Buying Real Estate Bookmark and Share

Real estate is a tangible asset, much like gold and silver. It also appreciates in value over time, just like these precious metals. Real estate can be a great cash-generating asset, and also has its benefits through the use of financial leverage in the form of a mortgage.

The Three Main Reasons to Buy Real Estate

The three main reasons to buy real estate are:

  • Cash Flow

    • By purchasing an investment property and obtaining good financing a real estate investor can experience significant positive cash flow. When the monthly rent covers your mortgage and all other expenses, any additional money goes into your pocket. It is similar to a stock that pays dividends, or a bond that pays interest. It provides the working capital you need to further expand your investment opportunities and obtain greater financial security.

  • Return on Taxes

    • The U.S. Government offers tax incentives to those that own property. The most popular exemption for individuals is that one can deduct mortgage interest on up to $1,000,000 of mortgage principal. For example, if you had a $1,000,000 mortgage at 5%, your yearly interest payment would be $50,000 (assuming no paydown of principal). The $50,000 would directly reduce your taxable income, and if you were in the 35% tax bracket it would represent $17,500 in tax savings. Because of this, many investors in higher tax brackets are less concerned with cash return and more focused on the tax advantages of real estate investment. Real estate investors are also able to deduct mortgage insurance as well as points paid on a home loan.

  • Price Appreciation

    • The main reason people invest in real estate is for price appreciation, which usually produces the largest gains. However, buying a property expecting a double digit percentage increase in price every year, borders on speculation, and one should be careful. Properties that are good candidates for price appreciation also produce good cash flow as the current value of the property is directly related to the discounted future cash flows. Properties can have significant increases in value over time and if you have long-term goals, one option is to buy land or a property in the path of development. Land near Disney World in Florida paid off handsomely for those investors that bought before the park was constructed.

All three are the above are components to your return on investment (ROI). When buying any property, you are always trying to maximize the return on your investment.

How do I Maximize the Return on my Investment?

Use Leverage

In order to maximize your ROI, you must use as much of the bank's money as possible. When you purchase with your own money and then use the bank’s money to pay for the rest of a property, you are implementing the concept of financial leverage. With leverage comes higher returns, but also more risk. During the housing bubble of the mid 2000's, investors were able to accumulate properties for little or no money down. Because of the leverage extended to these investors by the banks, they were able to accumulate extraordinary wealth when home prices were skyrocketing. When home prices fell, investors were stuck with homes worth less than their mortgages, and because of the leverage, did not have the equity to make up the difference. Thus, homes were foreclosed, and banks took losses due to their poor lending decisions.

To illustrate how this works, lets say you have $500,000 in the bank and would like to purchase some property. Well, you can purchase one home for $500,000 cash, or purchase 10 homes each with a $50,000 (10%) down payment and a $450,000 interest-only mortgage from the bank at 5%. Let's say home prices appreciate 10% over the year. In the first case, you've made $50,000 ($500,000 x 10%) on paper. In the second case, you've made $275,000 ($5,000,000 x 10% - $4,500,000 x 5%) on paper. You make alot more money in the second case because you are using leverage from the bank, your $500,000 in equity allows you to control $5,000,000 of real estate. In this case, you end up paying the bank $225,000 in mortgage interest, but still end up with a whopping $275,000 in profit. In the leveraged scenario, you end up with a 55% ROI, compared with only 10% ROI in the unleveraged scenario.

Let's take a look at the opposite scenario, the one that got so many investors in trouble who bought homes in 2006. Lets assume, home prices decrease by 10% over the year. In the first case, you've lost $50,000 ($500,000 x 10%) on paper. In the second case, you're out $725,000 ($5,000,000 x 10% + $4,500,000 x 5%) on paper. Wait a minute, but you only started with $500,000? Correct, you are now in debt, bank forecloses on homes, game over. In the first scenario, you can still sell your house and walk away with $450,000. In the second scenario, there is nothing you can do but be foreclosed upon. Leverage can be used to increase returns, but can be dangerous when you are too highly levered in an adverse market.

Financing Options

In addition to getting a mortgage loan from the bank, many different financing options may be available to purchasers of investment property. These include:

  • Lease options
  • Buying subject to existing financing
  • Owner-carry financing
  • Private money
  • Hard money
  • Your money

In order to maximize your ROI, you must use as little of your own money as possible.

Types of Investment Property

There are many types of investment properties to suit differing investing strategies and styles. Even though there are a large number of people owning their own homes, very few of these homeowners consider themselves property investors. The following are different types of investment properties ranging from the most common to the least common.

  • Primary Residence

    • Price appreciation of a primary residence is the most significant source of wealth creation for most people.

  • Second Home

    • Important to consider the resale appeal of these properties as they are usually sold after the family has grown.

  • Rental Home

    • Investment made for purpose of income generation and/or capital appreciation. Some investors advocate investing in low cost housing in poorer neighborhoods because the investment-to-income ratio is so attractive. Others suggest investing in upscale rental properties for the combination of income and asset appreciation.

  • Improvement Property

    • Buying property to renovate and sell on can be extremely satisfying and very profitable, but it can also be extremely risky. The key to making a profit from renovations is in buying the property at the right price.

  • Land

    • Land can be a very cheap way to speculate on an area for future development.

  • Multi-Family Homes

    • Two and three family homes are often popular as early-stage investments, especially with homeowners looking for help paying the mortgage.

  • Apartment Complexes

    • WIth apartment complexes it is increasingly important to consider your bottom-line income each year after deducting all of your operating and marketing expenses. This will give you your percentage return on your investment. You are also protected from inflation as you can pass your increased costs on to your tenants.

  • Commercial Property

    • More complex investments including office space, retail space , industrial space, hotels, marinas, campgrounds, ski parks, amusement parks, and sporting facilities.
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