It is interesting how rental real estate is treated as an investment. Like Rodney Dangerfield, he gets no respect. While conventional investments like stocks and bonds get the Financial Post and the Wall Street Journal, he does a search on “how to buy real estate” and you’ll discover all sorts of no-down-payment schemes that seem designed to sell books and tapes instead. . of real estate investments. On TV there is Report on Business TV, but in real estate you will see interesting shows or infomercials. I find it unfortunate that such a solid investment vehicle should have such a bad reputation.
Buying with no money down is possible, but it does involve taking out a high-proportion mortgage, and for rental property you only do this if you have equity in other properties. In other words, if you have free and clean property, it’s relatively easy to get a prime line of credit. A $100,000 property would cost about $400 per month, plus taxes and maintenance of about $200. In short, it would take place and give you income to pay your financing costs.
A more common method of purchasing rental real estate is with a deposit. Generally, if you can make an investment property itself with less than a 40% down payment, it’s probably a good deal. These types of properties are easier to find in stable markets.
There are many reasons to own investment real estate.
The #1 reason to own income real estate is because your tenants buy it for you. Even if the other benefits don’t add up, that alone justifies the investment. But the fact is, there are more benefits to buying a rental property.
Reason #2 is leverage. The most effective description of how leverage works comes from Lionel Needleman’s book Buy, Rent, Sell (Needleman doesn’t talk fast; in fact, he is an accomplished author and teacher with many books and articles published on housing in Britain and the United States. ). Canada his assumptions and math are a bit simplistic and need to be adjusted for your local market, but the book is worth looking at).
Explain leverage as follows: John and Mary each buy a property for $100,000. After one year both houses have increased 10% in value. Both buyers sell the properties and compare the profits.
John started with $100,000 and now has $110,000, which means he got a 10% return on his investment. Mary, on the other hand, put $10,000 into her property and mortgaged the balance for $90,000. When she sells, she pays off the mortgage and totals everything. She also received a profit of $10,000, but because she only invested $10,000 in the income property, she earned a 100% return on her down payment. As you might suspect, the real trick is that while John invested in one house, held it for a year, and then sold it for a $10,000 profit, Mary bought 10 houses, held them for a year, and then sold them for a $100 profit. 000. They both started with $100,000, but after a year, John only got $110,000 and Mary $90,000 more. The numbers are simplified in this example, but they decisively demonstrate the magic of leverage.
Reason #3 is taxes. In most tax areas, costs incurred on real estate investments are deducted from income. And you can typically incur depreciation expense on the structure, which is, in effect, a paper loss that reduces the tax burden. Depreciation works like this: We know that the value of a durable item, like a structure, decreases over the years. Even if the property is kept in perfect condition, an old house is not worth the same amount of money as a new house. This loss is depreciation, and you can use that depreciation loss to lower the total tax you pay.
Of course, when we invest in profitable property, we expect it to go up in price, and in the long run it often does. What happens to depreciation in that case? The tax collector was told that the property went down in price due to depreciation, but at the end of the process we sold it at a profit. The tax collector usually says that he has “recaptured” the depreciation tax and lien.
Recovery is not fun. It’s like finding out that she has already spent the money he planned to spend in the future.
There is a great solution. When you buy the investment, you divide the original investment between the value of the building and the value of the property. Without cheating, set the land value as low as possible and the structure as high as reasonable (do the math and it pays to be reasonable in your divisions). When the property goes up in price and you sell it off, you tell the tax collector that he didn’t get any depreciation back since the structure depreciated while the land went up in value. This gain is capital gain, and capital gain is generally taxed at lower rates than income like…rent. You depreciate the money you earn when you earn it as income and pay taxes on it when it comes from capital gains.
Owning an income-producing property also allows you to write off the costs of things you might have bought anyway, from office supplies to a trip to view the property.
Reason #4 is capital gain. Capital gain doesn’t always happen, but it often does. As we have seen with leverage, the capital gain can be leveraged. Even better, the capital gain can sometimes be more than what some people earn in a year of work.
Reason #5 brings it all together by combining cash flow, leverage, and tax planning. Rental properties generate cash flow. Initially, cash flow could be neutral or even negative, but after a while it will often turn positive. When you do, you must pay income tax on the excess rent. The solution to that is to remortgage and incur additional interest costs, reducing your taxes. It also recaptures your initial ownership. The next step is to take that money and buy another income property. You pay no income taxes, incur more depreciation, and still make a capital gain. Better yet, with two properties you spread the risk and when it comes time to sell, you can extend the term and sell the properties in different years to minimize taxes.
It cannot be repeated enough that you need to buy income property wisely. You need to know the location and the potential tenant. Properties that are desirable and in a desirable area remain rented. “Desirable” does not have to be “mansion”, but a place that is warm, clean, dry and at a good price are essential. Whether you buy a 1-bedroom apartment or a 3-bedroom house with a suite is not important.
Metrics are critical. The first is the price-rent ratio. What that means is you take the price, say $100,000, and divide the rent, say $1000/month, on that. In this case, the result would be 100. Numbers between 75 and 175 are great, but never forget that projected capital gains and interest rates affect the numbers you pick with. Low interest rates allow for higher numbers, and strong capital gains projections will call for higher numbers. More than 200 is not good in almost all places, unless all you need is dependent income, aren’t worried about capital gains, or never plan to sell.
Another excellent metric is the breakeven rate. This is the percentage of the price needed for a down payment that realistically allows rent to bring the property. The rent has to be a) market rent, not “expected” rent, and b) net rent, not gross rent. If the investment will drop below 45%, it’s worth looking at. Clearly, if interest rates are low, net income will generate more, which means that the equilibrium rate may be high. Remember that low rates don’t last forever, so unless you can secure a very long term, you should assume that the breakeven rate will be low in low interest rate environments and may be higher in low interest rate environments. higher interest.
If you discover a property that has a desirable price-to-rent ratio and a desirable break-even rate (and it’s in a good area and not a bad idea), it’s worth throwing the numbers into a spreadsheet and determining the internal rate of return (a real estate investment metric that combines various streams of income) and projected cash on sale. There are spreadsheets and programs that can calculate this for you, but the key is “GIGO”: garbage in, garbage out. Use the right taxes, the right interest rates, your income tax rate projections, and realistic estimates of earnings and capital maintenance. Properties in bustling urban areas generally increase in value more than properties in rural or depressed locations. They also tend to have what appear to be lower metrics: a condo in the center of the city could have a much worse rental price and break-even than a small house in an industrial city. However, capital appreciation in a rural area is probably much riskier. Measuring your mortgage down payment and tax benefits in a detailed spreadsheet allows you to gauge exactly how competitive investments stack up.
It would be foolish to ignore the issue of a housing bubble or crash. Buying in metrics helps and hinders. It helps because if you’re hard on break-even rates and rental multipliers, you wouldn’t buy an overvalued investment property (undervalued income property doesn’t really show up in a bubble, and its value doesn’t plummet). It hinders because you can’t buy metrics in a bubble, no matter how much you want to, because the properties that meet the metrics don’t exist.
The other side of this is that when a market crashes, there are plenty of properties meeting the metrics, but often little mortgage financing and lots of scared buyers and stressed sellers.
In general, a balanced market is optimal for buyers, although buyers who buy based on metrics and exit the market near the peak often feel like they’ve hit the jackpot.