Investment 101€¦ · Benefits of Real Estate as an Investment Vehicle Appreciation Real estate is...

Investment 101: Investing in Real Estate

Sponsored by: The Oregon Financial Education Network

Harlan MayerDirector [email protected]

Julee FelsmanOR Lic# ML-1332

WA Lic# 520-CL-49450-49451

[email protected] OFEN

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OFEN Why consider investing in real estate?

237 NE BROADWAY, SUITE 100 • WWW.FISCALWORKSHOPS.ORG • 503-836-7922 • [email protected]

Benefits of Real Estate as an Investment VehicleAppreciationReal estate is one of the few simple ways to take advantage of the power of moderately leveraged investing. With a 20-30% investment you own the appreciation generated by the larger asset. With leverage comes risk, but in the long run a little leverage can go a loan way toward dramatically increasing returns.

In the illustration below, you can see the impact of leverage and re-leveraging over time.

Scenario #1: buy one house and keep it

Scenario #2: buy one house, keep it for a while and then flip it into a bigger investment

Scenario #3: buy one house, keep it for a while and then flip it into a bigger investment. Let that grow and then use equity to buy a second investment.

value 85kdebt 68k equity 17k



value 250kdebt 22kequity 228k








value 1,100kdebt 523kequity 577k




May 1996 September 2002 April 2006 2014

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And how would a comparable amount of funds invested in the market have faired over the same period of time?

More leverage, by definition brings more debt. So how does cash flow fair?

DJIA 17,000 25,600 34,800 51,700

S&P 17,000 22,900 34,500 50,500

NASDAQ 17,000 17,900 33,900 61,100

Steady 10% 17,000 32,000 45,800 102,900

May 1996 September 2002 April 2006 May 2014

Scenario #1: buy one house and keep it

Scenario #2: buy one house, keep it for a while and then flip it into a bigger investment

Scenario #3: buy one house, keep it for a while and then flip it into a bigger investment. Let that grow and then use equity to buy a second investment.

rent 850PITI 650net 200




rent 3,000PITI 1,900net 1,100

rent 3,000PITI 1,900net 1,100

rent 5,000PITI 1,800net 3,200

rent 1,300PITI 750net 550

rent 3,740PITI 2,400net 1,340

rent 7,450PITI 2,800net 2,650

rent 9,100PITI 4,600 net 4,500

rent 5,000PITI 2,400net 2,600

rent 3,710PITI 2,400net 1,310

rent 4,100PITI 2,200net 1,900

May 1996 September 2002 April 2006 2014


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Cash FlowTo retire, one must convert earned income into assets that will generate passive income. Real estate is an obvious and natural means to this end. Best of all, rental income is automatically inflation-indexed—rents rise as the cost of living increases, generating a steady, predictable monthly income for retirement.

I stole the graphic below from a handout I use to illustrate the stabilizing benefit of a fixed rate home loan vs. rent. As a landlord, you get to turn that on it’s head: the difference between the payment and rent is your ever-increasing income.

$500

$1,500

$2,500

$3,500

$4,500

$5,500

$6,500

$7,500

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

Rent vs. Mortgage Payment

$1250 loan + $250 tax & insurance, 4% increase in tax & ins per year

Loan paid off!

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Special note: Real estate income/losses are “passive” under IRS rules. Passive income is not ever subject to FICA taxes, but passive losses are not always deductible. Up to $25k of passive losses can be deducted from earned income per year, but this deduction phases out between $100k and $150k per year in earned income. “Unused” passive losses are banked for future use.

Of course your year-to-year income is only part of the story. Ideally you’ll see a gain on your investment too. When you sell for a profit, capital gains tax will apply, however, real estate has a unique option. Under special rules for “like-kind” exchanges, the IRS will allow you to sell a rental and buy another and defer paying taxes on your gain.

Relative to mutual fund

investments it is worth noting

that you have 100% control

over the timing of your gains.

Tax BenefitsYear-to-year, from a tax standpoint, your rental is a small business, reported to the IRS on Schedule E. Rental Income – Expenses = Net Income/Loss. This is your real-world cash flow, but not the income the IRS sees. Net Income/Loss – Depreciation = Taxable Income/Loss.

In Appreciation of DepreciationYou get to write-off (depreciate)

the capital invested in your real

estate business: 27.5 years for

residential buildings, 15 years

for land improvements (garage,

landscaping, fence, sidewalk, etc.),

5 years for personal property

(appliances, tools, computers).

Real estate left to heirs...is inherited at a stepped-up tax basis equal to the value of the property at the time of death. Your heirs can sell with no capital gains tax due at all.

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How does this look in action?

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A few notes on PortlandOur fair city has strong demographic trends with

steady population growth projected. Many newcomers

are young professionals who make excellent tenants.

The Urban Growth Boundary limits supply for this

increasing demand. As

Peter Lynch (Fidelity Investments) famously says,

“Invest in what you know.”

IntangiblesYou have more control. Your

investment is concrete,

simple and comprehensible.

Owning investment real

estate can actually be a bit of

a fun hobby (if you have the

time, enjoy people and/or like

working on houses).

AmortizationEvery month, you owe a little less and own a little more. And if all is going as planned, your renters are making this happen for you.

A few negatives to consider (Relative to Stocks or Mutual Funds)There are a few disadvantages to real estate investment. Your investment is less liquid, and your portfolio will be less diverse. Owning investment real estate will be more work relative to mutual funds or stocks—IRS rules aside, it is definitely an “active” investment. The maintenance costs need to be considered, as well as the higher transaction costs. And finally, personal liability is something to be aware of and managed.

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OFEN A compelling time to buy...


We are experiencing what might be a once-in-a-lifetime convergence of low rates and significantly reduced prices.

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Average30

yrN

oteRa

te-Pe

rFredd

ieM

ac

The S&P/Case-Shiller Index is a

home price index, which tracks

matched pairs of sales of the

same home and uses these sales

to develop trends in the housing

market. The index for Portland

shows how much the market

deviated from a the established

steady trend as the housing

boom took off in 2005 and how

far it corrected from the top of

the market in 2007, as that bust

mirrored the boom and brought

us back to 2005 levels again.

Since January 2012 the trend has

reversed, and the market has

gained back much of what it lost

(although we have not quite caught

back up to the long-term trend).20

40

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200 July2007

Case

-Sch

iller

Inde

x

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OFEN


Taking What the Market Gives...

How does this look in the real world?

A $339/mo income on $37,500 down is a 10.8% return.

2005 2012 2014

Market Value $202,000 $150,000 $264,000

Down Payment 20%/$40,400 25%/$37,500 25%/$66,000

Loan Amount $161,600 $112,500 $198,000

Interest Rate 6% 4% 4.75%

Market Rents $900 $1,100 $1,250

P&I Payment $969 $537 $1,080

Taxes $155 $184 $203

Insurance $35 $35 $35

Net Income/Loss ($259) $344 ($68)

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OFEN Financing Investment Property


The bar is, in many ways, a little higher for financing “non-owner-occupied” properties.

Required down payment is 20-30%, depending on the type of property and how many mortgages you have.

Loan fees range from 1.5% of the loan amount to 4% of the loan amount higher than for owner-occupied purchases. Some, but often not all, of these fees can be avoided in exchange for a higher interest rate.

Lenders require that you have your own funds for the down payment (no gifts allowed) and seller credits to closing costs are limited to of 2% of the price. And you must also show that you have 6 months of your new loan payment left over in savings after closing.

Options with lower down paymentsIf you are willing to live in your future rental for at least a year, you can buy it as an owner-occupant with as little as 3-5% down.

Fannie Mae offers special financing for investors with as little as 10% down on designated foreclosed properties.

Visit www.homepath.com for eligible properties.

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OFEN Styles of Investing


Buy, Renovate & Resell• Immediate gratification, but at what cost?

• At best, short term capital gains tax due on any profits.

• At worst, can be subject to FICA taxes (if the IRS considers you a “dealer”).

• No time for appreciation.

• High transaction costs (you take on 100% of the risk and get paid last after your Realtor, lender and contractors).

Buy & Hold• Greater cash flow over time as rents increase.

• Costs spread out over time.

• Appreciation compounds over time (almost a problem as it erodes the rate of return).

• Tax benefits: depreciation, lower long term cap gains rates or eligibility for tax deferred exchanges.

• Just hold until you own it for retirement income.

• Sell on contract for income, tax benefits and no more property management hassle.

• Be sure you have the cash flow, assets or income to carry through and not sell in a down market!

Owner-Occupy then Move & Rent • Great way to get started.

• More favorable financing available with less money down.

• Make your improvements yourself while you occupy, saving on contractors and costly rental vacancy.

• The time you occupy the property allows time for rents and/or equity to increase.

• You’ll know the property really well for renting and future maintenance.

• Live there two years and you’ll establish some primary residence capital gains exemption.

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OFEN Odds & Ends


The Rental House College Fund• All the real estate investing benefits (leveraged appreciation and an inflation hedge) working to help

cover those inevitable bills.

• Pay your kid for working on the home and write of what you pay.

• Annual gifts of equity permitted up to the IRS limits (2009 limits $13k per person per year).

• When the time comes you can sell for the cash, borrow against the equity or use positive cash flow to supplement expenses.

• If selling is not necessary, you may be able to help your child into a first home early in life.

Managing yourself vs. Hiring a Property Manager• Ask yourself: do you have the right personality, the time and the skills to manage a property

yourself?

• Even if you hire a manager you still need to manage the manager.

• Cost is generally a intial set-up fee plus 8% of rent… and simple repairs are likely to cost you more.

• Perhaps fewer problems with tenants who know you… but individuals may be more of a target for scammers.

• Nobody can care more about your property than you do.

• Landlords love to talk shop! Consider joining the Rental Housing Association of Greater Portland (www.rhagp.org) or attending the Landlord Training classes offered for free by the Portland Police (503-823-7324).

Tenant Screening1. Set up criteria for tenants.

• Income requirements (ex: income = 3x rent)

• Credit requirements (ex: 90% of accounts are current)

• No felony convictions

• No bankruptcies in the last 7 years

2. Use a tenant screening company (Pacific Screening, Background Investigations, mysmartmove.com, etc)

3. Review Fair Housing requirement in Oregon to protect yourself: www.fhco.org

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OFEN Odds & Ends


Managing Liability• First and foremost… have good insurance!

• You should definitely have fire insurance with rent loss coverage and rental liability insurance.

• You should consider having insurance on personal property and an umbrella policy.

• Not a bad idea to require your tenants to carry renters insurance.

• Make sure you use a good, strong rental agreement.

• Consider forming an LLC. They’re fun to name but they might complicate filing your taxes, so talk to your CPA. (Oh yeah—get a CPA!)

• Not exactly liability, but consider a home warranty to help defray expensive repairs the first year or two.

Houses vs. PlexesHouses generally are lower maintenance.

• Generally “low touch” due to greater “ownership” mindset by tenants.

• Tenants pay utilities and (usually) maintain the yard. (Often they even make small repairs.)

• Lots of houses to choose from and the best financing options.

• Probably more liquid, quicker to sell in a pinch.

• 100% vacant or 100% occupied.

• Generally poorer cash flow (generally houses are not “intended” to be rentals).

Plexes generally have better cash flow and economies of scale.

• Not likely to be 100% vacant.

• May have the option to convert to condominiums when selling.

• Fewer to choose from and tougher, more expensive financing.

• Generally more hands-on management required.

• You pay for more utilities (water, sewer) and probably maintain the yard.

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OFEN What is your Goal?


If you’re interested in creating income:• Pretty simple, just work to get your property paid off by the time you need/want the income.

• Consider a 15 year fixed rate or prepay a longer term as loan aggressively as you can.

If you’re interested in growing wealth:• As equity grows, your eventual problem will be a diluted return on your investment.

• You’ll need to re-leverage to an appropriate level. (I like about 30% equity.)

• A tax-deferred exchange allows you to trade up into more or bigger properties.

• If you want to hold your property you can refinance it (or take out an equity loan) to reinvest some of the equity in another property.

Income creation and the increase in your equity... are not always mutually exclusive. Buy the right property at the

right price in the right location (at today’s rates) and you can

have it all.

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OFEN Investment Analysis Worksheet


Purchase Cost

Cash Invested

Financing Amount Rate P&I/mo

P&I/yr (Principal Reduction /Interest )

A great site to calculate principal and interest: www.ray.met.fsu/~bret/amortize.html

Depreciation (est. 4-5% of cost)

Annual Rent Less Vacancy(%) = Gross Income

Annual Operating Expenses

Tax

Utilities

Insurance

Management

Association Dues

Repairs

Supplies

Cleaning

Advertising

Miscellaneous

Total Operating Expenses

Cash Flow Before Tax

Gross Income

Minus Operating Expenses

Equals Net Operating Income

Minus Debt Service (P&I *12)

Equals Cash Flow Before Tax

Amortization

Debt Service

Minus Interest

Equals Principal Reduction

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Tax Cost / Savings

Net Operating Income

Minus Interest

Minus Depreciation

Equals Taxable Income

Times Tax Bracket

Equals Taxes Paid/Saved

Appreciation (estimate):

Total First-year Gain =

Cash Flow before Tax

Plus Amortization

Plus Tax Savings

Plus Appreciation

Cash-on-Cash =

Cash Flow Before Tax

Divided by Cash Invested

Return on Total Investment =

Cash Flow Before Tax + Principal Reduction + Tax Saved + Appreciation


Return on Investment Without Appreciation =

Cash Flow Before Tax + Principal Reduction + Tax Saved


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