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.
1) 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.
2) 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.
3) 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.
4) 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.
5) 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.
Real estate isn’t for everyone, but for those inclined, now is as good a time to get in as ever. It can provide a new challenge, solid returns, and low correlation with the rest of your portfolio.