Considerations for Real Estate Investing
Real Estate investing is one of the more common investments people make, particularly people in the Military. Either out of necessity, or perhaps perceived value, people generally find themselves as home owners at one point or another. As one gains experience, there is a natural tendency to want to find additional real estate commitments. I will talk more about some considerations for your next real estate purchase.
Active Duty military folks move, a lot! Usually every 2 to 4 years, Active Duty folks are moving about. At the beginning of careers, we are light and agile, and moving is little more than stuff in a suitcase and a backpack and driving to the next place. Over the years, that process morphs into a well-crafted ballet of boxes, pets, cars, and big-boy toys harmoniously transiting to a new home. Somewhere in that transition, home ownership sets in. And then, for a variety of reasons, when moving, the thought crops up to become landlords. This is an entirely different set of considerations from owner-occupied real estate. Investment real estate will be the focus of this article.
When considering owning investment real estate, there are many things to consider:
Whenever leverage is involved, investment risk increases as borrowed funds must eventually be repaid - one way or another. There is a ready market of lenders who will let you mortgage all the way up to certain limits. It is important to realize that these lenders have no responsibility to your well-being nor anything close to a fiduciary standard duty of care. Therefore, one should take caution when dealing with lenders of any sort, particularly if one is suggesting borrowing from your retirement accounts or some other silly strategy.
2) Opportunity Cost
When one commits capital (money) to an endeavor, he/she is effectively short every other investment. Meaning, if I am purchasing a piece of real estate for investment purposes, I am NOT investing in a Broad-based Index Fund, a Foreign Equity Mutual Fund, or any other security. Essentially, you are telling yourself that your real estate selection will, in aggregate, perform better than corporate America - this is a bold statement.
Real Estate requires much in the way of care and feeding, especially in the residential rental market where tenants can inflict some serious wear-and-tear on your rental home. Moreover, you are now on the hook for the potential calamities that may happen to your rental home. This can be a major issue if you are stationed overseas. Admittedly, there are ways to alleviate this. Though like we say in the military, you can delegate responsibility but not accountability.
When one purchases real estate - or any investment for that matter - there are two sources of investment return: (i) Appreciation of the Asset; and (ii) Income earned while owning the asset. With real estate, I have found that people generally focus on the first - asset appreciation - and neglect the second - Income Generation. Let's tackle the first item.
Generally speaking, real estate appreciates over time. However, as I have written about here, the appreciation over the long-term is usually somewhat close to inflation. So, in real terms - meaning adjusted for inflation - real estate in general is not super-well-known for asset appreciation. True, there are famous exceptions - discovering bountiful natural resources, new developments in proximity to your land, or location in a rapidly increasing real estate market - think San Francisco. However, those are much more the exception rather than the rule. Therefore, if you are purchasing a home specifically for the rapid ascent in its price, you are playing against a stacked deck.
The second component, Income Generation, is sometime ignored and/or forgotten by the real estate investor. Let's take a closer look at what I am talking about.
When investing in real estate, there are three broad items you need to know:
- Carrying Costs
- Interest Expense
- Property Taxes; and
- Your Loan Payment
When you know those items, you can calculate your after-tax cash flow, which in my opinion, is the all-important number know when investing in real estate. Let's look at an example of a typical situation - a rental home:
In this example, the average rent is $21,600 for the year, or $1,800 per month. Repairs and Property Taxes are the responsibility of the landlord and the property is financed with a loan payment somewhat below the rent - $1,480 per month. In this case, the Property Taxes are included as part of the loan payment....this may not always be the case.
The chart above is where most people stop as this is all that is required for income tax purposes. In this particular case, it is a happy result that no income taxes are due on this property. However, this does not tell the whole story as there is another calculation to make - cash flow. To do this, you take rental income and deduct all your payments: carrying costs, loan payments, income taxes due, and property taxes. Here is the calculation for the property above:
As you can see, the taxable income does not tell the whole story. The primary culprit here is depreciation - a non-cash expense. This fickle beast (depreciation) helps you tax-wise, though it doesn't aid cash flow in a similar manner. Therefore, it is wise to make both calculations when evaluating your property ownership.
This situation may not be unacceptable to the owner. For example, the home's current market value - in this case about $350,000, might be increasing at 2.5% per year. In that case, the market value appreciation is compensating the owner for the negative cash flow. However you look at it, if one must put somewhere between 0% to 20% down payment on a home, there is potential that the cash outlay may not see a return throughout the holding period of the asset - a decidedly bad situation for the investor.
The one big takeaway here - in my view - is that if you are PCS'ing and desire to become a landlord, you cannot simply set the rent at the amount of your loan - that is a sure way to the poor house. You must take into account the carrying costs of your home and attempt to account for them in your rental price. Otherwise, selling may be a batter option for you.
Most military folks are very familiar with the ins and outs of residential home purchases. There is another type of rental endeavor - commercial real estate - that is a bit less familiar. While there are some similarities, there are some distinct differences that in the right situation can make commercial real estate a much better endeavor. Here are a few:
1) Tenant Quality
When you rent to a commercial tenant - usually a business - that business has a vested interest in the general maintenance and upkeep of the premises....more attractive building, more customers will come in. Residential Tenants, usually no matter how well-intentioned, never quite see the accommodation as someone else's home.
2) Longer-Term Leases
The duration of leases in the commercial space run the gamut to very short all the way out to 20 years with extensions. For the most part, successful commercial tenants tend to stay put for a number of years. Residential tenants can be a bit more transient, and with every new tenant comes the heartache of a month were the unit is unoccupied and the intermediate maintenance usually required between occupants.
3) Net Leases
In the commercial property space, leases are a bit different in that some of the burdens of occupying the property are passed on to the tenant. For example, a "Double Net" lease has the occupant paying property taxes and smaller maintenance repairs with the landlord responsible for larger items like roof and structure. In general "Double Net" has the tenant paying for inside things and the landlord paying for outside things.
With "Triple Net" leases, the landlord has not responsibility besides cashing the monthly rent check.
The net lease concept ameliorates a great number of the headaches associated with being a residential landlord. Of course, there are still challenges, though clogged toilets are usually not one of them.
4) Great Liquidity
The commercial real estate space is bursting at the seams with properties and investors on the prowl. And since the buyers don't occupy the space, it is not at all uncommon to have a California Resident own commercial real estate in Georgia. Moreover, there are a great many more cash buyers in the commercial real estate space as financing is not as easily gotten...banks have to retain these loans on their own books. Thus, the underwriting can be a bit more cumbersome, believe it or not, for commercial real estate. And finally, the down payments tend to be higher and the payment terms shorter - 35% down and 15 year terms are pretty typical in the commercial space.
There are other nuances, though the above listing captures a few of the bigger ones. Let's look at a real example and see how the financials can differ somewhat, here are the details:
- Purchase Price: $255,000
- Down Payment (35%): $89,250
- Financing: $165,750
- Interest Rate: 5%
- Financing Term: 15 Years
- Triple Net Lease Term: 15 Years
- Monthly Rent: $2,400
Here are the same calculations previously made, though for this commercial property:
Income Tax Calculation:
And the Cash Flow Calculation:
As you can see, the "Net Lease" characteristics of commercial real estate are of tremendous value in this case. Also, the ability to depreciate this property over 15 years instead of 27 is of great consequence. The confluence of these two factors results in the owner "only" owing $636 in taxes while her cash flow is $12,435, which is an after-tax rate of return on invested capital of 13.9% ($12,435 / $89,250).
The example above is not always the case with commercial real estate, though it is not uncommon to find these opportunities if one looks enough and is patient.
Things to Think About
1) Being a Landlord is Hard Work in the Residential Space
As I alluded to before, being on the hook for a new HVAC or Water Heater - not to mention a new roof, is expensive business. In this area, commercial real estate has decided advantages over the residential one.
2) Transaction Costs
With commissions ranging between 3% to 6%, switching horses is an expensive proposition. And this leaves out the points and other bells and whistles your friendly banker will tag on to the deal. Therefore, it makes a lot of sense to buy and hold with real estate investing.
3) Don't Ignore Opportunity Costs
These are a real concern. If you read this, you will quickly understand that the juiciest returns are generally found in the stock market. Real Estate - especially in the residential space - is a tougher way to compound growth, and you generally have to do it with leverage, which further complicates things.
4) Cash Flow, Cash Flow, Cash Flow
I hope one of the broad takeaways from this piece is the primacy of cash flow when investing in real estate. True, some dirt may appreciate for unexpected reasons, though this is not the norm nor something one should count on. If you are speculating, by all mean, please do - just accept that speculation is a different form of financial commitment than what was described here.
5) The Ability to Defer Capital Gains
In my work as a Financial Planner, no pre-conceived notion has been reinforced more than people's general disdain for income taxes. Despite what you may see on the macro scale on television, it's true. With real estate, investors have the opportunity to defer capital gains upon the sale of properties via a 1031 Exchange. There are many details with this process, though for now, suffice it to say, if you are holding on to your first home purchased many years ago for fear of the income tax calculations, all is not lost, you can potentially defer the capital gain by purchasing another piece of real estate. As I said, there are many considerations with taking advantage of this wrinkle in the tax code, so please be sure to consult your tax advisor if this strategy is of interest to you.
This article does not even begin to scratch the surface of real estate investing....entire college courses are taught on the subject. My hope is that the careful reader took away a few nuggets to be applied to her specific situation. In my experience, not many people look at the cash flow calculation I showed above...perhaps it will be useful to you.
Comments, criticism, and suggestions are always welcome. If you would like to provide any or would like to discuss your personal situation with Resilient Asset Management, please contact us here.