Someone once asked me what the best financial investment is. While this is a fairly subjective question, I answered real estate, and I think many others would as well. Countless fortunes have been derived from land ownership and real estate investing including my very favorite example: In 1626, Peter Minuit bought Manhattan Island from the Dutch West Indians for $24. That’s about $600 in today’s dollars!* It would be quite difficult to quantify what Manhattan is worth now, but let’s just say he didn’t overpay. Anyway, I would answer real estate regardless of statistics which may show that the total return of the stock market over the last 50 years is actually more impressive, on average, than that of the real estate market. The primary reason is that we can live in our real estate and often factor the payments into our budgets. A home cannot be instantly converted to cash and therefore has a greater chance of building up equity. Besides this illiquidity advantage, real estate can be leveraged. You don’t need to secure the full purchase price of a home to buy it. Often 25%, 10%, or 0% will be enough money down to take possession. We’ll go into exactly why this is such an important advantage to investing in real estate below. We’ll also touch on mortgages, even though the subject can be quite boring, because the method of financing you choose will ultimately have an impact on your investment.
The most basic form of real estate ownership is your primary residence. Those who rent might notice that every month they send a chunk of money off to somebody else who owns their home. I’m not going to totally bash renting for two reasons. During volatile housing markets, renting can actually be a safe alternative to buying a home. Also, some people can’t afford to buy and therefore can’t be discriminated against for renting. That being said, given the evolution of the mortgage industry, it’s easier now than ever to secure a home, often without having to put in a down payment. At some point, many renters get frustrated with the process and decide to buy a home. This often happens when one gets married or has children, and the need for a home increases. Interestingly, statistics show that the purchase and eventual sale of a home tends to provide many retirees with an additional income source. After the kids grow up and leave the house, downsizing often makes sense and a portion of the home proceeds can be used to supplement government programs such as Social Security (more on that later). Here are some other advantages to owning real estate:
Appreciation Potential: While appreciation is never a certain thing, real estate has been one of the more reliable places to park money over the course of history. In the US, the economy has grown at a consistently healthy pace. There are a multitude of reasons why this happens including a large and productive labor force, a stable government (you may not love who’s in charge, but our government is incredibly efficient) and technology advances. The beauty of real estate ownership is that you can benefit from the expanding economy even if you don’t contribute to it, simply by holding on to your property. Your location contributes to appreciation potential as well. A friend of mine lives in an apartment building in New York City. Recently, her ground floor was converted into a luxury food market. Apartments in her building instantly became more expensive as a result. Similarly, if a corporation decided to build a huge corporate park in your city which employed 4,000 people, you’d likely see a great demand for property in that neighborhood. These are the sort of things real estate investors speculate on.
Income Potential: While many people buy homes to live in, others buy them as investments which will produce monthly income and hopefully appreciate in value as well. I have a friend who recently bought a two-family home instead of a single family home. His logic was that he had saved enough money to provide the down payment for the two-family home, so why not buy it and then rent out half the house? The renters would more than cover half the monthly mortgage payment and he’d try to find reasonable tenants who wouldn’t drive him too crazy. So far, his strategy has worked out exactly as planned. The real estate market has held up nicely and he’s two years into payments on a $700,000 home. Hopefully the home will continue to appreciate in value and he’ll have a nice profit when the property is sold. For tips on owning property for income, take a read of the landlord blog at www.thelandlordblog.com. It goes into detail on a variety of real estate investment strategies and gives a fresh, candid commentary on the intricacies of being a landlord.
Leverage: This is perhaps the greatest advantage to owning real estate and understanding why could improve your decision-making process forever. Consider the following hypothetical example which is both realistic and accurate of the recent market. It’s 1997 and you’re 30 years old. You have secured a job paying a stable $75,000 salary and managed to save $65,000 while sharing an apartment with an old friend. You’ve decided to buy a condominium in Miami which costs $350,000. The monthly payment is about $2,400 which you determine is reasonable considering your job stability and fairly responsible spending habits. The building requires that you put down 10% ($35,000) on the home. You move in, decorate the place and get comfortable. Six years later you and your significant other decide to have a child. You agree that a suburban home is more appropriate than the condo and decide to put it on the market. In 2003 you get a bite for your asking price, $600,000. The 72 payments you made since 1997 totaled $172,800, of which $45,000 was paid into the principal and $127,800 was paid to the bank as interest. While the interest is a bit paining, remember that you did get to live in a $350,000 home for a mere 10% down. You can think of all the bank interest as if it were rent. After paying back the bank $305,000 (your purchase price less your paid down principal) and giving the broker a $10,000 fee, your proceeds are $285,000! This is the advantage of leverage. You might now go and put $100,000 down on a million dollar home. With a leveraged purchase, even though you only secure the home with a fractional down payment, you are still entitled to the appreciation (or depreciation) which occurs. Granted, home prices don’t always appreciate so quickly, but if you pick a good location and are patient, you could eventually realize a profit. In fact, in the late 90’s you didn’t need much patience because home prices were soaring in many parts of the United States. Some people believe that the real estate market got way too hot. More details about the “bubble” phenomenon are discussed in some of the blogs mentioned below.
Lack of Liquidity: Logically speaking, an asset which takes a long time to sell should be less expensive as a result. This is why I included this attribute on the list of disadvantages as well. My reasoning here is more psychological in nature, a reaction to the impulsive nature of consumers regarding spending. If it’s difficult to sell a home, it’s more likely to be held a long time. Some financial advisors refer to homes as “forced savings vehicle” for this reason. The longer the homeowner makes payments, the more likely equity will build up. This equity can be used to purchase a bigger home, supplement retirement savings, fund an education, or any other large financial goal.
Before you go out and start buying property, let me emphasize that real estate investing isn’t all fun and games. You can lose your shirt before you ever step foot into a new property. A great blog to visit if you want an idea about some factors that may affect your purchase is www.curbed.com. Covering multiple cities, Curbed exposes real estate politics, neighborhood news, and gossip, all through user-friendly blog format. This allows for the user to get that insider feeling which makes blogs comforting and familiar. Let me explain some of the pitfalls in the real estate market since I’ve met so many people who don’t really consider the downsides before plunking down money. Part of this “real estate can’t lose” mentality may have to do with the blazing hot market since the early 90’s. In fact, with a few exceptions, real estate has been hot for decades. At the time I’m writing this book, there is talk about overly speculative purchasers and bursting bubbles in the housing market. What distinguishes an investment in real estate from an investment in the stock market is that you own a real, tangible item. Maybe you didn’t buy a house, but you bought five acres of land, either way you’re now exposed to the potential risks that are associated with owning a real, tangible assets. Some of these risks include:
Maintenance: Whether you live in the house or someone else does, the homeowner is ultimately responsible for maintaining the property. If you’ve ever lived in a house, you’ve probably noticed that home repairs aren’t cheap: a new boiler, paving the roof, replacing the garage door, etc. In theory, some of these improvements could raise the value of the home, but it’s difficult to focus on that while you’re shelling out money. Many homeowners take out lines of credit against the equity in their homes to finance home improvement and major maintenance. While this can be a good decision, always think twice before borrowing from an asset which can depreciate in value.
Tenant Liability: Many properties are purchased for the purpose of renting them out. The logic is that you take out a mortgage, and then rent out the house for an amount covering the mortgage, taxes, maintenance, etc. This way, the logic goes, your home will appreciate in value and other people will be making your payments for you. These things are all possible and do happen. Some people bought buildings in the 80’s and have rented them out since. They now own the buildings (which have appreciated in value) and have secondary income sources as well. Lewis Rudin, one of the great real estate legends of the 20th century once remarked “never sell, keep debt low, and stay liquid.”
The theory here is that you shouldn’t sell an income-producing investment. Eventually, after it’s paid in full, it will still remain an income source. This leads to the “liquidity” factor which makes you rich. I suppose this theory works well after you’ve gotten past the first investment. Many of the pitfalls of real estate investing occur when you’re first getting started. A common problem is dealing with a loony tenant who holds you responsible for every little thing, including those which may not be your responsibility. Once you’re a wealthier investor, you can afford to hire a management company to handle your property. For the time being, you might have to call a contractor to fix the leaky toilet. Remember, the pitfalls of being a landlord only apply if you’re renting out your real estate. If you live in it, you’re only responsible for you and your family.
Taxes: Property taxes are a reality. They often subsidize projects such as public schools and local improvements to a neighborhood. The classic example of a property tax debate is a family which votes in favor of a tax hike while their kids are in the school system and then vote against it after they graduate. Property taxes are much higher in some areas than others. While many people bundle their property taxes into their mortgage payment, therefore not taking notice of the expense, they’re still getting paid. This is why many retirees move down to places like Virginia, or North Carolina where the taxes are lower than places like Los Angeles, and Long Island. While the homeowner should carefully consider property taxes, from an investment standpoint it’s important to note that many expensive places to live (with heavy tax structures) have proved to be excellent investments since the 80’s.
Lack of Liquidity: Yes, I believe this disadvantage is often beneficial to homeowners. However, if you need to free up some cash in a hurry, liquidating a home can be a total mess. I used to know a guy who had minimal savings outside his home. The time came when he needed to free up money to meet some big payments including tuition for his child and alimony for his children. Because he had planned on downsizing anyway, he put the home up for sale rather than taking out a line of credit. A few days before the scheduled closing, the buyer backed out of the deal because of a smaller divorce settlement that would leave him struggling with the payments. Unfortunately, the seller didn’t know that the sale was contingent upon any factors such as a divorce settlement. Similarly, the buyer had no clue that the seller needed $20,000 in 30 days or would start defaulting on some very important payments. The seller was forced to lower the price $20,000 to get a buyer who would close within 30 days. These kinds of stories are not uncommon. When I create net worth statements, the issue of home equity comes up fairly often. It’s interesting to see how people assign astronomical values to their homes when planning their retirements. I tend to use more conservative figures since life has a way of throwing us surprises. Smart owners hold on to their primary homes for a while, giving the property a chance to appreciate and time to pay down the principal. Similar to the example above, making a low-ball offer on a home, with the promise of a quick closing could possibly land you a good deal.
These are some of the things to think about when buying real estate. Keep in mind that there are myriad potential ways to profit off real estate investments. The buy and hold philosophy is fairly conservative but not the only way to play the market. The quick flip tends to be quite profitable when the real estate market is hot. This happened frequently in 2003 and 2004. Buyers would secure homes, often with little or no money down, and simply pay interest for a few months until flipping the home. The hope was to make a few percentage points by taking possession of the property, but not have to make major payments. This strategy proved to be more dangerous in 2006 when home prices weren’t necessarily moving upward. Other real estate investors prefer the fix-up method. This entails buying a property at a discount because it has some sort of problem. Perhaps the floors are cracked, the roof is leaking, and the backyard hasn’t been touched in ten years. It might cost you $20,000 to restore the house, but it could potentially add substantially more than that to the resale price. If you did three or four of these a year, you could make a living at it, as many people do. You’d need access to handymen, good financing, etc, to practice this type of real estate. Some people chase after foreclosures because often homes will be sold at a steep discount when the banks want to get rid of excess inventory.
Having a decent credit score will help, along with buying your home when interest rates are fairly competitive. The length, amount, and type (fixed or variable rate) of your mortgage will factor in as well. We will get down to the nitty gritty on mortgages in the following chapter. On the blog front, I’ve got a few others notable mentions in addition to The Land Lord Blog and Curbed.com. If you’re concerned about issues surrounding overheating in the real estate market, check out Housing Doom. This “bubble blog,” is the creation of Debi Averett and John McLeod. They pull quotes and factoids from a variety of sources which discuss the pending “doom” of the housing market. If you’re in the Phoenix area you’ll get special attention. Housing Painc is another favorite of mine. The blog generates a lot of interesting feedback and has funny visuals as well.
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*Oregon State University Conversion Factor estimates $500-$700 on an inflation-adjusted basis. Actual purchase was 60 guilders of trade goods which converts to approximately $24.00.
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