If you really want to sink your cash into a money-making venture-real estate is where it's at. Real Estate Investing Made Simple is your manual on what's available to you and your family in building wealth.
What you won't find here are unbelievable claims of overnight successes that will load up your bank account in just a few weeks (though there are plenty of fact-based stories about people who have done that). Rather, the chapters here provide you with a commonsense approach to begin your real estate investing trek. Whether you want to invest in brick and mortar or the paper that finances real estate, you'll find tips and steps to get you started.
This is not an all-inclusive book on how to invest in real estate-that would take several volumes. Plus, I don't want you sitting around reading all the time. The best teacher is a trustworthy mentor and a couple of transactions! "Doing" is the best way to learn, and that's what this book is about.
As a primer, let's take a look at how good an investment real estate can be. First-the figures. Over the last thirty years, real estate has proven to be the best investment option to the average American. As you can see in figure 1-1, the value of real estate has moved forward without a blip since 1968. In addition, the median price of a home has increased by nearly 30 percent in the last five years, beating most stock investments hands down. (See figures 1-1 and 1-2.)
In 1998, the median price of a home across this great land was $128,400. At the end of 2003, it was around $167,000.
The Office of Federal Housing Enterprise Oversight (http://www.ofheo.gov/) keeps up with how much your house is worth. Actually, it tracks single-family housing prices in more than two hundred metropolitan areas. Its resiliency and strength was clearly demonstrated during the last recession. Between 2002 and 2003, only one of these areas experienced a downturn in the pricing of houses. Since 1968, the national median price has soared by 735 percent. What that has meant to homeowners who actually bought and held a home since then is an astonishing return on their investment of roughly 3,675 percent. That's right. This is not a typo-three thousand six hundred seventy-five percent. How could that have happened?
Simply-your investment in real estate is and, for most buyers, will always be a leveraged investment. What you put into the purchase of the property is not its full value. To buy a home today, you need only a very small down payment-heck with zero-down financing, some of you won't even need a down payment!
To demonstrate this astounding possibility, let's say you put down 10 percent on a purchase of a house valued at $200,000. That's $20,000. Since your investment is leveraged, the increase in the value of the house now results in exponential growth on your initial down payment.
When that $200,000 increases in value by 5 percent (2003's average appreciation rate), the property jumps to $210,000. Well, 5 percent doesn't sound like a lot to get excited about, right? Surely you could find a conservative stock that will give you more than 5 percent. But that's the beauty of real estate-the 5 percent on the house ($10,000) is actually 50 percent for the money you have in the property. So now, your investment has grown from $20,000 to $30,000. Keep doing that for five years and your $20,000 investment will have grown by $55,000-that's a return of 276% in five years!
Now, in real estate, you can leverage that property with a lot less money than $20,000. In fact, there are now down payment programs of 5 percent, 3 percent, 1 percent, and even 0 percent. Let's look at what happens with a 3 percent loan:
Year 1 Home Price: $200,000
Down Payment (3 percent): $6,000
Year 5 Value of House: $255,276
Total return on down payment 921 percent
Wow! No mutual fund can do that!
There are other ways to realize amazing returns on your money through real estate investments as well. If you're looking for more conservative but consistent returns, for instance, you may want to consider purchasing real estate tax liens or notes. I devote all of chapter 14 to tax liens; however, suffice it to say you can make consistent returns on these investments of 15 to 50 percent.
When renting out property, the return on your investment increases from the numbers above since you're also enjoying the monthly return of rental payments. Understanding the returns above from home appreciation, add to that the following scenario for the same house purchased with a down payment of 10 percent using investor financing:
Year 1 Home Price: $200,000
Down Payment (10 percent): $20,000
Note Amount: $180,000
Year 5 Value of House: $255,276
Total return on down payment: 276 percent
As you can see, the initial return on your down payment will be lower, however, let's key in the return on your down payment over the last five years from rental payments.
Note: These calculations use only the down payment and closing costs to determine a total return on investment. They do not take into account the monthly payments made to the lender to calculate the total return. The reason I've left out the monthly mortgage payment as a cost of investment is because most residents will have to pay on either a mortgage or rent, and thus the monthly payment on a mortgage is not an added expense compared to someone paying rent.
Here are the assumptions: You have a monthly payment of $1,226 with a 30-year fixed-rate mortgage and a 6.5 percent interest rate. We'll assume $250 per month for taxes and insurance, bringing your total payment to $1,476. If you are able to get $1,500 per month for the rental, your positive cash flow is going to be $24 per month. That's $288 positive cash flow for the first year-a return of 4.8 percent on the down payment. Though that doesn't sound like a lot, watch what happens as the money grows cumulatively. If your rent increases by 2 percent per year over the five years, then you will have a cumulative cash flow of $5,112-that's more than a 25 percent return on your money. As you can see by these simple calculations, the returns on investment for real estate can be tremendous.
Does this work in every market? No. Just like the stock market, you have to time your entry into the market and the exit. (And there's a section in this book on timing-chapter 7.) Long-term strategies will always work in your best financial interest.
When the stock market gets clobbered, like it did between 2000 and 2002, investors seek out safer havens for their dollars. Real estate, obviously, is at the top of the list. Unlike stocks, however, purchasing real estate is not as easy as clicking on a Web site and transferring your stocks from one fund to another.
Many differences abound between trading in stocks and real estate. If you are considering a change in your investment portfolio, keep in mind you're going to have some expenses in a real estate purchase that you don't have in a stock fund, but you will also enjoy some financial benefits a stock fund will never provide.
The good thing about stocks is that the price is the price. If a fund requires a deposit of $5,000, then you're in the fund for $5,000, less a few dollars for commissions or fees, depending on the fund. You hope and pray that it will grow to at least stay ahead of inflation these days, but in the past, 15 to 20 percent growth was not unusual. Thus a $5,000 investment that grew at 5 percent would be worth $5,250 in a year.
In real estate, it's not as simple. A $150,000 property isn't really going to cost you $150,000. It may cost you $15,000 by the time you fund the down payment, points, closing fees, and so on. However, the money you put into a real estate investment doesn't grow based on the amount of money you put into the transaction. A real estate investment grows based on the leveraged value.
The very nature of real estate enables you to earn much more per year than you could earn in a regular stock fund. The question usually follows immediately, "But what if the real estate market drops?"
Fair question, and I'll show you what happens through a condo I owned and sold two years ago, walking away with $11,000. The initial purchase price was $66,000 in 1989, to which my down payment was $1,980, using a Federal Housing Administration (FHA) 3-percent-down program. With closing and other costs, the investment ended up being about $3,000. So my total investment was less than 5 percent of the value of the property.
Unfortunately, I bought at the height of the market and then the bottom fell out. In five years, condos like mine were selling for as low as $49,000, but I had already converted the unit into a rental by then.
The monthly payment for my loan was more than the rent coming in. With the condo fee, I was still paying out $75 per month more than what I was bringing in on the rent. As you can see, this was the equivalent of what we experienced on Wall Street around 2000 and 2001. However, with rentals, there are more benefits than just cash flow. Real estate comes with options, unlike its securities-based counterparts.
The tax benefits for the rental property saved me thousands of dollars over the years. The IRS allows me to depreciate the condo by 4 percent each year (based on the $66,000 purchase price), as well as deduct expenses for upkeep and real estate taxes on the property. By the end of each tax year, I may have flowed $900 into the property, but I was also receiving a deduction of more than $4,000 for depreciation, taxes, interest, and various expenses.
Although I made no money during the years I rented the property, by the time I sold, the market had turned, rents were up to where the positive cash flow would have been $200 per month, plus the condo had appreciated to a value of $75,000. My eventual return was more than 300 percent on the original down payment, but that's not even including all the tax savings throughout the rental years.
One of the biggest benefits about real estate is that even in a bust market, you have options to make money on the investment. In addition, real estate markets can stand separate from their counterparts in other jurisdictions. When the stock market falls, it takes just about everybody with it. When home values drop in Houston, it's not going to take down other jurisdictions, as well.
The Fast Way to Get Started
So how can you get into this type of investing and return?
Many investor-owners of residential real estate became landlords by default. These are the owners who couldn't sell a house in a slow market, were facing a transfer deadline, and ended up renting out the house instead of selling it.
If you're already in a house, before you sell it and move up, might I suggest you consider renting out your current home as a matter of financial planning? Sometimes renting out a house can make more financial sense in the long run than selling it. With the change in the home sale tax exemption passed in 1997, homeowners can now keep-tax free-the first $250,000 (for single sellers) or $500,000 (for married couple) of capital gain from a personal residence. Many homeowners find themselves with a wad of cash from the sale of their principal residence and end up using it to purchase their next house, then spend or invest the rest.
By changing the financial plan, a homeowner can make more money in the long-term by renting out a principal residence than by selling it. If you can purchase another home without selling your current residence, then take a look at the financial and tax benefits you can take advantage of.
First of all, if there's a mortgage on the house and you rent it out to a tenant, someone else is now paying for the house. For our example, let's say someone bought a single family home in 1985 for $150,000 and took a 90 percent loan-to-value mortgage of $135,000 at 8 percent for 30 years. The monthly principal and interest payment would run $991. If taxes and insurance run roughly $200 per month, the total outlay is $1,191. After 16 years, the loan balance is down to under $100,000 and if the house appreciated 2 percent per year during that period of time, the value is now at $206,000. The investor's equity stands at $107,000.
Now that money looks mighty enticing-in the short-run. For the investor, however, it can be used for more than just moving up into one house or for taking vacations, paying off other consumer debt, buying cars and other luxuries. Instead, that equity can be used to purchase other investment houses. For the moment, let's just deal with the one house-yours.
For a monthly positive cash flow on our sample property, you will need to bring in more than $1,300 per month. If rental rates in your area are up to that level-great. Now you have a positive cash flow rental property that someone else is paying for. You're collecting the check, making the payments, and the value of your house is more than likely still moving up.
If the going rates are lower than that amount-say $1,000-then you might consider refinancing the balance of $100,000 over 30 years at 8 percent, bringing the principal, interest, taxes, and insurance (PITI) down to $756-now you have a positive cash flow, and someone else is still making the payments. (All rental income is taxable, but is reduced by rental expenses.)
As a landlord, you now have to keep the property up to code. It must be livable and have all housing systems in working order. This means you'll need to keep the heating and cooling systems in order, water flowing, electricity in working order, and so on. The renter should be taking care of regular maintenance, such as mowing the grass, trimming bushes, washing windows, and keeping the interior in shape. A blocked toilet, broken windows, and other incidental expenses may or may not be your responsibility, depending on what kind of limitations you have in your lease. I'll cover maintenance of property in chapter 11-this is just to give you an idea of what the whole investing scene is really about.
Other aspects of being a landlord include finding renters. I suggest working with a good rental agent in this regard. The agent will conduct background and financial checks on potential tenants-this is worth the agent's commission itself.
Other benefits of owning rental property are those carved out in the tax code for investors. Your expenses on upkeep are deductible, as are taxes, rental fees, legal and accounting expenses, and plenty of other items. There are limitations on deductions. For details check out the IRS Web site Digital Daily at http://www.irs.treas.gov/.
Before making a final decision on renting a property rather
than selling it, talk over the numbers with an accountant or
financial planner and the how-to's with your real estate
Excerpted from Real Estate Investing Made Simple by M. Anthony Carr Copyright © 2005 by M. Anthony Carr. Excerpted by permission.
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