Why is Real Estate an Attractive Investment?Is it Right forYou?

As the real estate market shows signs of recovery, it will only be a matter of time before the late night infomercials come on touting easy money from real estate. This, of course, will be followed by a slew of new books all capturing some semblance of “Make Money Now in Real Estate”.

I made my first real estate purchase in the late 80’s, followed by acquisitions in the late 90’s and early 2000’s. We’re now on the other side of the collapse. The investments that looked good at purchase, looked good through the crash and continue to accumulate wealth today. So, what is it about residential investment real estate that captures air time on television and shelf space at Barnes & Noble Booksellers?

Real Estate Investment CharacteristicsBroadly, residential real estate generates wealth two ways. One obvious

characteristic of investment property is the potential to gain value, or appreciate, over time. Investing for appreciation is not a bad assumption. Lots of people have made lots of money; some in relatively short periods of time during accelerated growth. In periods of fast real estate market growth, some investors simply purchase property for the express purpose of reselling, with or without improvements, and capturing the market gain in value. Buying for short term value gain is also known as “flipping”.

For illustration, during the mad dash heydays in Florida; it was not uncommon for builders and developers to extend Purchase and Sale contracts to hungry buyers before homes were built. These buyers, in turn, would sell the contracts within weeks or months at a nice gain, just because the real estate market had turned so “hot”. Appreciation was rapid and investors could easily make money by flipping acquired properties. All of this, of course, was really neat for investors; that is, until the music stopped and the market collapsed.

Nonetheless, though, property appreciation is a key characteristic for residential investment real estate. While there have been sharp downturns periodically (late 80’s and 2008); real estate generally has been a reliable investment producing good appreciation over time. While appreciation is generally the rule, the rate of appreciation is impacted by a range of local and site factors. Even through major price downturns, though, the savvy investor doesn’t necessarily have to get hurt financially, unless he’s forced to sell.

The second key investment characteristic of real estate is a property’s ability to generate cash flow through effective property management that ultimately yields productive rents and utilizes attractive tax benefits for the investor. Like some financial assets, such as stocks and bonds, the investor’s property can generate dividend-like cash flows over and above debt service (mortgage payments) and operating costs. Although there might be some similarity to a dividend paying stock with regard to cash flow; real estate investment provides the additional advantage of leveraged equity gains through the

simple amortization of mortgage. Whether a property’s value is increasing; or not, mortgage debt is eventually fully paid, releasing new cash into the investor’s flows.

Beyond the simple math resulting from rental income exceeding mortgage payments and operating costs; real estate investment offers a unique leverage opportunity. Using “other people’s money”; otherwise known as the mortgage, the investor initially controls a significantly larger income producing asset compared to a modest down payment. When cash flow internal rate of return is calculated by the amount of equity the investor actually has in the property, the resulting financial return is much greater than if the investor had no mortgage. The following illustration highlights the financial power of real estate and the effect of leverage on the investor’s equity:

For comparison, let’s say an investor has $58,000 to apply to either the purchase of stocks or a down payment on a $240,000 residential duplex. In the first scenario, the investor buys 4,000 shares of ABC company stock at $14.50 per share. Over 5 years, let’s say the investor received a 3% dividend and the price of the stock increased 5% every year. At the end of Year 5, the stock is sold at its appreciated value. The following chart shows the net cash flow from this investment option:

Stock Purchase Cash Flow Table

Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5

Value/Share Increases 5%/year   $14.50  $15.23  $15.99  $16.79  $17.62 Total Value 4000 shares ($58,000) $58,000  $60,900  $63,945  $67,142  $70,499 3% Dividend/Year   $1,740 $1,827 $1,918 $2,014 $2,115Residual Value Yr 5           $70,499Cash Flow ($58,000) $1,740 $1,827 $1,918 $2,014 $72,614

Internal Rate of Return (IRR) 7.0%

As shown, with an initial $58,000 investment, including the annual dividends and stock appreciation, the resulting Internal Rate of Return is just over 7%.

With the $58,000 stock investment as benchmark, take a look at the return associated with purchase of a residential duplex priced at $240,000. In this example, let’s assume the investor puts 20% down ($48,000) on a mortgage with associated closing costs of $10,000. Instead of appreciating 5%/year, as we just reviewed from the previous stock illustration, the investment property appreciates a more modest 2%/year. The following chart summarizes the cash flow from the property, assuming the property is sold at the end of year 5 with a 5% commission cost:

Investment Property Income Statement  Year 1 Year 2 Year 3 Year 4 Year 5Gross Rent $34,800  $35,160  $35,520  $35,880  $36,240 Turnover Vacancy ($1,450) ($1,465) ($1,480) ($1,495) ($1,510)Net Rents $33,350  $33,695  $34,040  $34,385  $34,730           Maintenance & Repairs ($2,400) ($2,450) ($2,500) ($2,550) ($2,600)Insurance ($850) ($867) ($884) ($902) ($920)Mortgage Interest ($8,577) ($8,434) ($8,285) ($8,130) ($7,967)Property Taxes ($5,800) ($5,974) ($6,153) ($6,337) ($6,527)Depreciation ($6,981) ($6,981) ($6,981) ($6,981) ($6,981)Pretax Income $8,742  $8,989  $9,237  $9,485  $9,735 Taxes $2,448  $2,517  $2,586  $2,656  $2,726 

After Tax Income $6,294  $6,472  $6,651  $6,829  $7,009 

Cash Flow TableAfter Tax Income   $6,294  $6,472  $6,651  $6,829  $7,009 Depreciation Add Back   $6,981  $6,981  $6,981  $6,981  $6,981 Minus Principle   ($3,099) ($3,242) ($3,391) ($3,546) ($3,709)

Initial Investment ($58,000)          Residual Value Year 5           $69,462 Net Cash Flow ($58,000) $10,176  $10,211  $10,211  $10,241  $79,743 Internal Rate of Return 20.3%

In the previous Cash Flow Table, notice that we pull the After Tax Income from the property and then add back depreciation. While depreciation is treated as a taxable expense in the income statement; the investor really does not write a check payable to anyone for “Depreciation”. Hence, depreciation is added back to the After Tax Income number. Lastly, the principle portion of the accumulated monthly payments is an actual cash outflow for the mortgage payment, leaving the net cash flow until the fifth year when the property is sold, commissions paid and mortgage balance liquidated.

In summary, we have compared the same initial investment of $58,000. In the first illustration, we bought a 3% dividend paying stock that appreciated 5%/year. Similarly, we compared the same investment in a multifamily duplex and made more conservative appreciation estimates (2%/year). While we have invested the same amount of money ($58,000) the real estate illustration exhibits almost triple the internal rate of return compared to the stock illustration.

Slight of hand? Perhaps “money magic” portrayed by the real estate infomercials? What is illustrated is the power of financial leverage whereby you use “other people’s money” to control a $240,000 piece of real estate by investing only $58,000. When the cash Internal Rate of Return is calculated on the owner’s invested funds, the result shows the clear financial advantage potential associated with investment real estate.

Is Real Estate Investing Right For You?While we have just illustrated how the power of financial leverage, using “other

people’s money” can result in significantly higher returns than other investment instruments, there are multiple considerations to determine whether investment real estate is right for you. First, when looking at any class of investments, the fundamental rule is that greater risk should be compensated with greater reward. Compared to conservative stock investments, such as we illustrated, owning property carries more risk.

Compared to stock, for example, real estate is not a liquid investment. The investor who achieves their targeted returns must have the financial strength to weather unexpected costs or disruptions in their financial world. A septic system can fail and require replacement or a primary job loss can put significant strain on an owner that is managing investment real estate. Among the first considerations for a potential real estate investor is sustainability. Is the investor prepared to manage unexpected income disruptions without having to liquidate at a fire-sale price or, worse still, face foreclosure?

Assuming necessary resources to ensure sustainability, the next question centers on whether the investor has the interest, time and necessary skill portfolio to personally manage property. Many begin investing in real estate while employed full time elsewhere. Quickly, the new owner will find managing the real estate investment takes a broad eclectic of skills and a team of players necessary to consistently maintain low vacancy rates and satisfied end customer/tenants. These skills and capabilities will include tenant selection, maintenance management, conflict resolution, legal counsel, accounting and business management; just to name a few.

In some cases, an investor will find they excel and enjoy the maintenance aspects of property management; but may find it difficult selecting strong tenants or resolving issues that may arise between neighbors. Alternately, the demands of a full time job and family may limit the realistic ability to successfully manage investment property.

While the investor may want to benefit from the financial advantage of real estate, time constraints and/or undesirable aspects of management may point the owner to professional property management; or possibly avoid property acquisition. If the investor decides to hold property, a professional property manager can apply their expertise and time to all the elements necessary for a property to perform financially.

Alternately, the would-be investor should consult with their financial advisor on opportunities to participate in Real Estate Investment Trusts (REIT’s). Similar to a stock fund, REIT’s reflect a type of real estate investing where the owner does not hold actual property; but shares in a fund that has its underlying assets in real estate properties. While REIT’s may not allow the investor to benefit from direct financial leverage, financial return will result from the underlying performance of the fund’s real estate assets.

Finally, real estate investing is an effective vehicle for building wealth and independence. While the financial potential of investment real estate is magnified by the owner’s ability to control a comparatively large asset with a much smaller cash outlay, investment property must be bought at the right price and managed effectively to generate projected returns. To best determine whether real estate may belong in your portfolio, read the literature readily available and compare notes with investors already in the business as well as talk with your financial advisor and local realtor/property manager team. The numbers can work…and work best with “eyes wide open” to the opportunity, the risk, and what is necessary to delivery performance.

Tim WegeReal Estate InvestorPrinciple Broker – New Star Properties L.L.C.