Chapter 1

Evaluating Real Estate as an Investment

IN THIS CHAPTER

Focusing on the potential of real estate investing

Contrasting real estate with other investing options

Deciding whether real estate is really for you

Arranging your investment and financial plans to include real estate

When coauthor Robert first entered the real estate field while attending college decades ago, his father, a retired real estate attorney, advised that he use his employment income primarily to pay day-to-day living expenses and allocate money each month into long-term financial investments like real estate. This solid advice has served Robert well over the years.

It's never too early or too late to formulate your own plan for a comprehensive wealth-building strategy. For many, such a strategy can help with the goals of funding future education for children and ensuring a comfortable retirement.

The challenge involved with real estate is that it takes some real planning to get started. Contacting an investment company and purchasing some shares of your favorite mutual fund or stock is a lot easier than acquiring your first rental income property. Buying property need not be too difficult, though. With a financial and real estate investment plan, a lot of patience, and the willingness to do some hard work, you can be on your way to building your own real estate empire!

In this chapter, we give you information that can help you decide whether you have what it takes to make money and be comfortable with investing in real estate. We compare real estate investments to other investments. We provide some questions you should ask yourself before making any decisions. And finally, we offer guidance on how real estate investments can fit into your overall personal financial plans. Along the way, we share our experience, insights, and thoughts on a long-term strategy for building wealth through real estate that virtually everyone can understand and actually achieve.

The vast majority of people who don't make money in real estate make easily avoidable mistakes, which we help you avoid.

Understanding Real Estate's Income- and Wealth-Producing Potential

Compared with most other investments, good real estate can excel at producing periodic or monthly cash flow for property owners. So in addition to the longer-term appreciation potential, you can also earn investment income year in and year out. Real estate is a true growth and income investment.

The following list highlights the major benefits of investing in real estate:

• Tax-deferred compounding of value: In real estate investing, the appreciation of your properties compounds tax-deferred during your years of ownership. You don't pay tax on this appreciation/profit until you sell your property - and even then, with some careful planning, you may be able to roll over your gain into another investment property and avoid paying taxes. (See the "Being aware of the tax advantages" section later in this chapter.)

• Regular cash flow: If you have property that you rent out, you have money coming in every month in the form of rents. Some properties, particularly larger multi-unit complexes, may have some additional sources, such as from parking, storage, or laundry equipment.

  When you own investment real estate, you should also expect to incur expenses that include your mortgage payment, property taxes, insurance, and maintenance. The interaction of the revenues coming in and the expenses going out is what tells you whether you realize a positive operating cash flow each month.

• Reduced income tax bills: For income tax purposes, you also get to claim an expense that isn't really an out-of-pocket cost - depreciation. Depreciation enables you to reduce your current income tax bill and hence increase your cash flow from a property. (We explain this tax advantage and others later in the "Being aware of the tax advantages" section.)
• Rate of increase of rental income versus overall expenses: While not always true in recent years, often over time, your operating cash flow and even your net profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than the rate of increase for your property's overall expenses. What follows is a simple example to show why even modest rental increases are magnified into larger operating profits and healthy returns on investment over time.

Suppose that you're in the market to purchase a single-family home that you want to rent out and that such properties are selling for about $300,000 in the area you've deemed to be a good investment. (Note: Housing prices vary widely across different areas, but the following example should give you a relative sense of how a rental property's expenses and revenue change over time.) You expect to make a 20 percent down payment and take out a 30-year fixed rate mortgage at 6 percent for the remainder of the purchase price - $240,000. Here are the details:

Monthly mortgage payment

$1,440

Monthly property tax

$300

Other monthly expenses (maintenance, insurance)

$300

Monthly rent

$2,100

In Table 1-1, we show you what happens with your investment over time. We assume that your rent and expenses (except for your mortgage payment, which is fixed) increase 3 percent annually and that your property appreciates a conservative 4 percent per year. (For simplification purposes, we ignore depreciation in this example. If we had included the benefit of depreciation, it would further enhance the calculated investment returns.)

Now, notice what happens over time. When you first buy the property, the monthly rent and the monthly expenses are about equal. By year five, the monthly income exceeds the expenses by about $300 per month. Consider why this happens - your largest monthly expense, the mortgage payment, doesn't increase. So, even though we assume that the rent increases just 3 percent per year, which is the same rate of increase assumed for your nonmortgage expenses, the compounding of rental inflation begins to produce larger and larger cash flows to you, the property owner. Cash flow of $300 per month may not sound like much, but consider that this $3,600 annual income is from an original $60,000 investment. Thus, by year five, your rental property is producing a 6 percent return on your down payment investment. (And remember, if you factor in the tax deduction for depreciation, your cash flow and return are even higher.)

TABLE 1-1 How a Rental Property's Income and Wealth Build Over Time

Year

Monthly Rent

Monthly Expenses

Property Value

Mortgage Balance

0

$2,100

$2,040

$300,000

$240,000

5

$2,434

$2,136

$364,995

$223,440

10

$2,821

$2,247

$444,075

$200,880

20

$3,793

$2,523

$657,337

$129,600

30

$5,097

$2,896

$973,020

$0

31

$5,250

$1,500

$1,011,937

$0

In addition to the monthly cash flow from the amount that the rent exceeds the property's expenses, also look at the last two columns in Table 1-1 to see what has happened by year five to your equity (the difference between market value and mortgage balance owed) in the property. With just a 4 percent annual increase in market value, your $60,000 in equity (the down payment) has more than doubled to $141,555 ($364,995 - 223,440).

By years 10 and 20, you can see the further increases in your monthly cash flow and significant expansion in your property's equity. By year 30, the property is producing more than $2,200 per month cash flow and you're now the proud owner of a mortgage-free property worth more than triple what you paid for it!

After you get the mortgage paid off in year 30, take a look at what happens in year 31 and beyond to your monthly expenses (big drop as your monthly mortgage payment disappears!) and therefore your cash flow (big increase).

Recognizing the Caveats of Real Estate Investing

Despite all its potential, real estate investing isn't lucrative at all times and for all people - here's a quick outline of the biggest caveats that accompany investing in real estate:

• Few home runs: Your likely returns from real estate won't approach the biggest home runs that the most accomplished entrepreneurs achieve in the business world. That said, by doing your homework, improving properties, and practicing good management (and sometimes enjoying a bit of luck),...