’s.

The factors that you need to consider (in the order of priority) when making this decision are:

1.    Am I ready to settle down in one location for the next 7 to 10 years?

2.    How much more per month is this going to cost me above the rent I’m currently paying?

3.    How stable is my current rent?

4.    Where do I think property values will be in 7 to 10 years?

5.    What is the approximate value of the tax benefits of ownership to me?

You can’t calculate the rate of return on this investment

When making an investment decision you want to see what your anticipate rate of return will be. For example if you purchase a $10,000 Certificate of Deposit with a 1 year term paying 5% interest you expect to earn $500.00 at the end of the year (assuming no compounding). If you put $500.00 a year into a savings account that pays 5% annually then you can expect to have $6,288.95 in that account after 10 years. Both calculations are straightforward. You divert a fixed amount of your assets and expect a specific dollar of profit.

Transitioning from paying rent to paying a mortgage is a different story. You are diverting a monthly expense (rent) into an ongoing investment (mortgage payment). You are now investing an expense, not reallocating your assets. How do you calculate your rate of return under this condition? You can’t.

Let’s take an example. You purchased a house 10 years ago for $100,000 mortgaging $80,000. You sell the house today for $120,000. We can see the first piece of the “profit”, the increase in the sales price of $20,000. The mortgage you’ve been paying for the last 10 years is now less than $80,000. The original term and its initial interest will dictate how much you’ve paid off. For this example we’ll use a 30 year fixed rate mortgage at 5.0%. Over 10 years the mortgage has been paid down $13,752.88. So now we’re up to $33,752.88 in “profit”.

This property also served as a place for you to live in for the last 10 years. What additional contribution to the “profit” does that make? In addition, the sale of your primary residence has special treatment in the tax code. The $500.00 profit on our CD is taxable income. You need to share this profit with the government. The profit on the sale of your primary residence is tax free up to the first $250,000 in net profit for an individual. This also contributes to the “profit” on this sale.

This is an over simplification for discussion purposes but you can see that the true return really is impossible to calculate with any degree of certainty. There are other costs associated with ownership that you don’t have as a tenant such as transaction costs and maintenance which also needs to be given consideraion.

It’s good to be aware of the market trends for housing but don’t let them control your life. Owning your home is a personal decision. The market trend is only one of many considerations when you ultimately decide to buy or rent or whether to buy now or later.

Different standards for real estate investing and investing in the stock market

Now we’re going to look at investing in real estate. That is, buying property without intending to live in it. What is the attraction to investing in real estate? The events of the last few years have shown that real estate can be just as volatile as any other investment. That is not a reason to avoid investing in real estate.

Real estate is held to a different set of standards than other forms of investments by the public. The obvious example of this was the assumption that real estate only goes up and never comes down. We all agree that assumption proved to be invalid.

Leveraging your Investment

For a real estate purchase to be considered a good investment It’s expected to be able to be leveraged at least 80%, at a relatively low interest rate over a long term and expected that the cash flow of the property will at least carry all the expenses as well as the mortgage payment.

Let’s compare this to buying stock with borrowed money (buying on margin). First, the most you can borrow against the stock is 50% by law, you probably won’t have fixed rate money available and you wouldn’t expect the dividend flow of the stock to be able to support the debt service. On top of this, in the event the value of your stock portfolio drops, you are expected to pay that loan down immediately to bring the leverage back to under 50% of value. Most mortgages on the other hand don’t have that feature.

Investing for both cash flow and capital appreciation

When investing in stocks you are primarily buying based on anticipated appreciation with some dividend payments along the way. The dividends are nice, but not the primary concern when buying stock. Bonds, CDs, and the like are purchased primarily for the annual cash flow they provide. Commodities and options are purchased solely for appreciation, they have no dividend or interest pay out.

Real estate, in most instances is purchased as much as for cash flow as it is for appreciation. Should the property value not appreciate as quickly as planned, there is still a regular flow of annual income. This balance of cash flow and appreciation is a major reason people are attracted to real estate investing.

There is nothing preventing you from speculating in real estate. You may have purchased a property without any consideration given to its cash flow potential with the intention of simply selling it for a profit at some later date. The cash flow potential then serves as a safety net should things not go as planned.

Long term time horizon

All investments are made with an intention to cash in at some point in the future. Investing in options typically is done with a short holding period, maybe even measured in days. Stocks purchases can be made with a planned holding period of any length of time. The nature of the business you are buying stock in will dictate the planned holding period. Bonds generally are long term purchases since they are commonly bought for regular cash flow. 

Real estate requires the longest holding period of any investment. As in all investments, as time progresses things will happen that will impact your plan. The stock you bought appreciated faster than expected, you got an unsolicited offer on the property you bought last year and you decide to take it, etc. The point is that as a real estate investor you must be prepared to be in the deal for the long haul. 

A major contributing fact to the housing crisis was that people began expecting real estate to generate short term gains. Buy a property this year and sell it next year making 20% on your money. Or enter into contract to purchase a property and then sell the contract for a profit. It seems like a crazy notion but only a few years ago everybody thought they could make money over night in real estate.

Real estate transactions come with expenses, both when you buy and when you sell. There needs to be enough appreciation at the time you sell to cover these expenses and still generate a profit to you. This alone should tell you that you need to expect to hold onto a property for many years before selling becomes profitable.

Even after this market correction if a person bought a property 10 years ago it’s probably worth more now that when it was purchased.  Yes, it was worth more 3 years ago than now but it’s still worth more today that when it was purchased.

If you’re not a patient person, real estate is not the right investment to make.

The Different Property Types

There are property types to meet the needs of any investor. From a small condo apartment to a multifamily high rise or a shopping mall, there is product available for any level of sophistication and net worth. Every property type has its unique set of qualities and problems. The investor needs to analyze each property type in addition to the rest of his work in determining which property to invest in.

You need to decide the property type in an area that interests you. Then you need to as much as you can about how that property type has, is and will perform in the region you have decided to focus on.

The Unique Tax Benefit Afforded to Real Estate Investing

Any investment you make can be sold at a later date. You sell the investment, recognize the profit, pay the taxes and you move on. Some investments you can pledge to a lender, take the proceeds of the financing and move on. Both these options are available to the real estate investor. Property can be sold, taxes paid or the property can be mortgaged, property kept and the mortgage proceeds are a non-taxable event.

Real estate investments have a third alternative that other forms of investments do not, a 1031 tax free exchange. Let’s say you invest in the stock market. You seen your investment in Ford rise nicely but you think Toyota’s future appreciation potential is now better that Ford’s. To move your cash you sell Ford, pay the capital gains tax and then you can reinvest what’s left in Toyota.

You’re a real estate investor. You’ve owned a multifamily property for some time but you think its current rate of appreciation is tapering off and you want to move into a commercial property because you feel it has great growth potential.

As long as the acquisition cost of the commercial property is greater than the sale price of the multifamily property you can move from the property you are selling to the property you are buying without paying any tax now. The tax you would ordinarily owe by selling the multifamily is deferred until you sell the commercial property.

There are certain timeframes and other details that you need to comply with but the 1031 exchange permits you to keep all the profits working for you until you are ready to cash out of real estate altogether. You can do a 1031 exchange as often as you like, anywhere in the country you like and can be done on any type of investment property. No other investment vehicle gets this form of preferential tax treatment. How much can this tool enhancing the yield on your real estate investments?   

This is a business, not a passive investment

You must treat real estate investment as a business. That’s precisely the reason the 1031 exchange applies to real estate. The 1031 exchange was written to allow businesses to evolve as needed over time. If you think you just can’t buy a property and ignore it, you are destined to fail. If you don’t have the desire or the time to stay actively involved do not invest in real estate.

For starters, you need to research which geographic area you want to invest in, then you need to find the particular property, negotiate the terms of the sale, arrange for financing, perform any renovations that’s needed and find your tenants. After this initial effort you will be renewing leases, finding new tenants, making sure the property is properly maintained and all the bills are paid.

Real estate investing is attractive to those who like to be actively involved and take full responsibility for management. Even if a management service is used, you still need to monitor management. There will be a substantial amount of time invested when you start and as you get more experienced you will find it takes less time and effort. You will always be actively involved to some degree. It comes with the territory.

In addition to the financial rewards of investing you also can take create for the success.  After all you made all the decisions; you didn’t depend on someone else leading you along. Every decision, good or bad was yours.

Realistic Expectations

Is real estate the perfect investment? Is it without risks? The answer to both questions is no. There is no perfect investment, bubbles occur at times in all areas of investments. Crashes also occur, no investment is immune. An investment decision is based on identifying the potential rewards and the potential risks then deciding if the potential rewards outweigh the potential risks. This is what investing is all about. When too many people lose focus we end up with a bubble or a crash. During the last 5 years we saw both happen in the real estate market.

There is no easy way to build wealth; you need to work at it. Historically, real estate investments have made a substantial contribution to the net worth of all the wealthiest families in this country.