Real estate investing is becoming more and more attractive lately. Not only are home prices dropping, but mortgage rates are at all time lows for those of us with good credit and plenty of cash to invest. In many markets, rents are even climbing. Many people, like me, are being pushed into real estate investing against their will, as they either cannot sell their property at any reasonable price or are so far underwater they cannot, or at least do not want to, bring that much cash to closing.
Keep in mind that real estate investing is much more like a second job than investing in a fixed allocation of index funds. Searching for a property, closing on it, fixing it up, finding a renter, maintaining it, evicting a renter, fixing it up again, and selling it all require time and/or money. Your index fund is never going to call you at 3 am to unclog a toilet. These factors mean real estate investing isn't a great choice for a resident or a surgeon working 70 hours a week.
You make money in 5 different ways when investing in real estate.
Appreciation
As a general rule (recent past excepted) the price of property generally goes up over time at about the rate of inflation, or perhaps slightly higher. If you buy it at a low price, then sell it at a high price, you make money. You can earn a very high rate of return if you are highly leveraged or in a real estate boom. Of course, leverage works both ways.
Cash Flow
If your property generates more money than it costs you, the extra cash is income to you. Positive cash flow properties are surprisingly hard to find unless you put down a lot of money (say 30% of the value), but just about any property is eventually cash flow positive as the mortgage is paid off.
Loan Amortization
Speaking of mortgages, as you hold a property, you gradually pay its mortgage off. Initially most of your mortgage payment goes toward interest, but as the years go by, the payment becomes more and more principal. That's money in your pocket when you eventually sell. You can amortize faster by getting a loan with a shorter term, but that will affect your cash flow return.
Tax Shelter
This aspect of return is a little harder to calculate, but for someone in a high tax bracket, can be pretty valuable. Mortgage interest, property taxes, repair expenses, management fees, utilities and other expenses are deductible. You can even deduct a trip out to “take care of” your property in on Oahu or down in Florida. Your capital gains are also tax-deferred until you sell, much like with shares of stock or mutual funds. And if you exchange the gains into another investment property, you can defer the taxes even longer. A final source of tax shelter return is from depreciation. You get to deduct 3.6% of the price of the property plus the cost of any improvements from the income you earn from the property. Unfortunately for most doctors, you cannot apply a passive loss (real estate loss) towards your regular income if you make more than $150,000. But the tax shelter return of an investment property is still a major benefit.
Sweat Equity
While this isn't technically a return on your original investment, it is a way to make money associated with your investment. Making improvements yourself, doing your own repairs, and managing the renters on your own can save you some real money. It's even possible to save the real estate commissions by buying/selling by owner or getting your (or better yet, your spouse's) real estate license. Some investors find maintaining an apartment to be a great way to employ their children, providing income for the child and further reducing the investor's taxable income, or just as a way to teach their children to work hard. Money saved spends just as well as money earned.
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Hi there,
My wife and I are interested in buying a rental income property for investing purposes. Do you know of any good books to read for newbie real estate investors? I’ve read some of the books that you have recommended on personal finance and have found them to be quite useful. Thanks in advance for your help.
If you really want to learn about real estate investing, biggerpockets.com is the only source you really need. Start with their podcasts and move onto posting in the forums. There are people on the site who can really teach you a lot and help you not make expensive mistakes.
I’ve met the biggerpockets.com guys and agree there are lots of good resources there. One downside of the site is there is a lot of “cheerleading” going on there. It’s like a song from the Lego Movie- “Everything is awesome, everything is cool!” But if you temper their enthusiasm for real estate with John T. Reed’s curmudgeonly but realistic view on making money in real estate, then I think you’ll end up in a good place.
The unfortunate thing, in my mind, about Bigger Pockets is that there are a lot of people who made a ton of money in REI after the housing bubble, buying properties at up to 70-80% discounts. For people trying to get in right now you have to really be scrupulous and you just can’t make what some of these folks made a few years ago. I think in the podcasts they could do a better job of pointing out the recent good fortune (vs. good timing) of these folks and that some of those results cannot be reasonably expected.
For me, I think it is smart to stay out of the REI game until there is another housing market correction or if I stumble on a really good deal. That being said I can see some reasonably good potential cash-on-cash returns on properties that are not technically Bigger Pockets good deals (not meeting the 2% rule).
I did find this good Bigger Pocket blog post that I think most REI don’t really know or pay attention too.
http://www.biggerpockets.com/renewsblog/2013/07/17/real-estate-vs-stocks/
But like I said once in a lifetime deals like 2009-2010 RE investments beat anything the stock market could ever do for your net worth. Even if you bought Berkshire Hathaway in 2009 at the rock bottom price of ~$70k you still would not have yet tripled your money since then. But there were parts of Las Vegas in Phoenix where you could buy houses for $30-40K in 2010 that you could now sell for $400k. I think that if you know your market in RE you really can time the market where as in stocks research has proven that basically no one can time the market.
I agree. It’s a very inefficient market.
My favorite real estate investment book so far (there’ll be a review out in the next week or two) is called What Every Real Estate Investor Needs to Know About Cash Flow.
just purchased via your link.
So is this book kind of like the Money Ratios book you recommended a while back but targeted towards real estate investing? I’m going to download it to my Kindle Fire via your link once I get home. Thanks.
White Coat Investor,
Is there any data/studies to suggest the returns from “real” property is vastly greater than that from a REIT index fund over the long term ?
The book is better than the Money Ratios one I think. Very practical. As far as studies of real property having a higher return than REIT funds, not that I know of, at least not without leverage. Remember though that you buy REITs without leverage (although the REITS themselves are usually heavily leveraged) and generally buy investment property WITH leverage.
Two benefits of direct property investment is that you get much lower correlation with your stock heavy portfolio AND you get to deal with a much less efficient market. I find it much easier to identify real estate bubbles than stock bubbles. There are plenty of downsides as well-like transaction costs and lack of diversification. I wouldn’t feel like investment property is a “must-hold” investment for a busy doctor. It isn’t.
I am a seasoned real estate investor/anesthsiologist here in Phoenix, AZ. I have accumulated 17 single family homes with a business partner. Let me start by saying you have to know what you are doing and I would suggest finding a good real estate agent with experience dealing with investors. You will make mistakes along the way but if you invest properly you will be very happy 5, 10 years from now. Annual returns in the 20% range are easily achievable depending on where you live.
Leverage and an inefficient market can be powerful allies, especially in markets that have had a big crash, such as Phoenix. Timing the Arizona/Nevada bubble and crash well could have generated some great returns.
I agree that real estate is a great investment and that all doctors should have some real estate in their portfolio. I echo the cautionary sentiment of others against residential real estate. Its labor intensive and in my opinion, not worth it. However, if you insist on doing it, then invest in areas where the jobs are. Look in areas where unemployment rates are much lower than the national average. Another hint, is to look at PMI – risk scores. PMI = private mortgage insurance. PMI is usually required on properties that are over-leveraged to protect the banks against default. Not surprisingly, the folks involved with PMI study the different markets. They put out a “risk score” which looks at the likelihood that houses will drop in value over the next 3 years in a given market. You don’t want to buy a property that is likely to go down in value.
Personally, I avoid residential real estate altogether and invest in large multifamily apartments. I too get double digit returns between the cash-flow, principle pay down and appreciation. The tax benefits are excellent and real estate is a hedge against inflation. When going this route, you will need to find a good syndicator / asset manager with a lot of experience and proven results. Due diligence is key. However, once you do that, the only thing you have to manage is your mailbox as your checks come in.
How can I find good syndicators / asset managers?
https://www.whitecoatinvestor.com/investing-in-commercial-real-estate/
As for REIT’s….the compounded annual returns of REIT’s versus the U.S. benchmarks from 1975 to 2005 are as follows:
REIT’s = 13.8%
S&P 500= 12.7%
NASDAQ = 10.9%
Dow Jones = 8.8%
Since 2005 all of these have taken a hit. I worry about what will happen in the stock market as the wealthiest and largest generation (Babyboomers) retire and approach the age of mandatory withdrawal from their retirement accounts. The Echoboomers are also a very large population that doesn’t have a lot of money and are just entering their prime rental years.
Direct or fractional ownership of real estate has all of the advantages that the White Coat Investor
mentioned. Additionally this type of real estate most closely follows population cycles. I think of REIT’s a lot like real estate flavored stock. They have a more exposure to the economic cycles than direct or fractional ownership does.
Thanks for the post, Jim.
I am considering buying a practice (office + land). is it better to be purchased outright by my MD PA entity, or should it be in a separate Real Estate LLC? Do you have any recommendations on companies from which to obtain commercial real estate loans (assuming that’s how it is labeled)?
I’m quite new to this, so any input is appreciated.
Thank you,
Jon
I think I’d put it in a separate LLC. That way if your professional entity is sued the real estate is separately protected, but consult with an asset protection attorney in your state. I don’t have a list specifically of banks and other lenders offering commercial real estate loans. I have at least one practice loan lender and I have dozens of mortgage lenders under the recommendations tab on the home page.