Beginning Guide to Real Estate Investments
Real estate is a proven wealth builder. It can build wealth in 3 ways: it can reduce your cost of living, it can provide income, and it can provide appreciation. Both the income and the appreciation have significant tax benefits. Furthermore, you can begin without being wealthy nor do you need a high income. Owning a home incurs expenses that renters do not have to pay directly, such as property insurance, real estate taxes, and other costs. Although renters do not pay these expenses directly, they pay them indirectly as part of their rent, since property owners rent to make a profit. The benefit of owning your own home is that homes generally appreciate, so much so that they largely offset the cost of those expenses. Furthermore, when the home is sold, the home sale exclusion benefit excludes up to $250,000 — $500,000 for married couples — from federal taxes. If you buy rental property, then taxes on a portion of that income can be deferred through depreciation until the property is sold. For residential real estate, depreciation can be claimed for 27½ years, and the amount of that depreciation roughly equals 3.6% of your tax basis in the property, initially equal to what you paid for it. So if you bought a home for $100,000, then you can deduct $3600 of depreciation each year for 27½ years.
This will help you get started. First, you will need good credit and significant savings. Although what lenders consider a good credit score varies, a FICO score of 740 is considered excellent credit. Although it is possible to buy property with poor credit or with little or no money down, you will generally pay a higher interest rate and may need to buy premium mortgage insurance. You need significant savings for the down payment and to cover any unanticipated expenses. Many financial advisors recommend that a person should have at least 6 months to 1 year of living expenses saved in a savings account, so that it is readily available at any time. Although a savings account generally does not pay much interest, it can save a lot of money by not having to pay fees incurred by late payments, nonsufficient funds, or deferring payments. And that money saved is like earning that money tax-free. To paraphrase Ben Franklin, a penny saved is more than a penny earned, since no tax must be paid on savings. This is the true value of a savings account. Additionally, it gives you peace of mind because it frees you from financial stress.
After establishing good credit and sufficient savings, if you do not own your own home, then the 1st step to creating wealth through real estate is by buying your own home.
Buying Your Own Home
There are several phases of buying a home that are discussed in detail elsewhere: opening escrow, appraising the property, performing due diligence, and closing the real estate transaction. Because you will spend a good deal of time in your home, the 1st consideration should be buying a home with the maximum utility that you can afford comfortably. Maximum utility is that which yields the most satisfaction. Additionally, you will want to ensure that you receive good value for your money by performing due diligence: making sure that the property does not have significant defects that would lower the value of the property and that would be expensive to repair. For a given value, you will generally want to pay as low a price as possible, but certainly do not pay more than the appraised value.
Since you will eventually want to sell the property, select property that tends to appreciate more rapidly than other similar properties. Make property improvements with a high resale value and avoid improvements where the resale value may be lower than their cost, unless it is something desired. For instance, in many areas, a swimming pool may be undesirable for many buyers, lowering buyer competition for your property.
An effective way to profit from appreciation is to select properties that need improvement and that have less value than surrounding properties in the neighborhood. Never buy a property for significantly more than what surrounding properties would fetch, since people willing to pay much more for a home will also want a more prosperous neighborhood.
If you have children, then select a property in a good school district, especially since that will increase the resale value of the property. However, if you do not have any children, then the quality of the school district should not be a major consideration. While property in a good school district will generally sell for more than would otherwise be the case, it will also mean you will pay more for the property.
Another major consideration is to select a good location. Property will appreciate more in a high-growth area. As they say, buy in the path of progress. A growing area has a diversity of employment opportunities in a good location and a minimum of crime.
Buying Income-Producing Property
Rental property is a great way to generate income, but consider your own constitution or temperament in deciding how you want to invest in real estate, since rental properties are not for everyone. Consider other types of real estate investments, such as real estate investment trusts, which can also be bought as an exchange-traded fund, and some more obscure types of investments, such as tax liens and tax deeds. At the beginning of your real estate investment career, you can start with small properties, but eventually you will want to buy larger properties because they are more efficient to manage. Another major success factor is properly selecting tenants who will take care of the property and pay their bills on time. An easy way to screen tenants is to obtain a credit report and to verify income. If you intend to do a significant amount of real estate investing, then form a team that can help you assess the value of the property, buy the property, operate it for maximum income, all within the confines of the law; people such as a real estate agent, real estate attorney, tax advisor, loan officer, and a property inspector.
Avoid buy-and-flip strategies, unless you have extensive experience in pricing repairs and remodeling and you have extensive knowledge of the local real estate market. Buy-and-flip strategies may work in rapidly appreciating markets, but such appreciation occurs only for short durations. Additionally, buying and selling costs must be taken into account in calculating profits, and if the property is held for no more than 1 year, then any gains will be subject to the ordinary income tax rate instead of the more favorable long-term capital gains tax rate.
As with most businesses, an improving economy, especially the local economy, will auger greater success in real estate investing. On the other hand, if the economy is contracting, then it would be best to wait until it starts expanding again. At that point, property prices will have declined, but will then appreciate as the economy expands. Hence, you can buy low and sell high, which is the usual way to profit from appreciation, while collecting rent in the meantime.
Purchase real estate that is close to where you live, since you will be more familiar with the neighborhood and it will be much easier to manage. The management of rental properties takes work. A real estate manager can be hired to reduce or eliminate the workload, but will also reduce profits.
Start out with single-family homes because they are usually in demand in the marketplace, so they would be easy to resell. With other types of rental properties, the sale price will largely be determined by the income that the properties earn, whereas a single-family home may appeal to buyers in other ways, such as the neighborhood or the atmosphere.
Although commercial property can be more lucrative, there is also greater risk and financing options are more expensive than for residential real estate. Commercial property includes rental properties with 5 or more units.
When buying rental property, 1st examine the historical income and expenses, but then make your own evaluation as to what the cash flow could be, then set your price accordingly, since the price of income-producing property is set by the net operating income (NOI). Examine how income can be increased or expenses reduced. For instance, could the property be improved to increase rents? Is the seller charging below market rents?
Because the price of most rental properties depends on net operating income, many sellers try to inflate the perceived value of their property by maximizing income and minimizing expenses. Because buyers generally look at net operating income for the past year, sellers can employ several tricks to inflate NOI for the previous year, such as deferring income to collect lump-sum payments; not making any more property improvements; and prepaying supplies before the 12-month look-back period. Also, maintenance or repairs can simply be avoided during the NOI period. Another method for improving NOI is to classify some expenses as capital expenses, which are not normally used to calculate NOI. Therefore, it would behoove you to calculate the budget for the property during the due diligence period to arrive at realistic numbers.
Capitalization Rate (Cap Rate)
The capitalization rate, often just called the cap rate, is most often used in real estate as a way to measure the return on investment on the purchase of different properties that changes with the market value of the property. For real estate:
Capitalization Rate = Net Income from Property / Current Market Value of Property
The current market value of the property is used instead of the purchase price to determine if the property continues to be the best use of funds. For instance, suppose you had $100,000 to invest in either the stock market or real estate, both yielding about 10%. You decide to buy real estate where you earn a net income of $10,000 annually. Both the return on investment and your capitalization rate is 10%. Then a business, with a much better use for your property, offers to buy it from you for $200,000. How would you decide? You’re still earning the 10% that you expected, but now your property is worth $200,000, so your capitalization rate drops to only 5%, much less than what you can earn in the stock market. By selling for $200,000, you can invest that money in the stock market to earn $20,000 annually instead of just $10,000.
So you can think of the capitalization rate as the return on investment for each successive period, such as annually: the annual return on investment if the investment was purchased at the start of each new year. The capitalization rate measures the ongoing value of the investment. The cap rate is a great way to monitor whether your real estate investment continues to be the best use of your money.
Increasing the Value of Real Estate
The value of real estate can be increased by changing its use. When real estate is not being used for its highest and best use, then its value can be increased by preparing the property for its best use or actually converting it to its best use. Common ways of changing property use include entitlements, conversion of use, and lot splitting and assemblage.
Entitlement, as used in real estate, is the right to develop land that is already approved by the government for zoning, occupancy and use permits, utility installations and streets, and any other approval required for certain use. Because there are many laws governing land use, including municipal, state, and federal law, getting such government approval requires considerable time and money. Therefore, a real estate investor can greatly increase the value of the real estate by getting the entitlements, which can then generally be sold to a developer for substantial profit, since it not only saves time and money for the developer, but it eliminates uncertainty about getting the necessary approvals for the property's projected use.
Another means of increasing value for real estate is by doing the conversion yourself: converting its present use to another more profitable use, such as converting an old warehouse into residential units.
Often times, the highest price for real estate can be obtained by having it in the optimal size. For instance, a large parcel of land located in a residential zoning section can be subdivided and sold as individual lots for a much higher aggregate price than the entire property would fetch. On the other hand, small parcels of land can be combined for a luxury home or a business enterprise.
Use Leverage to Boost Your Return on Investment
You can increase your return on investment (ROI) by paying for properties with a smaller down payment. For instance, the following example shows the various returns on investment for a property with a sale price of $100,000, net operating income of $10,000 annually, a fixed interest rate of 6%, but with different downpayments. Note that the smaller the down payment, the greater the ROI. The cash throw-off is the net operating income minus annual mortgage payments:
Cash Throw-Off = NOI – Annual Mortgage Payments
|Net Operating Income||$10,000|
|Annual Mortgage Payment||$0|
|Total ROI with 3% Appreciation||13.00%|
|Total ROI with 5% Appreciation||15.00%|
|Annual Mortgage Payment||($3,632)|
|Total ROI with 3% Appreciation||15.74%|
|Total ROI with 5% Appreciation||17.74%|
|Annual Mortgage Payment||($5,449)|
|Total ROI with 3% Appreciation||21.21%|
|Total ROI with 5% Appreciation||23.21%|
|Annual Mortgage Payment||($6,538)|
|Total ROI with 3% Appreciation||37.62%|
|Total ROI with 5% Appreciation||39.62%|
Remember, also, that as property appreciates, rents can be increased, yielding even larger ROI's than suggested here.
Other Ways to Invest in Real Estate
There are other ways to invest in real estate: real estate investment trusts, tax liens and deeds, net leases, tenancy in common, and real estate limited partnerships. The main problem with most of these investments is that they offer little or no control over the investment. Furthermore, it is more difficult to perform due diligence since these investments are set up by other people and their success will depend on those people, and, often times, these investments will be set up to provide more value to the sponsors and managers of these investments than would be warranted by their service. By buying your own home or rental properties, you have complete control over the investment, you can augment the value of the investment, and you can more easily assess and control risk. That is the added value of owning real estate directly.