Basics of Financial Investing – Part 10

Investing in Real Estate

Bonds constitute one major investment alternative to the stock market. Real estate represents another. The market for real estate is huge. Indeed, the total market value of U.S. real estate exceeds the total market value of U.S. stocks and bonds. And yet, its one-of-a-kind nature makes buying and selling real estate quite a bit different from, and generally more costly than (higher transaction costs), buying and selling an equivalent dollar value of stocks. Still, the real estate market does provide investors with some interesting opportunities.

In what follows I shall offer a few general guidelines designed to help the potential real estate investor decide whether and, if so, how to become involved in this market. Note, however, that many entire books have been written on the subject of real estate investing. If you are especially interested in the topic, you may want to pursue the matter in greater depth than I can do here. My guidelines should, however, get you started.

One of the most attractive opportunities to invest in real estate is to own the place where you live.

Owning your own home (whether house, condo, mobile home, houseboat, motor home, etc.) has many benefits. Owner-occupied housing is usually an attractive investment for the investor/homeowner. It is a useful place to begin learning about investing in real estate. Home ownership has a number of significant advantages over the alternative of renting the place where you live. First, home ownership offers valuable tax benefits. Both mortgage interest and real estate taxes are tax deductible expenses. If you itemize (and most active investors with moderate or higher incomes do), these two deductions can be used to reduce your tax liability substantially. Taxpayers are allowed to compute their taxable income by reducing their adjustable gross income in either of two ways. Specifically, they can either itemize deductions or take the standard deduction. If the taxpayer can identify a greater amount in deductible expenses by itemizing than by taking the standard deduction, itemization will lower his or her tax liability. In 2004 the standard deduction for a married couple (single person) was set at $9,700 ($4,850). A homeowner’s mortgage interest and real estate taxes alone are often more than that sum. State income taxes are another major deductible expense, as are charitable contributions. So if the sum of your real estate and state income taxes, mortgage interest payments, and charitable contributions is large enough (greater than the standard deduction), you should itemize. The money that you pay in the form of mortgage interest and real estate taxes are itemized deductions that you can subtract from your gross income in the process of computing your taxable income. Once you exceed the standard deduction amount, every dollar that you pay in the form of real estate taxes and mortgage interest reduces your tax liability by $1 times your marginal tax rate.

Thus a substantial percentage of the costs that you incur as a homeowner can be used as deductions to reduce your tax bill. The higher your tax bracket, the greater is the value of these deductions.

Suppose, for example, that you are in the 35 percent tax bracket. If your mortgage payment is $1,000 a month and 80 percent of this sum represents interest, your mortgage payment of $12,000 a year would consist of $9,600 in interest (.8 x $12,000 = $9,600). At the 35 percent tax rate, this amount of mortgage interest payment would save you $3,360 (.35 x $9,600 = $3,360) a year on your federal income taxes. Similarly, a $5,000 real estate tax bill could be used as a deduction to save you $1,750 (.35 x $5,000 = $1,750) in taxes at the federal level. Thus the $17,000 ($12,000 + $5,000 = $17,000) in combined mortgage and real estate tax payments generates a $5,110 ($3,360 + $1,750) reduction in your tax liability. Moreover, the other 20 percent of the mortgage payments (the $2,400 per year not allocated as interest) represents a reduction in the amount that you owe on your mortgage. This amortization of your mortgage balance is a form of forced savings. Therefore the actual economic cost of the combined $17,000 payments would be offset by a total of $7,510 ($5,110 + $2,400) in the form of tax savings and loan pay-down. In other words, the economic impact of the $17,000 in annual home ownership payments is reduced to $9,490 ($17,000 - $7,510) as a result of the positive effect of the payments on your tax liability and debt position.

Second, real estate market values tend to rise over time. Homes held for a number of years are almost always worth much more in the marketplace than the amount that the owner originally paid for them. When you retire, you may be able to sell your home for a substantial profit. You could buy a much smaller, easier-to-manage place with part of the money. You would then have the rest of the money available to assist with living costs once your paycheck stops. In a typical year, a $250,000 house (corresponding to a 5.5 percent $180,000 thirty-year mortgage and a payment of about $1,000 a month) might appreciate by 3 percent, or $7,500. That sum of appreciation would increase your net worth (or wealth) and thereby reduce the net cost of your housing to less than $2,000 ($9,490 - $7,500 = $1,990) a year. Moreover, the benefits would grow over time (net cost would decline) as the house appreciates and the outstanding mortgage balance is paid down. Each mortgage payment reduces the outstanding loan balance. As the outstanding balance declines, the interest charge component of the mortgage payment also declines. As a result, less and less of the mortgage payment represents interest and more and more represents repayment of loan principal. A dollar of debt reduction is always worth more to you than a one-dollar deduction on your taxable income. Even if you are in the 35 percent tax bracket, a tax deduction of one dollar is worth only 35¢ in reduced tax liability, whereas a debt reduction of one dollar is worth $1 (regardless of what tax bracket you are in).

Put another way, simultaneously reducing your debt by a dollar and increasing your taxable income by a dollar would increase your net worth by $0.65 if you are in the 35 percent tax bracket. The positive impact on your net worth would be even greater if you are in a lower tax bracket. The more of your mortgage payment that is allocated to paying off the loan balance, the greater the positive impact on your financial position. Similarly, as the market value of your house increases, a given annual percentage increase in its value represents a larger and larger sum of money. For example, after five years the market value of the home that you purchased for $250,000 could have risen to $300,000, which, at a 3 percent appreciation rate, would correspond to a $9,000 value increase in year six (compared with $7,500 in the first year).

Similarly, after five years of mortgage payments, the amount of annual paydown of the mortgage balance will have risen from $2,400 a year to about $3,300. At some point in time the total financial benefits of home ownership in the form of tax deductions, loan pay-down, and market value appreciation will equal and then exceed the amounts of the mortgage and real estate tax payments. At that juncture the benefits in terms of tax shelter, debt reduction, and price appreciation would fully offset the out-of-pocket costs of maintaining your home. You will, in effect, be living in your house for free (except for normal maintenance expenses). With a rental, in contrast, the total amount paid for housing is fully used up just to pay the landlord. The renter obtains no tax benefits, no loan pay-down, and no wealth benefit from any appreciation in real estate value. And indeed, the cost of renting is likely to increase over time.

Third, with a fixed-rate mortgage you can stabilize a large part of the monthly out-of-pocket housing cost. Real estate taxes, insurance, and maintenance costs will tend to rise with the market value of your home. But the financing costs (mortgage payment) of home ownership will not increase as long as the original fixed-rate loan remains in place. This mortgage payment is by far the largest cost of home ownership. As the loan principal is amortized, the interest cost will decline and the portion of the payment used to pay down the mortgage balance will increase. Ultimately the mortgage balance will be paid down to zero. At that point your mortgage payment obligation will disappear. Your out-of-pocket housing costs will decline dramatically and you will own a valuable asset outright. As a renter, in contrast, the cost of your housing is likely never to stop increasing.

Fourth, the equity in your home (total market value less mortgage balance outstanding) provides excellent collateral against which to borrow additional funds, if and when they are needed. The easiest way to access this value is with a home equity loan.

Alternatively, if the existing mortgage loan balance is sufficiently below the property’s market value, one can refinance (take out a new, larger mortgage) and extract cash. A third option is to enter into a reverse mortgage. Such mortgages are structured to make a fixed monthly income payment to homeowners who are older than a certain pre-specified age (e.g., sixty-five). The sums paid out plus interest on the prior payments accumulates as a debit balance. This total becomes a lien against the home’s collateral value. The lender agrees to continue making the income payments as long as the borrower continues to live in the home. Once the home is sold, the lender collects the amount due out of the sales proceeds. Even if the accumulated amount exceeds the sale price of the home, the lender is committed to continue making the payments.

Fifth, if market interest rates fall, a homeowner with a fixed-rate mortgage can refinance the debt and thereby lock in a lower interest rate. You can take out cash, reduce the monthly payment, or shorten the life of the loan while keeping the monthly payment constant. If market interest rates rise, you can stick with your existing fixed-rate mortgage and be protected from the higher rates.

Sixth, because the property is yours, you can fix it up pretty much as you like. Most homeowners realize that whatever they do to their home will affect its value. Accordingly, they tend to take much better care of it than do renters.

To sum up, the rate of return on the funds invested in a home (including the value of occupancy) tends to be quite attractive. While home ownership is not suitable for everyone, it is an attractive type of investment for many. It is a particularly attractive way to start to learn about investing in real estate. Once you have a few years of home ownership experience, you may be ready to explore other types of real estate investing. But even home ownership is not for everyone. Read on.

Do not buy a home unless you plan to live in it for at least several years and can afford to make all of the payments as they come due.

Notwithstanding all of its advantages, home ownership is not suitable for everyone. Buying a home requires money both up front (down payment, closing costs) and over time (mortgage payment, property taxes, insurance, maintenance). If you do not make the required (mortgage and other) payments as they come due, the lender will foreclose on the property, and you will lose your house and perhaps everything you have invested in it. Never buy a more expensive house than you can afford.

A number of costs are associated with the real estate transaction itself. When you purchase a house or any other type of living space, you will almost always need to finance most of the purchase price with a mortgage. Obtaining a mortgage is likely to be costly. You will need to hire a lawyer to undertake a title search. Various other fees and expenses (loan application fee, points, etc.) will also be incurred. If you buy or sell through an agent, a substantial brokerage fee (perhaps 6 percent of the sales price) will be assessed on the transaction. Technically the seller pays the broker’s commission in the form of a deduction from the selling price. That real estate agent’s fee tends, however, to be reflected in the price that the seller charges. Thus both buyers and the sellers can be said to share in the cost of the agent’s commission. Moreover, when the time comes to sell your home, you will need to pay the real estate agent’s fee again (assuming you use a broker). In addition, you will have to bear the cost of a move as well as the implicit cost of searching for a new home. Accordingly, the transaction costs involved in purchasing or selling real estate (house or otherwise) can add up to as much as 10 percent of the market value. Clearly, you don’t want to incur these costs over and over again.

Advantages of Home Ownership

  1. Taxes: Mortgage interest expense and real estate taxes are deductible expenses on your income tax return.
  2. Price Appreciation: Real estate market values tend to rise over time.
  3. Stabilize Housing Costs: The largest part of the cost of home ownership is the mortgage payment. A fixed-rate fully amortizing mortgage stabilizes this cost.
  4. Collateral Value: The equity in your home represents a valuable asset against which you can borrow.
  5. Refinancing Options: If mortgage interest rates fall sufficiently, you can reduce your monthly payment or take out additional cash by refinancing
  6. Control over Property: It’s yours, you can fix it up the way you like. If you make improvements, the increased value is yours.

If you find yourself in a position where you must sell too soon after your purchase, all of the financial benefits of home ownership can be offset by these transaction costs.

If you end up living in a house five or ten years or more, the initial costs (real estate commission, title search, points, bank fees, etc.) of the transaction are, in effect, spread over an extended period of time. Moreover, the house’s value would have had a reasonable chance to appreciate. If, however, you buy a house and then must sell it a year or so later, these transaction costs are likely to eat up any modest gain you might otherwise have achieved for the short time that you owned it (and perhaps more).

Furthermore, the housing market itself has ups and downs. If you have owned your house for, say, ten years, chances are very good that you will still be able to sell it for a nice profit, even if the housing market is depressed. The appreciation in your home’s market value will, in all probability, much more than offset the transaction costs. If, however, you must sell within a year or so of the initial purchase, a soft housing market can mean that you will be able to sell your home only if you are willing to accept a loss. And, in addition, you will incur transaction costs on the sale. Moreover, selling real estate takes time, sometimes a long time.

While investing in rental property can be quite profitable, active real estate investing is much more demanding than the much more passive process of investing in securities.

Many people begin investing in real estate with a small sum of money. Utilizing this seed capital, plus a lot of sweat equity and an aggressive use of leverage, they are able to build an extensive portfolio of real estate properties over a period of time. They might begin by making a small down payment on a duplex and taking out a large mortgage loan. They can live on one side and rent out the other. The rental payments that they receive on the side that they lease out may be sufficient to cover most of their mortgage payment. They set aside the money that they save on their own housing. After a year or so, they have saved enough to buy and rent out both sides of another duplex (and, of course, take out another large mortgage). After another year or so they may have accumulated sufficient funds for still another down payment. At that point they might move up the real estate food chain. They could sell their second duplex at a substantial profit and use the net proceeds to invest in a small apartment complex or strip mall. Before long this budding entrepreneur has constructed a little real estate empire. It sounds simple. It’s not.

Owning and operating a portfolio of developed real estate properties requires extensive management. As a landlord, you assume the responsibilities of a plumber, carpenter, accountant, bill collector, electrician, credit analyst, and financial officer. You may take on many other roles (e.g., amateur psychologist) as well. These tasks are time-consuming and challenging. You can do much of the property management and maintenance work yourself. Or, for a price, you can hire someone else to do the work. A great deal of the money earned by real estate investors represents compensation for the time and effort they must expend to manage their property.

In addition to being time-consuming, investing in rental real estate can also be rather risky. Most real estate investors make substantial use of leverage. They may, for example, invest 25 percent of their own money and borrow 75 percent on each property that they buy. They may borrow an even higher percentage if the lender will allow. Real estate investors almost always depend upon the rental income from their properties to cover the cost of debt service, real estate taxes, and upkeep on their property. They hope that enough money will be left over after making these payments to provide an attractive cash return on their investment. They also hope, and indeed generally count on, the rental income increasing at a faster rate than the rate of increase in the combined costs of servicing the debt and maintaining the property. Their projections generally show a tight cash flow situation initially coupled with a handsome potential profit to be derived from their properties’ anticipated market value appreciation. The investments are almost always projected to work out well on paper. All too often, however, they do not perform quite so well in practice. Projections always involve assumptions. Assumptions can (and often do) turn out to be too optimistic (or sometimes too pessimistic). Realize that the costs of maintaining rental real estate are steady, relentless, and in some cases, increasing (e.g., property taxes, costs of maintenance; have you ever known a plumber to reduce his rates?). Indeed, large unexpected costs may be incurred from time to time (for example, when a roof or furnace needs to be replaced). The rental revenues, in contrast, tend to be much more variable. Only when property is leased will rents be paid by the renter and received by the owner (and you have to be sure to collect, as renters sometimes skip out without paying). If the occupancy rate falls, so will the property’s rental revenues. Moreover, the rental market will itself vary with market conditions. When the overall vacancy rate in the community is low, rental rates tend to rise, but when a substantial excess of unused space is available on the market, rental rates are likely to fall.

Many a would-be real estate mogul has been caught with too much debt on too many properties when the rental real estate market turns south. Unless he or she has the staying power (financial resources) to ride out the weak market, the budding real estate empire is likely to collapse. If you invest in rental real estate, be cautious and conservative. Don’t let yourself become overextended.

One attractive alternative to investing in rental real estate is to buy undeveloped land.

Unlike developed properties, land ownership requires very little management. Leave it alone and let the trees grow taller. Some day you may be able to sell the timber. Eventually someone else may come along, see development potential, and offer you an attractive price for your property. The profit potential from land investment is substantial. As cities grow out and as the population increases, undeveloped land becomes economic to develop either residentially or commercially. The process proceeds haphazardly, in fits and starts, but it proceeds.

Investing in land does not take a lot of work on the part of the investor. You buy the property, pay the taxes and insurance, and wait. You may even be able to enjoy your land as a campsite, wood lot, or spot to plant a nice garden. The disadvantages of land investing include the following: First, undeveloped land produces little or no current income. Perhaps you can sell off some timber or, if you put in the effort, sometimes more (vegetables, Christmas trees, etc.) but for the most part, undeveloped land produces no income. And yet its upkeep continues. You must pay real estate taxes and you will need to purchase some liability insurance. In addition, lenders will not advance very much loan money on land. You will have to pay most or all of the property’s purchase price up front. Lenders realize that land produces little or no income and that its market price is speculative. Accordingly, most lenders will not allow you to use the land as collateral to borrow more than a small percentage of the property’s market value. If you invest in land, be prepared to wait. Don’t expect to receive any income on your investment until you sell.

Another attractive alternative to direct ownership of rental real estate is the Real Estate Investment Trust (REIT).

REITs are a bit like mutual funds that invest in real estate. Their ownership units trade on the market like the stocks of corporations (exchange or OTC), but unlike corporations, REITs are not liable for corporate income tax. REITs assemble portfolios of real estate–related assets. Some own developed rental properties (apartments, office buildings, shopping centers, warehouses, etc.). Others have inventories of land that they subdivide, develop, and sell as home-sites. Still others own portfolios of real estate mortgages (commercial and/or residential).

By purchasing shares of a REIT, you acquire a stake in a portfolio of real estate–related assets. But you leave the management of the properties to the professionals running the company. Qualifying REITs pay no federal income tax. The special tax treatment is available only if the REITs pay out all of their net income to their shareholders. Because they must distribute all of their income each year, REITs generally pay rather attractive dividends. In addition, the properties that the REITs own tend to appreciate in the marketplace, thereby producing both growing rental income and capital gains when sold. As a result, the dividends and market prices of most REITs tend to increase over time. The dividends on most common stocks are subject to a 15 percent maximum federal tax rate. REIT dividends are, in contrast, fully taxable to the recipient as ordinary income. So if you are in the 35 percent income tax bracket, your REIT dividend will be taxed at that rate. You will only keep 65 percent of the dividend after taxes (even less if you are subject to a state income tax).

Compared to direct ownership of property, REITs are a much less time-consuming way to invest in real estate. Because their portfolios of properties are diversified, their risks are spread. Their returns are, however, net of the fees and expenses taken out by the managers. These fees and expenses can have a significant impact on returns.

Certain operating companies own large portfolios of real estate, thereby making them real estate investment players.

A variety of different types of companies own so much valuable real estate that the liquidation value of their properties dwarfs the income-producing potential of their ostensible line of business. At one time, many movie companies owned Hollywood movie lots having very substantial development potentials. That real estate value often dominated the enterprise value that was derived from the profit potential of their movie-making. Similarly, many railroads once owned vast tracts of land awarded to them by the federal government. These government land grants were designed to facilitate the westward expansion of their rail lines (western land grants). Today we find many agricultural enterprises in such places as Florida and California owning large tracts of land, some of which sits in the path of potential future development. Other types of companies may own valuable downtown properties.

Indeed, the downtown switching yards of some railroads may offer substantial development potential. In most cases these real estate holdings are carried on the books at a small fraction of their current valuations. The total market value of their property may substantially exceed the value that the market has put on the enterprise.

Suppose the liquidation value of a company (after deducting any outstanding debt) is in the neighborhood of two or more times the value that the market places on the company’s stock. You might expect that some profit-seeking investors would buy a controlling interest in the company and then liquidate it for a substantial profit. Many large investors have the resources for just such a move. The new owners would earn a nice return and those stockholders who hung on would share in the gains. At least one of two possible barriers frequently stand in the way of such an outcome. First, as an outside group seeks to take control of a company, the current management may put up roadblocks: A proxy fight with existing management may be the result, with the result uncertain.

Second, an established family may already own a controlling interest in the firm. If, for example, the founder’s family owns 50 percent or so of the firm’s shares, no liquidation can take place without their blessing. The family’s desire to maintain the current structure could explain why no liquidation has occurred to date. All is not lost, however. Often, once the founder (who may be rather elderly) turns control over to a new generation of owners, they may be much more likely to be interested in unlocking the underlying values by selling.

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