Real Estate Is the IDEAL Investment
Despite what you may read in the financial press, real estate has always been and continues to be, the IDEAL investment. The best real estate most of us will ever own is the real estate we bought yesterday (or last year, or ten years ago, or even longer ago). Everyone you talk to wants to own real estate. Few people will tell you they purchased more real estate than they should have. In fact, just the opposite is true. Most people will tell you that they wish they had purchased, and held on to, more real estate over their lifetime. The major drawback of real estate as an investment in years past has been its liquidity. For the most part, and particularly with technology and the Internet, that is no longer much of an issue. Properly priced property sells and real estate can be turned into cash should the need arise. The secret of course (not much of a secret), is not to be forced to sell but to sell when the market will yield the greatest return to you, the investor. "Buy low, sell high" is sage advice, but when it comes to real estate. "Buy, hold for a long time, sell" will almost always yield fantastic overall investment results.
Real Estate Investment Objectives:
Income - Real estate investments structured with enough down payment, will generate a positive cash flow. As time passes, in most markets, even a highly leveraged, negative cash flow property can turn into a positive cash flow investment.
Depreciation - Theoretical Depreciation is the tax deduction one can use against the income real estate produces. Depreciation is a "non cash expenditure." Residential income property is usually depreciated over 27.5 years. Only the improvements are depreciable, not the land.
Equity Build-up - This results from the periodic pay down of the principal amount of the loan, usually through monthly payments on an amortized loan. Even if there is no appreciation over the life of the loan, the property owner would end up with a free and clear property at the end of the loan payment period on a fully amortized loan. This is usually a 30 year period on residential property.
Appreciation - While the amount of appreciation varies from market to market, real estate is a growth asset and often the largest part of the return on an investment in real estate is the equity gained through appreciation. Even small amounts of appreciation year after year can be considerable. Usually, the longer you hold on to a property, the better. The effect of appreciation is greatly magnified by the use of leverage.
Leverage - Through the use of borrowed money (OPM - Other People's Money), combined with a small amount of money of your own, you can control real property. The best leverage most of us can obtain in the stock market is 50%. In real estate, it is not unusual to obtain 80%, 90%, and even 100% leverage. With leverage usually comes risk, and with risk comes potential for investment reward.
In addition to the IDEAL as stated above, real estate investments have potential additional tax benefits - Investors are allowed to write-off (within income limitations) all operating expenses, interest on loans secured by the property, and property taxes. Also, Gain from the sale of real estate is treated as capital gain and investors also have the option of exchanging which, if done in accordance with the tax laws (IRC 1031), can result in partial to no recognized gain, which effects the immediate cash tax consequence.
What are you willing to pay today for a real estate investment to enjoy the IDEAL benefits outlined above? In other words, what is the "present worth of future benefits" to be derived from a real estate investment? We would refer to this as the value, and there are different types of value.
FAIR MARKET VALUE - The highest monetary price which a property would bring, if offered for sale for a reasonable period of time in a competitive market, to a seller who is willing but not compelled to sell, from a buyer, willing but not compelled to buy, both parties being fully informed of all the purposes to which the property is best adapted and is capable of being used.
Loan Value - Since a lenders security for a real estate loan is the sale of the real estate in the event of default on the loan, loan value is usually a conservative estimate of market value.
Value is determined three different ways, known as Approaches to Value by appraisers. The three Approaches to Value are the Market Data Approach, the Cost Approach, and the Income Approach.
Keep in mind that future income is impacted, positively or negatively by the "Four Great Forces" that influence value. Investors should be cognizant of these forces in the areas in which they own property or plan to own real estate. These "forces" will have an impact on the income which can be generated from any given property and the value of income producing property is directly related to the income the property produces.
The Forces Influencing Value
- Physical Forces - the quality and convenience of schools, shopping centers, playgrounds, transportation systems, etc. It also includes the climatic conditions.
- Social Forces - Population growth or decline; Marriage, divorce and birth rates; educational and religious standards.
- Economic Forces - Business and real estate cycles, variations in directional growth, natural resources, wage levels, tax levels and insurance schedules.
- Political Forces - Zoning, fire and police protection, government loan and other subsidy programs.
Value by the Numbers
1. Gross Multipliers - Value=GSI X GM
Does not take into consideration expenses.
2. The value of income producing property is directly related to the net income the property produces. The greater the net income, the greater the value. Net income can be increased by increasing gross income, by decreasing expenses, or a combination of both.
- Income - Rent amounts are usually controlled by supply and demand
- It is net income that we are most concerned with
- Gross Scheduled Income
- Vacancy and Uncollectible Rent
- Effective Gross Income
- Operating Expenses (Fixed and Variable)
- Net Income
- Debt Service
- Cash Flow
- Added Taxes
- Increases and decreases in income increase and decrease value.
- If you can increase the net income by increasing rents or decreasing expenses, you increase the value.
- Income = Rate X Value - You can use this as a comparison without understanding capitalization rate.
- Changes in value based on changes in income.
3. Value by Tire Kicking
- Cost per Unit
- Unit Composition
- Type of Roof
- Individual Utility Meters
- Size of Units
- Seller Financing Assistance
- Deferred Maintenance
- Individual Water Heaters
- Modern Kitchen
- Orientation, Light or Dark
- Price per Square Foot
- Put on your tenant's hat
- What about assemblage and plottage?
Rents and the Rental Market Place
You, as an investor, should be able to determine the dynamics of the rental market and in fact, should not purchase until you thoroughly acquainted with it.
Contract Rent - what is being paid under the existing rental agreements and for how long.
Economic Rent - what could be charged on the open market if the property were readily available.
Other Rent Factors:
Quantity - how much is collected.
Quality - financial stability of the tenant. For commercial property, you can ask to see the financial statements of commercial tenants if the lease so provides. For residential income property, review the rental applications of tenants.
Durability - if the property is residential, you may be concerned if the term of the lease is for a prolonged period. If the property is commercial, industrial or office type, you want the lease term to be at least three to five years.
How do you determine market rents? You call. Do continuous rent surveys. Be up to date in your market area.
(Saul Klein is CEO of Real Estate Electronic Publishing Company, home of RealTown.)