Real Estate, the Sensible Investment

With all the turmoil in the stock market and the uncertainty of your investments, perhaps the best advice to follow would be that offered years ago by Will Rogers: “Put your money in land because they ain’t making any more of it.” Simple but true. I think we are all familiar with the concept of supply and demand and the fact that a commodity in limited supply holds its value. That is certainly the case with real estate in western Pennsylvania. It is true enough even if all you are doing is buying land or a single family home—over time, the value will increase significantly. However, I think it may be time to revisit the idea of investment real estate as an alternative to stocks and bonds.

Let’s get the downside out of the way right up front. Real estate is not a liquid asset, meaning it isn’t quickly liquidated. If you need an investment that you can cash out quickly, real estate isn’t it. Even if you found a buyer for it today, it would likely take weeks to close the sale, due to your buyer’s mortgage considerations. But if liquidity isn’t a concern, then I can’t think of a more secure way to invest. Real estate is definitely tangible; if nothing else, you can always put your hands on it and it can be a very lucrative investment. In most cases, real estate is making you money in two ways: You are realizing a return immediately through rent payments, but also as appreciation over the long term.

Let’s consider some details. First, how do you know what’s a fair price to pay for an investment? You will need to know the annual income of the property, the annual expenses and the rate of return you require for your risk. For example, say you are looking at a four-unit residential apartment building, with each apartment renting for $600 per month. The monthly income would be $2,400 (four units times $600), so annually the building grosses $28,800 ($2,400 per month times 12 months). Now, let’s say the annual property expenses are $8,800 (taxes, insurance, maintenance, utilities, etc.), that would leave you with net income of $20,000. Many investors feel that a real estate investment should be capitalized in 10 years, therefore requiring a 10 percent return each year. Therefore, if you are looking for a 10 percent annual return, $20,000 is a 10 percent return on a $200,000 investment ($200,000 divided by 10 percent equals $20,000).

In addition to the immediate return on investment, real estate has a rather favorable tax treatment, so you may be able to deduct all of the property expenses, plus depreciation and mortgage interest, from the income of the property. This leaves you in a desirable tax position as you may have no tax liability for the income the building generates. If the building shows a loss on paper, you may be able to deduct this loss against other earned income, thus reducing your overall tax liability.

Let’s look at a practical example of this. Take that $200,000 property—if you take out a mortgage at 7 percent interest, the annual interest paid in the first year will be $14,000. If you depreciate the property for 20 years using the straight line method, deducting $25,000 for the value of the land (land doesn’t depreciate) you can deduct another $8,750 per year ($200,000 less the land value of $25,000 leaves $175,000 to depreciate, divided by 20 years equals $8,750). Continuing then, the income after expenses is $20,000, less interest ($14,000) and depreciation ($8,750), providing a loss on paper of $2,750.

WOW! Win-Win. And the loss can probably be applied against your earned income, further reducing your taxes. Sweet! You see, real estate doesn’t actually depreciate; it is one of the incentives built into the tax code to encourage real estate investment.

As you can see, a real estate investment can be of value in several ways, not just as a direct return but as a long-term investment and tax shelter as well. These investments make for a great retirement plan. Consider this—you begin investing in real estate when you are 30 years old, and every two years you purchase a duplex using a 20-year mortgage. By the time you are 66, you will own 10 duplexes free and clear. Forgetting about the tremendous asset you have developed and the equity it represents, the gross income alone will provide you with a very comfortable living. Think about it—if the duplex currently rents for $600 per unit, even if rents do not increase over the next 36 years (highly unlikely), you would have a gross monthly income of $12,000. Awesome!

So get in on the Monopoly game. You have numerous options for your real estate investments, including residential apartment units, commercial properties, retail and industrial. Or diversify, and mix it up. The key to success is careful property selection, careful tenant selection and adequate property maintenance. Speak to your tax professional and devise a plan that works for you. It’s a great vehicle for wealth building.

Gary Straub is an independent real estate consultant who has been a real estate professional for 36 years.