Many believe that real estate investments are one of the best ways to build wealth. We often hear “rags to riches” stories of those who accumulated fortunes by investing in properties, and there are countless seminars promising to give the secret to making it big in real estate. But a balanced glimpse at this wealth accumulation tool is rare, so I will attempt such a feat here.
Real estate and tax breaks
Real estate is technically another investment asset class—like large US stocks or government bonds—with some unique properties. (Pardon the pun.) Unlike other investments, you may get some interesting tax breaks when you buy investment property—like depreciation deductions. These deductions can help offset the taxes on income from rent payments. While you can’t depreciate the land, the ability to deduct the cost of buying a structure over time can be appealing to would-be investors. Somewhat like the appeal of deducting retirement plan contributions.
This can be a two-edged sword, however, because you may have to pay a large tax on the recapture of that depreciation if you want to get out of the real estate business later in life. The part of the gain attributed to recapture is taxed at higher rates than the part that comes from capital gains or the property’s increase in value. I’ve known many people who felt trapped by their real estate holdings due to the tax ramifications of liquidating. This is why it is important to understand these issues before you ever get involved in buying properties.
Related to this issue is the unknowable threat of tax law change and its effects on property values. I remember, all too well, some of the tax code changes that occurred in the mid-1980s that negatively impacted property values. Is it possible that something similar could happen in the future? In short—yes. What if Congress decides that we shouldn’t be able to depreciate an asset that, historically, appreciates in value? What if they do away with some rules that allow for tax-free exchanges of properties or the so called step-up in basis rules?
While a detailed discussion on tax law is beyond the scope of this book, it is important to recognize that part of the value of real estate is the tax benefits that come with it. If they go away, it could have a surprising negative impact.
Real estate returns
The returns of real estate typically come from two main sources—rental income and appreciation. Rental income is, of course, the payments you get from people using your property. Payments vary based on property value, location, whether the property is commercial or residential, and more. Because of this, you can end up with different returns on similar properties.
My parents, for example, owned residential units and charged slightly below market prices for rent. Why? For one, they may have felt bad about raising rents on their tenants. But it also helped practically by making a “revolving door” less likely. Who wants to move out when you have such a great deal? They gave up return for more potential stability.
Historically, total returns on properties are a subject of much debate. Some, like Nobel prize-winning economist Robert Shiller, believe that the future of returns could be much lower due to lower demand for larger properties in both residential and farming applications. People can make better use of smaller spaces these days. For example, you can have a living room that doubles as a bedroom with a bed that folds up into the wall. Smaller kitchens may be desirable in an age where you have quick food delivery options. Electronic storage can help save filing space and do away with the need for bookcases and filing cabinets. New agricultural technology can reduce the amount of land necessary to grow crops.
Demographic trends can also skew expected returns. Will upcoming generations be more or less likely to want to own their own homes? What will interest rates do? Will people drift out of major cities as transportation changes make commuting easier? Will birth rates go up or down? How about building activity? All these issues can have huge impacts on future returns, and I’ve only scratched the surface.
Another factor to consider is the use of leverage in buying property. Typically, when I invest, I’m taking money that I’ve accumulated and buying some investment with it—clean and simple. With real estate, I may be able to make the purchase with OPM—Other People’s Money. This presents an opportunity and a potential risk. If the return exceeds the cost of borrowing, all could be great. However, if I run into issues with keeping the property rented for any of the reasons discussed above, I could end up with great losses or even losing the property altogether.
Is real estate more real than stocks?
Some people have told me that they like investing in real estate because they “can touch it.” It’s tangible and they can visit their property any time they want. I like to respond that I feel the same way about stocks. I can go visit the companies I own any time I want. I can walk into stores or drive by their buildings knowing that I have an ownership interest. I don’t think that differently about a stock certificate versus a deed on a home. They both represent ownership, and our legal system affords me protection of my rights to own property.
I remember teaching my son’s 4th grade class on career day one year. I wondered how I was going to make my job sound fun to a bunch of kids who were more interested in cartoons than what they were going to do for a living. Then it hit me. “How many of you guys play Nintendo?” All the hands went in the air. “Andrew (my son) owns part of that company” “Whoa!” He was now the coolest kid in the class.
Then I went on to ask them how many had shopped at the local grocery story, eaten at a chain restaurant or at the big-box home improvement center. Yes, Andrew and my other son, Alex, own a piece of them all.
In fact, almost all the cool things we use on a regular basis to make our lives better are made by public companies that allow outside ownership. Investing is actually pretty exciting.
Real estate risks
While real estate can have its own set of benefits, keep in mind that we are owners of an undiversified asset when we own single properties. As I’ve discussed, these risks can be great if things don’t go as planned. What if a renter stops paying and you end up with a costly eviction?
The factors that affect property value are often completely out of your control. Taxes can go up, driving businesses and potential renters from your area. Crime may rise in the area where you own property, or the demand for property could decline.
Someone told me that they were completely safe with the property they owned because it was near a college and they had a steady stream of students. That works until universities increase online classes or a virus strikes. These issues are typically downplayed at the “get rich with real estate” workshops, but they must be considered by the prudent investor.
I’m often asked if I use real estate in my regular investment accounts for clients. The answer is, “not usually.” While I’ve made exceptions when a client’s company retirement plan lacks options, I avoid real estate funds for a couple of reasons. First, a portfolio with stock mutual funds or ETFs already has a lot of exposure to real estate. Companies often have significant property ownership as part of their assets. Second, the historic return of real estate has been lower than many other asset classes, and there are other investment alternatives that can help provide greater diversification benefits.
REITs (real estate investment trusts) offer the ability to invest in a group of income-producing properties without the work required to manage them. I’ve seen REITs sold as stand-alone investments for income, often promising high returns and low risk, but they can have problems as well.
They are often sold on commission which drags returns down, can—and often do—experience reductions in promised income, and they can be very illiquid. The last point can’t be emphasized enough. Investors are often shocked when they learn that they can only get pennies on the dollar for real estate trusts they bought for income purposes but are no longer producing income. Often the only entities willing to buy the investment back are third-party investors—and they probably won’t pay anywhere near the original investment amount.
Real estate is a business
Real estate is best thought of as a business venture. Some of the most successful investors are those that treat it that way. They may buy distressed properties and use their contacts, experience, and skills to strategically add value and sell at a profit. This is a very competitive arena, and it’s easy to lose money with just a few mistakes. People overpay for properties, overestimate what they can sell them for, underestimate costs of repairs and the cost and time required to sell. They often run into unforeseen issues that can cause profits to dry up instantly.
When calculating returns it is not unusual for an investor to forget to include the time value of their labor in the project. This is like the highly publicized investment club that included their dues payments in their return reports. They were famous for their returns but ended up being infamous when the truth was discovered. (I’ll refrain from naming names since they’ve suffered enough embarrassment.)
If a property owner spends time personally repairing or replacing broken or outdated items in the house, or acting as a contractor for those tasks, then they’ve added value to the property that technically could have been paid for. The value added was partially due to their labor and would be labeled “sweat equity.” Stated another way: if you replaced a water heater in your neighbor’s house for $200 and put the money in your IRA, it wouldn’t be honest to count that as part of the IRA’s earnings.
Part of the reason that people think the returns on real estate investments have been higher than they actually have been can be attributed to counting this “sweat equity” as investment return.
What about your personal home?
I often hear people refer to their personal residence as an investment. An old mentor of mine used to adamantly tell his clients that their home was only an investment if they sold it “and moved into a tent.” While that was slightly oversimplified since the ownership of your home can save you from having to make rent payments to a landlord, it’s an important point.
An investment is when you put your money into something with the hope that it will make a profit. But with your personal living space, there’s no profit generated. If, however, you sell your house later in life and move into a smaller residence, you could make the case that there was an investment element.
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Another tool that can complicate the investment aspect of a personal residence is the reverse mortgage. While an entire chapter could be dedicated to this tool, I will only make a few points about how they can serve to bring an investment quality to your home.
To keep this simple, let’s say you’ve retired with a paid-off residence, and most of the equity is tied up in the brick and mortar of your home. Is there a way to access that money? Possibly. With a reverse mortgage, you can, within limits, use some of the equity for a multitude of purposes.
For example, it may be used to go on vacations, pay living expenses, medical costs, or other spending needs. Some have tapped home equity reverse mortgages to get quick access to cash during market downturns. Rather than selling stock when stock prices are low, they will use the cash available through this product to hold them over until the market climbs back up. This can help increase the sustainable income of a retirement portfolio.
When you vacate the home, either through sale or death, the house is sold and the balance of the mortgage (including the original borrowed amount and interest tacked on) is paid off and the remaining cash stays with you or your heirs. If the property is worth less than the amount owed, there is no harm to you or your heirs because this is a non-recourse loan. When you purchase a reverse mortgage, you are also required to purchase insurance for this reason.
This is a complicated product but can be a valuable tool in the right circumstances. Any well-qualified planner can help you understand if this may be right for you.
Should you buy or rent?
Related to the concept of a personal residence as an investment is the question of whether someone should buy or rent their home. This topic can get deep in a hurry so I will just give you a few basic things to consider when making this decision.
When I’m talking to people about this topic, they tell me their biggest reason for buying a home as soon as possible is to avoid “throwing money away on rent.” Why make someone else rich? This may sound good in theory, but there is more to consider.
Owning a home creates several opportunity costs that must be taken into account. I had a young financial planner who worked for me in the early years of starting my company and together we did a very detailed analysis of the buying decision. I’ll use his case and talk about the way we went about the calculation.
First, we considered the amount of commissions that would be paid from the purchase. We also had to think about the closing costs. Next, we had to calculate interest costs that would be part of his mortgage payment, as well as property taxes. We also looked at the difference in cost for homeowners insurance, which covers damage to the dwelling and contents, versus the lower cost of renter’s insurance that just covers the contents of the apartment or house. We also can’t forget costs of repairs when the A/C unit goes bad, the toilet won’t flush, or the roof leaks worse than a litter of week-old puppies. You also have to think about lawncare, trash pickup, gutter cleaning, painting costs, carpet replacement, mold remediation, exterminator fees, and other items of routine maintenance.
My planner also had to consider the fact that he was planning on getting married someday and it was almost a guarantee that the girl of his dreams would decide that his choice in housing left much to be desired. There goes another sales commission and a commission for the replacement property. This can also be an issue for someone who may have their job relocated to a new area.
The end of our story for the young man was that he decided it was more cost efficient to stay in the apartment for a while. This is not necessarily the case for everyone, but I hope I’ve given you an idea of the type of calculations needed to make this decision. As you can see, it is not as cut and dried as it may appear at first glance.
Buying a home is a decision that should be thought out carefully. I remember my wife and I buying our first home in a lower cost area of town. When we moved there, the community was dominated by young couples and families like ours. In a couple of years, we made our move across town to a larger home. As it turned out, the area of town we first lived in had a significant increase in crime a few years after we left. We lucked out by leaving when we did.
As you can see, the decision to buy property can be loaded with complexities and possible pitfalls. We often hear all the success stories without the challenges that may be involved. There can be some really compelling reasons to own your personal residence, but it‘s wise to make that determination after doing some careful calculations. When considering real estate as an outside investment, it‘s important to think about it as a job and decide if it’s a line of work that fits your overall plan for life. It is clearly not for everyone regardless of what you hear from the “get rich quick with real estate” crowd.
By Paul Winkler
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