Since he economic downturn of 2001 and the resulting uncertainty in the stock market, many investors have turned to real estate as a means of earning significant return on their money. The most experienced know that a long-term commitment to a rental property will realize the best profit. Everyone has a “friend-of-a-friend” who brags about making a huge profit in a short time flipping houses and, as a result, many naive investors try to use real estate as a short-term investment vehicle. That frame of mind is risky, to say the least, and not what this article is about.
Real estate should be thought of as a long-term investment. Without a large portion of luck it is not viable as a quick in and out proposition. Developing a long-term perspective in real estate allows one to take advantage of four elements: leverage, appreciation, cash flow, and tax benefits. When analyzing whether a property is right for you investment purposes, these four major elements need to be considered. It is the combination of these components that make rental property so powerful as an investment.
Leverage refers to the ability to buy and control a property with a down payment of 0% to 30% of the total value of the property (see below on cash flow regarding how much you put down). With paper investments such as stocks, bonds, mutual funds, CDs, etc. we usually purchase 100% of the value. Let’s say we buy $40,000 of stock. If the stock gives us a 5% return over the next year, that adds up to a $2,000 gain. If we take the same $40,000 and buy a $2000,000 house (which is a 20% down payment) and it appreciates 5% over the same year, we will realize a $10,000 gain on our $40,000 down payment, which would represent a 25% return on our investment. Any appreciation on real estate applies to the total value of property, which magnifies or leverages the return on your down payment.
How confident can we be that real estate will appreciate? Figures available from the government (www.ofheo.gov) show quarterly appreciation for almost every part of the country since 1979 when records first started being kept. Except for 1983 (-9.02%), 1987 (4.22%), and 1988 (.07%), average housing prices in Boulder County have appreciated at least 5% every year. Many of the years since 1979 have shown much higher appreciation than just 5%.
With investment property, the overall value isn’t the only thing that appreciates. Rents appreciate an average of 3% per year. Cash flow wise that means if you treat investment real estate as a long term commitment, your cash flow in rents will get better and better, while your mortgage payments remain the same (assuming you have a fixed rate loan), disappearing completely when you finish paying off the loan. When that happens, think of the options you will have. You can keep the rental and receive a significant monthly income from the rents, or you can sell the property – which by then will potentially be worth significantly more than your original purchase price.
There are many other expenses besides mortgage that you will want to consider in order to figure your overall cash flow on a rental property. These include utilities, property taxes and hazard insurance, potential vacancies, and maintenance – just to mention a few.
While it is possible to buy investment real estate for no money down, it may be harder for you to justify from an initial cash flow standpoint. Ask your Realtor to run a cash flow analysis for you on a specific property to see if it makes sense for you. The more you put down on the property, the better the interest rate you will get on the mortgage, and the better your cash flow will be because of lower monthly mortgage payments.
Upon the sale of the property, the same capital gains tax advantages apply as with other capital investments (mutual funds, etc.). In addition, you are allowed to deduct expenses related to the property and to depreciate the property annually on your tax return with potentially significant tax savings. Ask your tax accountant for details related to your personal tax situation.
When applied with a long-term investment strategy, leverage, appreciation, cash flow, and tax benefits make a strong case for investment rental property.