Have you ever been approached to invest in real estate? If you not, you likely will be someday. We routinely assist our clients in assessing opportunities and risks associated with making investments in commercial and residential rental properties, as well as personal residences. Before turning to an assessment of personal residence to decide whether it can ever legitimately be considered an investment, let’s examine ways to look at commercial or residential rental property. Here we are going to focus on owning the physical asset vs. owning shares of a real estate investment trust (REIT). As investment managers, we have often advised that many clients should own the physical property rather than paying a REIT manager to do it for them.
There are essentially four ways to earn a rate of return on rental property: 1) appreciation; 2) cash-on-cash; 3) income tax savings; and 4) use of debt financing. For years, the focus was on appreciation. The near-universal belief was that real estate “could never decline in value” because “they aren’t making any more.” I cannot tell you how many times I heard people voice that belief prior to the Greater Recession of ’08. Indeed, for the decades leading up to 2008, it was quite common to see property values systematically increase from two to five percent per year—thus, the belief appeared to be well-founded. Reality struck and investors learned pretty quickly that real estate, like every other investment with growth potential, can also go down in value. The crisis of 2008 was systemic and overdetermined for sure. The mortgage industry bears a lot of the blame, but that’s a subject for another piece. The bottom line is that the bubble burst, and many are still paying the price for their prerecession beliefs. We often warn that the return from appreciation is often the result of a great purchase. The expected appreciation rate cannot simply be an average for the local area; it must be assessed property-by-property based on the original purchase price. This is the return technique most often employed by those who buy distressed properties. It’s a good strategy for the rest of us as well.
We have seen other investors focus solely on cash-on-cash return by simply asking, “Can I rent the property for more than my expenses?” We have seen this singular focus lead to a decrease in future returns because the investor has neglected to make needed repairs and upkeep for the sake of current cash flow. Cash flow is vital to any business, including real estate, but the decision of whether to invest cannot rest entirely on cash flow. One key component in assessing a potential real estate investment is an allowance for vacancies. A five to 10 percent vacancy allowance seems appropriate in many cases. Some often over-looked expenses are management fees (or the decline in income from your day-job if you manage it yourself) and setting aside a repairs allowance during those years when repairs are not necessary. In addition, unless you require a triple-net lease, there are always the more common expenses for annual property taxes and insurance.
Real estate investments have long been sold based on their tax efficiency. The investor gets to take deductions for all the expenses of operation, including interest on the financing and deprecation. Being able to take a deprecation deduction on an asset that is actually appreciating appears to be too good to be true. Depreciation is a widely misunderstood tax concept and is one of the more hotly debated parts of the tax code. Many investors will overlook the fact that some depreciation may have to be recaptured as ordinary income upon the sale of property. Furthermore, years ago, Congress determined that real estate rentals are “passive activities” and that we cannot deduct passive losses against “active income” such as our wages. The losses essentially get suspended until the property is sold. The bottom line is that real estate investing is tax-advantaged but requires careful scrutiny to assess the true return from tax savings and must take into consideration the investor’s overall tax situation.
Recently, there was a resurgence of TV infomercials and local seminars touting an expert’s method of making money in real estate. No doubt, many of those centered on using OPM (other people’s money) as a key technique. Nearly all investment in real estate is leveraged and debt comes at cost (the up ront borrowing costs as well as the interest). Obviously, the more that is borrowed, the less equity involved—enhancing return on that equity. More leverage can result in greater tax savings, but it occurs at the expense of less cash-on-cash return as the payments on the loan will be higher. Furthermore, financing of investment property usually costs more than financing an owner-occupied residence. More leverage means more risk.
Speaking of risk, each of these returns comes with its own form of risk. It is vital to assess the riskiness of each before jumping into a real estate investment.
Finally, in evaluating a potential real estate investment, it is important to have a good exit strategy at the time of the investment. Over the life of the investment it is quite reasonable to expect that cash flow will increase via higher rents. However, it could also decrease due to higher repairs expenses caused by normal wear and tear, as well as inflation of other expenses such as insurance and management fees. Also, as the loan is paid down, the increase in equity suppresses the effect of leverage on return. Sooner or later, it probably makes sense to consider either selling or trading via a tax-free exchange made possible by Section 1031 of the tax code.
Good money has been and can continue to be made in real estate investing, but realizing real estate’s true potential requires diligence in buying, operating, and selling. It is wise to set out a plan before jumping in and then revisiting the plan from time to time to insure that the investment is still pointed toward your goals. Next month, we will consider whether you can ever think of your personal residence as an investment.
Scott Neal a CPA and CFP is president of D. Scott Neal, Inc. a FEE-ONLY financial planning and investment advisory firm with offices in Lexington and Louisville. He can be reached at scott@dsneal.com or toll free at 1-800-344-9098.