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Why Invest in Real Estate?

In my most recent Blog Post “Other Retirement Income” I suggested that investing in real estate is still one of the best methods for the average person to accumulate wealth. I truly believe this. In this post I will discuss why I think real estate is still a good investment tool to use to supplement your retirement income.

Due to the housing market’s recent meltdown many people were burned by owning real estate. In fact, due to financial hardships, many people are trying to unload their homes or investment properties. For these people their personal situation is such that unloading their real estate may be the best thing to do at this time. One of the obvious lessons of the past decade is that there is a good time to buy real estate and a bad time to buy real estate. I will discuss how to know the difference in a future post. But in this post I want to describe the advantages of owning real estate as an investment.

Owning real estate as an investment has many advantages over stock ownership. I think one of the best advantages is the sense of control you have over the investment. When you own company stock, you have direct ownership in the company, but your ownership involvement is more like a limited partner in that you do not get involved in the day-to-day operations of the company. Direct ownership of real estate is more attuned to being the sole proprietor of a small business. As a stock owner one can feel helpless to the changes of the stock market mood. On the other hand, as a real estate investor, you make all the decisions regarding the investment. For example, you can choose to delay capital improvements when times are tough or change the type of rental lease you offer when the local market calls for a different approach.

But the biggest advantage of real estate investing is it allows you to employ the “Law of Leverage.” Leverage is the ability to use a small amount of money (your down payment) to control a larger valued asset through mortgage financing. Many of you may be thinking “financing of real estate is what got me into trouble.” It is true leverage can be a double-edged sword. It can hurt you when real estate values decrease as in recent years, but it can also turbo-charge your investment returns when housing values increase. You must be careful using leverage when buying property. But you do not need to worry about leverage if you buy property with the right approach. There is a very simple and disciplined way to know when to move forward with a real estate deal and when to walk away. I will discuss this approach in one of my next blog posts.

Let me illustrate how leverage works to your advantage. Let’s say you decide to invest in a $300,000 single family house. Let’s assume after 12 months the value of this home goes up 5% to $315,000. Your one year investment return is 5% right? Your return is 5% only if you paid $300,000 cash when you bought the property. However, if you bought the property with a 20% down payment ($60,000) and you financed the balance of the purchase price, $240,000, via mortgage debt, your investment return is not 5% but 25%. The $15,000 increase in property value is actually a 25% return on your $60,000 down payment. This is how the law of leverage works and how it allows you to enhance your investment return.

Specifically, there are four ways to make money owning real estate as an investment. They are:

• Capital appreciation; when the property increases in value,
• Income; derived from renting the property use to others,
• Equity increase; derived from paying down the mortgage debt,
• Tax benefit; derived from depreciating the property improvements.

I will illustrate how each of the listed financial areas contributes to your overall investment return. Continuing with our previous example of the $300,000 investment home, let’s assume you bought the investment properly and the following figures apply:

• Your $240,000 loan is financed with a 4.25% fixed rate payable at a fixed monthly payment of $1,180 principle and interest,
• Your property taxes and insurance escrow payments are $250 monthly.
• Annual property maintenance is $1,800 or $150 monthly,
• Your monthly rental income is $1,800,
• The value of the property improvements (i.e., the buildings) is $220,000 providing an $8,000 per year depreciation tax deduction.

Let’s now tally up how each financial area contributes to your overall annual investment return:

• Capital appreciation = $15,000 (assuming a 5% increase in property value),
• Net annual rental income = $2,640 ($1,800 – ($1,180 + $250 + $150)) = $220 x 12 months
• 1^st year equity increase = $4,000 ($240,000 initial loan balance – $236,000 balance remaining after 12 monthly payments),
• Tax benefit = $2,400 ($8,000 x 30%; assuming 30% combined federal and state tax bracket).

The total financial gain after the first year of owning this property is $24,040. This represents a 40% return on the initial $60,000 investment. But the capital appreciation is only a paper gain; it could disappear in the following year. This is certainly a possibility so let’s leave out the $15,000 capital appreciation. The remaining gain is $9,040 ($2,640 + $4,000 + $2,400). This still represents a 15% gain on your $60,000 investment. Frankly, you could do worse.

But the beauty of real estate is it gets better over time. The rental income should increase every year with inflation and your equity will increase each year as your mortgage balance decreases with each monthly payment.

Let’s fast forward 10 years from your initial purchase of this $300,000 property assuming 3% annual inflation on your rent and your property expenses. Let’s also continue to ignore any property appreciation. The financial figures 10 years later have now changed to:

• Monthly rental Income has increased 35% to $2,430,
• Monthly real estate taxes and insurance has increased 35% to $338,
• Monthly property maintenance has increased 35% to $203,
• Net annual rental income = $8,508 ($2,430 – ($1,180 + $338 + $203)) = $709 x 12 months
• Loan balance reduction in year 10 of property ownership = $5,926,
• Tax depreciation benefit = $2,400 (annual depreciation amount remains fixed for 27.5 years).

After 10 years of owning this property the total annual gain (excluding property appreciation) has increased to $16,834. This now represents a 28% return on the initial $60,000 investment.

One very important thing I want to note in the year 10 figures above. All rental income and property costs increased 3% per year for a 10 year compounded rate of 35%. But notice the “Net annual rental income” figure of $8,508. This figure is 222% higher than the $2,640 net annual rent in the first year. This is equivalent to a 12.4% average return per year for the 10-year period. Why did the net rental income increase at a much faster rate than the inflation rate? This occurred because the $1,180 monthly debt payment is fixed. The debt payment is the largest operating cost, but it does not increase with inflation (assuming you obtained a 30-year fixed rate mortgage which you always should). The law of leverage boosts your income also. This is how you get wealthy with real estate investments. Over time real estate investments get better and better. Most importantly for someone in retirement, your income increases must faster than inflation.

One other big advantage to having a real estate business versus most other businesses is you can operate it in your spare time. I think it is a perfect business for a stay-at-home mother to get involved in.

Currently I spend only about 10 to 12 hours per year on my two real estate investments including tax preparation. Over time I have gotten the investment process down to a science and I no longer perform the month to month management duties. I hire a property management company to handle these activities. But a beginning investor will have to handle all property management duties to keep business costs down. When I started my real estate investing in the late 1980s, property management took me about 50 hours per year per property. Keep in mind that property management gets easier after you become more experienced.

Also I did not personally perform any property repairs or maintenance. I only managed the property tenant issues and arranged for the maintenance issues to be handled by contractors. But if you have the time and the inclination, handling the property maintenance yourself will save you a lot of money. This flexibility is yet another advantage of real estate investments.

I did not mean to get so far into the nuts & bolts of real estate investing, but I think it is necessary to explain the benefits in detail so one can appreciate the power this investment provides. But real estate, like all investments, is a long term venture. You need to have patience. In my next post I will discuss the biggest mistake people make when investing in real estate that sabotages their plans from the beginning.

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