Your Guide has been fortunate to sell a lot of investment real estate over the years. And even pick up a little condo or house here and there himself. A couple conversations with clients has inspired me to compose a little pep talk about the fundamentals in investment real estate.
This is not intended to diminish the pain that some of you, and some of my clients are feeling. It can be quite scary as one watches rents decline, vacancies rise and the prospect of making some mortgage payments on empty condos or apartments looms.
Three out of four fundamentals still apply
The first fundamental of investment real estate is leverage. In most circumstances, investors buy real estate with a mortgage. Not as large a mortgage as a home buyer. But normally, it makes sense to borrow 50% to 75% of the cost of the property. The reason is simple: You’re buying something that your renters will help pay for. This is still true in the current real estate environment.
There really aren’t many other avenues where you can buy more investment than you have cash on hand. In the stocks and bonds universe, they call it “Buying on Margin.” But just look at your stock broker’s face if you ask him to purchase $250,000 in stocks with only $25,000 down. He’d say you were crazy. And you would be to try.
The second fundamental of investment real estate is someone else pays your mortgage. Notwithstanding the vagaries of how much you put down, your interest rate, and other expenses; generally the goal is to cover all the payments by having a renter pay more than those expenses. And if you hold on long enough, the rent should increase while expenses stay stable. Mostly. And if you are truly in the game for the long term, you’ll have an investment that’s paid off. Then starts the gravy train. Nearly every dollar that comes in as rent is cash in your pocket.
The third fundamental of investment is the passive income and depreciation. No where else in the tax code can you take expenses, and deduct them from income. With investment real estate if you bring in $1,500, but spend $1,000 on your mortgage, plus $200 in expenses and another $200 in taxes, you earn $100. That’s it.
In the real world, if you earn $30,000 in salary, but spend nearly all of it on your home, your utilities, your car, your family, your clothes, and everything else, you still get taxed on your income. Of course it’s not quite that simple, but the comparison to investment real estate is nearly that stark. Every dollar you spend can offset income. Heck, if you spend MORE, you can even start making reductions in your personal income!
And real estate is depreciable. The tax code even allows investors to rapidly depreciate investment property during the first few years of ownership affording some extremely dramatic tax benefits.
The missing fundamental in the current market is the appreciation. In any ten-year period from around 1850 to today, you could point to a spot on the timeline and see values in Chicago double. Sometimes more, sometimes less. But roughly – you could count on your real estate to double every ten years. Another way of looking at it: every time you made a mortgage payment, you’d get another of equal value in appreciation for free.
It seems those days are over. With the recent tumble in property values, there hasn’t been significant property appreciation in Chicago since 2005 – and we’re already at 2010. I think this will be the “lost decade” in property appreciation. I predict that it will take several more years before we get steady appreciation again as the recovery from the financial mess is going to take a few more years. That takes us close to 2015 – truly a decade of lost appreciation.
Three out of four aren’t bad. Investors have been spoiled with all the benefits to investment property ownership. But even if you take the appreciation out of the equation, investing in real estate is still a great way to build equity and guarantee income for later years.
To quote one of the founding fathers of Chicago, Marshall Field, “Real estate is not only the best and quickest way to make you wealthy, for the average person, it truly is the only way.”