Pros and cons of real estate investing
/Real estate investing can be a highly profitable activity for many people. This is especially the case if you are willing to hold onto property for an extended period of time, to take advantage of property appreciation. However, it is also possible to go wrong in this area and lose your investment. The following discussion of the pros and cons of real estate investing clarifies the benefits and risks associated with this important asset class.
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Advantages of Real Estate Investing
There are several good reasons why it makes sense to invest in real estate. Consider the following items:
1. Real Estate Can Be Purchased at Below-Market Prices
It is sometimes possible to acquire real estate at a below-market price – especially when the seller needs to sell quickly, and you have sufficient cash on hand to fill this need. Taking advantage of these anomalies requires a deep knowledge of local market prices, which is easier to obtain when you commit to real estate investing on a full-time basis. Real estate agents are especially good at locating properties that are available at below-market prices.
2. Real Estate Generates Steady Cash Inflows
When a property is currently being rented out, it generates a stream of monthly rent payments. Some properties may have additional payments associated with them, such as for washers and dryers, storage, and parking. Depending on the offsetting cash outflows for mortgage payments, property taxes, maintenance, and so forth, the net cash inflows may be substantial.
3. Real Estate Provides a Depreciation Tax Shield
The depreciation expense that can be claimed on a real estate investment involves no cash outflow, and yet reduces the amount of taxable income – thereby shielding you from a portion of the taxes that would otherwise be due. Currently, the depreciation period for residential real estate is 27½ years, while the depreciation period for commercial buildings is 39 years.
4. Real Estate Appreciates in Value
Depending on the area, real estate tends to appreciate – depending on local demand levels. This can vary substantially within even a short distance, but if you choose property carefully, it can appreciate quite substantially over a long period of time. Also, if you are good at fixing up real estate, doing so may trigger a substantial increase in property value.
5. Real Estate Provides an Inflationary Hedge
Ongoing increases in inflation tend to cut into the earnings generated from most forms of investment. This has historically not been the case for real estate, which tends to appreciate at a rate faster than inflation. Part of the reason for this is that investors see real estate as a hedge against inflation, and so are more likely to bid up its price when inflation is high. Real estate prices may also increase during times of uncertainty, since it is considered to be a safe investment.
6. Real Estate Financing Creates Leverage Benefits
Real estate is usually purchased with the assistance of a substantial mortgage, typically in the range of 70-80% of the purchase price. This means that any returns from the property are magnified by the amount of this debt. For example, if you use a $50,000 down payment to acquire a $300,000 rental property and then earn $25,000 per year from it, you have generated a return of 50% on your $50,000 down payment – because so much debt was used to fund the purchase.
7. Real Estate Defers Taxes
You do not pay income tax on any increases in the value of property until you sell it, which may not take place until years after the initial investment. In addition, it is possible under the current tax laws to roll the gain over into another real estate investment, thereby extending the tax deferral period even further. These mechanisms make it possible to potentially avoid income taxes on the sale of a property for your entire life.
8. Real Estate Income Gradually Increases
If it is possible to increase rental rates at the rate of inflation, then your income gradually increases, since the fixed-rate mortgage being paid off (your primary expense) does not increase at the rate of inflation. This results in a gradually increasing rate of return on the property. This advantage only applies if you avoid variable-rate mortgages.
9. Real Estate Allows for Active Investment Control
Most investors simply buy shares or bonds, for which the related income can go up or down without their having any control over the proceeds. This is not the case with real estate. An active investor can search for the best deals, control costs, judge which applicants will become tenants, and decide when to sell. By participating in every aspect of the investment process, you can impose more control over how much you earn. In short, your own actions determine how much you make.
Disadvantages of Real Estate Investing
Despite the positives just noted, there are a few disadvantages to be aware of before investing in real estate – some of them significant enough to keep you from proceeding. They are noted below.
1. Real Estate Investing is a Long Grind
The returns from real estate investing generally only accrue over an extended period of time, and only if you purchase judiciously and invest enough to properly maintain properties. Also, depending on the types of properties acquired and the nature of your tenants, it may be necessary to spend a substantial amount of time managing the properties. If you plan to manage properties directly, this may mean that you will not be able to take any vacation time for years.
2. Real Estate Income Can Be Variable
You may lose money in some periods. This is especially likely when only a small down payment was made, resulting in larger mortgage payments. Also, in periods when demand is soft, a property may not be rented at all or it will not be possible to raise the rental rate as much as you would like. This is especially the case if you have acquired property in an area with fundamental weaknesses, such as a reliance on one local employer that subsequently closes and lays off its employees.
3. Real Estate Requires Maintenance
There may be times when unexpected maintenance issues arise, such as a failed water heater or a leaky roof. The associated repair or replacement costs may be substantial, and could wipe out your cash reserves. This can come as a particular surprise when the home inspection on a recently acquired property did not spot the issue.
4. Real Estate is Impacted by Rent Control
If you are investing in residential units, there is a possibility that the local government will impose rent controls, which severely limit your ability to raise rents. Though it may be possible to apply to a rent control board for a targeted rent increase, these requests are usually only granted grudgingly.
5. Real Estate Requires Your Time
Investing in real estate requires a significant amount of time. You will need to spend time learning about the neighborhoods in which you want to invest, identifying problems with prospective investment opportunities, and dealing with maintenance issues. It is possible to hire a property manager to deal with tenants, but dealing with the property manager will still require a certain amount of time.
6. Real Estate Transaction Costs are High
The transaction costs associated with buying and selling properties can be quite steep. These costs, which include commissions, title insurance, loan origination fees, and a variety of closing costs, can easily wipe out the appreciation in market value of a property. These costs can only be offset by holding onto properties for an extended period of time, so that they can appreciate to a substantial degree. A large part of these costs is the real estate agent’s commission, which varies by type of property. The commission on a free-standing home is among the highest rates charged by a realtor.
7. Real Estate Income is Subject to Taxation
Ongoing income from real estate, as well as gains from the sale of a property, are all subject to federal and state income taxes – which can be substantial. There are situations where gains from the sale of a property are not immediately taxable, as noted earlier.
8. Real Estate Values Can Decline
It is entirely possible that the market value of real estate will decline sharply over the short term, especially when it was preceded by a bubble in property values that sent prices surging higher than the long-run trend. If you buy property near its peak price with a modest down payment, experience a valuation decline and then sell at the bottom of the market, it is quite possible that the entire amount of your down payment will be lost.
9. Real Estate Rents Can Decline
During economic contractions, it can be difficult to find quality tenants. If the contraction is prolonged, you may be faced with ongoing mortgage, maintenance, and utility payments without any offsetting rental payments. Or, you may be faced with a series of delinquent tenants.
10. Real Estate Leverage Effects Can Be Negative
The leverage effect already noted as an advantage of investing in real estate can also be a disadvantage, magnifying your losses. To return to the earlier example of using a $50,000 down payment to acquire a $300,000 rental property, what if the result is a $25,000 loss in the first year? You will have generated a return of -50% on your $50,000 down payment, wiping out half of the investment. Thus, using debt to buy properties can very much work in your favor – or against it.
11. Real Estate is Not Liquid
It can be difficult to sell off real estate within a short period of time. This can be a problem if you have an immediate need for a significant amount of cash. When you are really pressed for cash, a vulture investor may swoop in and offer cash immediately at a steep discount to the market price of the property. This can result in a significant loss on the sale.
These disadvantages can be mitigated by holding real estate for many years, maintaining a cash reserve to keep you solvent during any negative cash flow situations, and rolling your gains from property sales over into new property investments (in order to avoid taxes). In short, there are disadvantages to real estate investing, but there are ways to keep them from overwhelming you.
Key Real Estate Investing Metrics
The decision to invest in real estate should have a quantitative basis - that is, run the numbers and decide based on what those numbers tell you. Here are several key real estate investing metrics that can assist you in making that decision:
Net cash flow. Project the cash outflows and cash inflows from the investment in each year, and net them together to determine the net amount of cash that will have to be expended, or (better) received back. This analysis should include all projected expenditures (including mortgage payments), as well as all rental payments received (with a reasonable reserve for non-payments by renters).
Net operating income. Summarize all operating expenses incurred to maintain the property (not including mortgage payments) and subtract it from the actual amount of rental income collected to arrive at net operating income.
Rate of return. Divide net operating income by the price you paid for the property to arrive at the percentage rate of return generated by it. It is useful to compare this percentage to other possible investments, to see if your real estate investment has been worthwhile.
Total return. Add together the total cash profit from your sale of the property, plus all net cash flows to date, minus the payout needed to pay off the residual mortgage balance. This is your total return on investment, unadjusted for the time value of money.
Alternatives to Real Estate Investing
What if you don’t have the time to directly invest in real estate? If so, a more passive approach is to buy shares in a real estate investment trust (REIT). An REIT acquires and operates real estate properties that generate income. The shares of many REITs can be bought and sold on stock exchanges, making it easy for investors to acquire shares. Shareholders receive periodic dividends paid out by the REIT in which they have invested, which are essentially the proceeds from indirectly owning property.
Summary
Real estate has historically been one of the best investment options available. As long as you are careful about researching your purchases and are willing to hold properties for an extended period of time, there is a good chance that your investments will pay off handsomely. However, general economic conditions can influence the value of real estate and a great deal of your personal time will be needed to oversee these properties, so you must be willing to grind it out over a long period of time in order to realize the benefits of real estate investing.