One of my most frequently asked questions is this: Is Real Estate really as good an investment as everyone says? The answer is yes…and no! It depends more on you than it does the investment vehicle. Allow me to expand a bit on this thought.
To steal (and slightly alter) a famous line written by Charles Dickens; It is the best of times. It is the worst of times. Which one it is for you depends entirely on which side of the fence you are on.
If you purchased your home in the last 5 or 6 years at grossly inflated prices it may well be the worst of times. If you have owned your home for years but borrowed against the equity and fully leveraged it, again, it very well may be the worst of times.
The Good News!
If you are an investor looking to add to your portfolio, these could, indeed, be the best of times.
According to statistics at MGIC.com, even though the recession has technically ended, home prices continue to fall throughout the United States. The inventory of houses for sale is at or near historical highs. The same holds true for foreclosures. If you are a buyer or an investor looking to buy, that is good. If you are a seller, that is bad.
If you are looking to pick up an investment property or two, at least from an inventory and price perspective, there has never been a better time than now. For that matter, if you are looking for a home to live in, due to the glut of homes on the market and depressed prices, this is an ideal time to find your dream home.
The problem that buyers face right now is a lending/borrowing problem. The sub-prime mortgage debacle of 2007-08 nearly brought the banking system to its knees. As a result the entire banking industry was forced to look closely at their lending habits and make drastic changes. Now, even with stellar credit ratings of 700+ getting money is difficult, especially for non-owner occupied investment properties.
With that as an introduction, let’s discuss some of the advantages and disadvantages of Real Estate as an investment. One big advantage is leverage. A relatively small amount of money down controls an expensive asset/investment.
Before the lending crisis hit, a very small down payment was all that was required. I own several properties where I put down 0 to10%, got an 80% first mortgage and a 10 or 20% second. It was even possible to have the seller finance the down payment and go in with little or no money down. Fortunately or unfortunately depending on your perspective, those days are gone.
If you are using conventional financing (bank financing) you will need at least a 20% down payment. Once the bank knows it is investment property (you won’t be living there), the down payment requirement often soars to 30% if they will lend to you at all. And, don’t even think of trying to fool the lender by not disclosing that it is investment property. That is fraud and they will (as well they should) prosecute to the fullest!
The article is not about creative buying/selling strategies but there are many ways to employ creative financing and avoid banks altogether. If you are a real estate investor or thinking about becoming one, you should explore these strategies. Using these non-bank strategies, there are still many ways to buy real estate with little or no money down.
We will discuss disadvantages in a moment but remember, leverage is a two-way street. It can be as big a disadvantage as it is an advantage. The last 3 years have clearly proven that.
Let me illustrate the effect of leverage with a simple example. Just for this example we will use simple numbers and avoid holding costs, vacancies, etc. Let’s say you put $10,000 down on a property worth $100,000. It’s been a good year and your investment appreciated 5% so it is now worth $105,000. In effect, the $10K you put down is now worth $15K; a growth of 50% with a 5% move in the market.
On the flip side, assume it’s been a bad year (a bit more realistic today) and your property value decreased 5% and is now only worth $95,000. This 5% decrease in asset value results in a 50% decrease in the value of your money invested.
Another advantage of real estate is cash flow. There are many ways to buy and sell investment real estate. All the different methods are beyond the scope of this article. But, if your strategy involves holding the properties and renting them out, as long as you purchased the properties correctly to begin with, and it’s not sitting empty half the time, it can provide a nice stream of cash flow.
Many proponents of real estate investing will refer to this as passive income. I giggle a bit when I hear this. If you have ever owned rental real estate, you certainly know that there is very little passive about it. It is earned income if it is anything!
Over time your tenants will help you pay off our mortgage. Every time they make their payment to you and you, in turn, pay the bank, your loan balance falls just a little. Your equity position grows just a little bit each month. Eventually, the mortgage is paid off and you get to keep all the revenue from the property.
Perhaps one of, if not the largest advantage is the favorable tax treatment for real estate under the current US tax code. It is entirely possible, at least at the time of this writing, to make a profit on a piece of real estate but, because of depreciation and other favorable tax treatment, declare a paper loss for tax purposes. These tax benefits phase out as your income level increases unless you are a Real Estate Professional in the eyes of the IRS. Even with this slight negative, for most people this is a huge advantage.
In the interest of brevity, I am going to bring this article to a close. Tomorrow, we’ll look at some of the disadvantages of real estate investing and how to lessen their impact.
Till then, make your day great and your life truly rich in every way!