There’s a reason why real estate has been the foundation of fortunes for thousands of years. Put simply, people need a place to live and work. Those who own real estate are therefore able to provide an essential need and earn income secured directly by a tangible asset.
In the United States, real estate investors are able to earn this kind of secure income and enjoy substantial tax benefits. After all, they’re maintaining most of the nation’s residential and commercial building stock.
Real estate is I.D.E.A.L.
Real estate is often described as an I.D.E.A.L. investment:
- Income: Real estate of course provides income to its owner(s) in the form of rent. A piece of real estate that is leveraged (has a loan), provides income to both the owner and the lender. The lender in particular, whether a traditional bank, hard money lender, or private lender, values income from real estate because their loan is secured by a tangible asset. Should an owner fail to pay their loan, the lender can foreclose and can often recoup most if not all of their initial loan amount. The income from investment property often provides a solid return to its owner that greatly exceeds the return from a savings account, bonds, or money market fund. Depending on the economic environment, real estate returns often compete with and sometimes exceed the returns found in the stock market. An unleveraged investment property in particular usually provides a great return to its owner(s).
- Depreciation: The US tax code provides a substantial benefit to the owners of investment property in the form of depreciation. On their annual taxes an owner of a residential investment property may take the improvement value of the property (the property’s land cannot be depreciated) and depreciate its value over 27.5 years. Commercial properties may be depreciated over 39 years. This annual depreciation can greatly reduce or eliminate the taxes an owner of investment property would have to pay on their property’s income minus other deductible expenses.
- Equity: Real estate investors typically buy properties below market value and earn instant equity in the process. By repairing and improving their properties, investors “force” appreciation to retail value. In addition, once their properties are rented, an investor’s tenants provide the income necessary to pay the mortgage, helping the investor build additional equity each month. Equity from an investor’s portfolio can then be leveraged to further improve or grow their portfolio over time.
- Appreciation: Real estate investors reap the benefits of annual appreciation of their properties if they hold them for the long term. Across the nation, including here in the Tallahassee market, residential properties appreciate at a rough average of 3% per year. This average appreciation includes downturns like the one endured during the housing market collapse in 2007-2008. A property bought 30 years ago for $50,000 would be worth more than $121,000 today at this average rate. Local real estate markets vary greatly however, and your area may have a higher or lower appreciation rate. As mentioned previously, investors can also “force” appreciation by purchasing an investment property below retail value and then improving it.
- Leverage: Real estate investors can use a substantial amount of leverage to build their portfolio of properties through lending. Instead of spending $100,000 for one piece of property, an investor can leverage that same amount of cash to buy 5 individual $100,000 properties with a 20% ($20,000) down payment. This leverage allows investors to often make a good cash-on-cash return on the money they invest in their properties.
There are downsides to consider.
While there are substantial benefits to real estate, it’s important for any investor to consider a few of the potential downsides.
- Income: A property’s rent may not be enough to cover its mortgage and operating expenses (repairs and maintenance, vacancies, capital expenditures, and general management.) Any good investor should run a conservative analysis of a property before purchasing it to ensure a property will be cash flow positive. Good investors also maintain cash reserves to handle the unexpected repair or vacancy beyond what’s budgeted for the property.
- Depreciation: Accumulated depreciation will be “recaptured” by the IRS at normal tax rates should the property be sold. If the property is held for many years, this tax could be substantial. Nonetheless, investors typically defer this recapture tax (and capital gains taxes as well) through another great tax benefit known as a 1031 exchange. In a 1031 exchange, an investor sells a property and uses all of the proceeds to purchase another investment property. The taxes from the sale of the first property are simply rolled into the second property. These taxes are eliminated once an owner dies, and therefore this tax bill is not inherited by the owner’s heirs.
- Equity and Appreciation: As with any investment, the value of real estate can go down. An investment property bought during an economic downturn or in a declining neighborhood can see depreciation and reduced equity. An extreme scenario like the one experienced by many homeowners during the Great Recession and its aftermath, a property could be “underwater” with the mortgage being worth more than the property itself. However, a property held long enough almost always overcomes these losses and continues to appreciate relative to its initial purchase price.
- Leverage: Debt is an important tool for any real estate investor. Nonetheless, the leverage that is gained from debt must be used wisely, and only on properties that will provide reliable cash flow to its owner(s). Otherwise, properties can become overleveraged, leading to potential foreclosure and ultimately bankruptcy for the investor.
Overall, real estate is well worth it.
As a real estate investor, naturally I believe real estate’s advantages largely outweigh the drawbacks. I focus on buying property “right” as is often said in the investor community. This means buying property usually below retail value in a good neighborhood, improving it, and turning it into a place a good tenant can call home. That’s essentially been the core model for every successful real estate investor, and I’m no different.
There’s a lot to real estate investing, so it’s natural if you’ve got questions. Feel free to reach out if you do. I’m happy to help where I can!