Investing in Rental Real Estate

Investing in Rental Real Estate

It’s interesting how rental real estate gets treated as an investment. Like Rodney Dangerfield, it gets no respect. While traditional investments like stocks and bonds get the Financial Post and the Wall Street Journal, do a search on “how to buy real estate” and you’ll discover all kinds of no-money down schemes that seem designed to sell books and tapes instead of investment real estate. On TV there is Report on Business TV, but for real estate you’ll see flipping shows or infomercials. It strikes me as pitiful that such a substantial investment means gets such a bad reputation.

It is possible to buy with no money down, but it involves arranging a high ratio mortgage, and for rental character you only do that if you have equity in other similarities. In other words, if you’ve got one character free and clear its comparatively easy to position a line of credit at chief. A $100,000 character would cost about $400 per month, plus taxes and maintenance of about $200. In short, it would carry itself and give you income to pay the financing costs.

A more shared method to buy income real estate is with a place. Usually is you can make investment character itself with less than 40% down its probably a good deal. These kinds of similarities are easier to come across in stable markets.

There are lots of reasons to own investment real estate.

Reason #1 to own income real estate is because your renters buy it for you. already if the other benefits didn’t accrue, that on it’s own justifies the investment. But the fact is, there are more benefits to buying rental character

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 fast talker; in fact, he’s an achieved author and professor with many published books and articles on housing in Great Britain and Canada. His assumptions and math is a bit simplistic, and need to be tweaked for your local market, but the book is worth looking at).

He explains leverage in the following manner: John and Mary each buy a character $100,000. After a year both houses have increased 10% in value. Both buyers sell the similarities and compare the profits.

John began with $100,000, and now has $110,000, which method he has earned a 10% return on his investment. Mary, however, put $10,000 down on her character, and mortgaged the balance for$90,000. When she sells she clears off the mortgage and totals everything. She also received a $10,000 profit, but since she only invested $10,000 in the income character, she’s made a 100% return on her down payment. As you may speculate, the real kicker is that while John invested in one house, kept it for a year and then sold it with a $10,000 profit, Mary acquired 10 houses, kept them one year, and then sold them for a $100,000 profit. Both started out with $100,000, but after a year John has only got $110,000 while Mary $90,000 more. The numbers are simplified in this example, but they decisively demonstrate the magic of leverage.

Reason #3 is taxes. In most tax zones costs incurred on investment real estate is comes off income. And, you can generally incur depreciation expense on the structure that in effect are paper losses that reduce the tax burden. Depreciation works like this: we know that the value of a lasting item, like a structure, decreases with the years. already if the character is maintained perfectly, an old house is not worth the same amount of money as a new house. This loss is depreciation, and you can use that depreciation loss to decline the total tax payable.

Of course, when we invest in income character we expect that it will go up in price, and over the long run it often does. What occurs with the depreciation in that case? The tax collector was told the character fell in price by depreciation, but at the end of the time of action we sold at a profit. The taxman usually says that you’ve “re-captured” the depreciation and levy tax.

Re-capture is no fun. It’s like discovering that you’ve already spent the money that you intended on spending in the future.

There is a great solution. When you buy the investment you cut up the original investment between the building value and the character value. Without cheating you set the value of the land as low as possible and the structure as high as reasonable (do the math and you’ll see it pays to be reasonable on your splits). When the character goes up in price and you liquidate, you tell the taxman that you didn’t recapture any depreciation since the structure did depreciate, while the land increased in value. This profit is capital gain, and capital gain is usually taxed at lower rates than income like…rent. You depreciate the money you make when you earn it as rent, and pay tax on it when it comes from capital gain.

Owning income producing character also enables you to write off the costs of things that you might have bought anyway, from office supplies to a trip to see the character.

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. already better, the capital gain can, sometimes, be greater than what some folks earn in a year of work.

Reason #5 puts everything together by combining cash flow, leverage, and tax planning. Rental real estate generate cash flow. Initially the cash flow could be neutral or already negative, but after some time it will often becomes positive. When it does you need to pay income tax on the excess rent. The solution for that is to re-mortgage and incur additional interest cost, reducing your taxes. You also re-leverage your initial character. The next step is to take that money and buy another income character. You pay no income tax, incur more depreciation, and nevertheless earn a capital gain. Better however, with two similarities you spread the risk, and when the time comes to sell you can stretch out the timeline and sell the similarities in different years to minimize tax.

It can’t be repeated enough that you need to buy income character wisely. You need to know the location and the possible tenant. similarities 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 basic. Whether you buy a 1 bedroom apartment or a three bedroom house with a suite isn’t important.

Metrics are basic. The first is price-to-rent ratio. What that method is that you take the price, say $100,000, and divide the rent, say $1000/month, into that. In this case the consequence would be 100. Numbers between 75 and 175 are great, but never forget that projected capital gains and interest rates impact what numbers you go with. Low interest rates permit higher numbers, and substantial capital gain projections will need higher numbers. Over 200 is no good in almost every location unless all you need is dependable income, aren’t concerned about capital gain or don’t ever plan to sell.

Another excellent metric is the break already rate. This is the percentage of the price need for a down payment to allow the realistic rent to carry the character. The rent has to be a) market rent, not “hoped for” rent, and b) net rent, not gross rent. If the investment will carry at less than 45% down its worth looking at. Clearly, if interest rates are low the net rent will carry more, meaning the break already rate can be high. Remember that low rates don’t last forever, so unless you can lock in very long term you have to assume that the break already rate to be low in low interest rate environments, and can be higher in higher interest rate environments.

If you discover a piece of character that has a desirable price to rent ratio and a desirable break already rate (and is in a good area and isn’t a bad idea), its worth throwing the numbers onto a spreadsheet and calculating the internal rate of return (a real estate investment metric that combines various income flows) and projected cash on sale. There are spreadsheets and programs that can calculate this for you, but the meaningful is “GIGO” – garbage in, garbage out. Use correct taxes, the correct interest rates, your projections of income tax rate, and realistic estimates of capital gain and maintenance. similarities in active urban areas generally go up in value more than similarities in rural or depressed locales. They also often have what seem to be inferior metrics – a downtown city condo could have a much worse price to rent and break already point than small house in a mill town. However, capital appreciation in a rural area is likely much riskier. Measuring mortgage pay down and tax benefits on a detailed spreadsheet let’s you fairly estimate exactly how competing investments compare.

It would be foolish to ignore the issue of a character bubble, or crash. Buying on metrics both helps and hinders. It helps because if you are hard-nosed with break already rates and rent multipliers you wouldn’t buy overpriced investment character (underpriced income character doesn’t really turn up 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 similarities don’t exist.

The other side of this is that when a market crashes there are lots of metric compliant similarities, but often little mortgage financing and plenty of scared buyers and stressed sellers.

All in all, a balanced market is the optimum for purchasers, although buyers who acquire on metrics and exit the market near the peak often feel like they’ve hit the jackpot.

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