INTRODUCTION TO REAL ESTATE AS AN INVESTMENTWhy do people invest in real estate? Investment motives areas diverse as the investors who acquire real estate.
Overview1. Characteristics of real estate as an investment.2. Advantages of real estate ownership and the returns investment properties offer.3. Disadvantages of owning real estate.4. Five investment opportunities for first-time investors and the advantages and disadvantages of each. a) Apartment Buildings b) Condominiums c) Single-Family Homes d) Post Offices e) Syndications
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLE• What distinguishes real estate from other investments such as stocks and bonds?Investment Size:1. Securities (stocks and bonds) can usually be purchased with relatively small amounts of cash ($100).2. Real estate investments generally require relatively large amounts of cash, both equity and debt ($100,000+).
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLEHolding Period:1. Securities can usually be purchased and sold relatively quickly.2. Marketing real estate and the legal requirements of transferring real property generally involves substantially greater amounts of time.
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLEComplexity of Transfer Mechanism:1. With securities, an investor can usually open an account with a stockbroker and begin trading very quickly.2. The purchase, sale, and financing of real estate usually: Involves numerous legal documents, financial institutions, government regulations, etc.3. Requires many other parties to effect a real estate purchase, (e.g., appraisers, brokers, insurance salesmen, attorneys, title companies, escrow companies, etc).
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLENo Formal Market Structure For Real Estate:1. Many securities (and commodities) are traded on organized, centralized exchanges, such as the New York Stock Exchange.2. There are numerous large brokerage houses organized to aid in the purchase and sale of such securities.3. Similar institutionalized exchanges and large national brokerage houses do not exist to facilitate the sale or exchange of real estate.4. Real estate purchases and sales are usually handled on an individual basis.
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLEAbsence of Standardized Performance Information:1. With respect to securities investments there are: a. Numerous statistics and averages kept with respect to their performance (P/E ratios, Price to Book, etc.). b. There are hundred of widely circulated, publications (i.e., Wall Street Journal) reporting information relevant to making such investments.2. Information about real estate and the performance of such investments is more difficult to obtain and generally reported on a less standardized and more irregular basis.
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLEUniqueness of Each Parcel of Real Estate:1. Each parcel of real estate is situated in a different location.2. The “uniqueness” in location makes reliance on quantitative data (income and expenses) alone insufficient ‑‑ investors who buy real estate have to physically inspect the property.
CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLEEntrepreneurial Potential:1. Once the purchase of securities (stocks and bonds) is made, the securities investor remains relatively passive.2. The real estate investor need not remain passive and can initiate activities with respect to the investment such as renovation, subdivisions, rezoning, implementation of new management and marketing plans, etc.
REAL ESTATE ADVANTAGES AND RETURNS• What are the advantages of owning commercial real estate?
REAL ESTATE ADVANTAGES AND RETURNS Profit/Return (An investment in income‑producing property can produce the following four returns):1. Cash flow ‑ the cash available from operations after all cash expenditures of every kind have been disbursed (other than income taxes), including payments on the loan encumbering the property.2. Equity build‑up - increases in equity ownership as a result of loan amortization (i.e., principal reduction). a. Equity buildup is not a spendable component of return. b. When the property is sold, the investor owes less on the loan, thus receiving more cash at closing.3. Tax shelter ‑ tax losses which can be applied to shelter income from the property and also from other sources as well.4. Appreciation ‑ refers to an increase in the value of the property over time. a. Some of the increase in the propertys value may be due to inflation. b. Some of the increase may result from changes in the supply and demand forces in the real estate market.
REAL ESTATE ADVANTAGES AND RETURNSLeverage:1. One of the major attractions of real estate is the investors ability to control a large asset with a relatively small amount of equity capital.2. Investments in real estate are generally made with the use of a considerable amount of borrowed funds (OPM) ‑ referred to as “leveraging”.3. If the return on total capital invested (equity and debt) is greater than the cost of the borrowed capital, the ability to leverage the investment gives the investor additional return on his/her invested capital ("equity") that would not otherwise be possible. Otherwise known as positive leverage.
EXAMPLE OF LEVERAGE A B• Purchase all cash • Purchase with 20% (100% down) at down ($40,000) at $200,000 price: $200,000 price:• 10% appreciation = • 10% appreciation = $20,000 return on $20,000 return on $200,000 investment $40,000 investment or 10% yield or 50% yield
REAL ESTATE ADVANTAGES AND RETURNSInflation Hedge:1. Historically, real estate has been a good inflation hedge. During inflationary periods hard assets like commodities, gold, oil, rare art, and real estate tend to appreciate. Moreover, rental rates rise as well because economy is usually booming.2. Also, it has been quite common for commercial real estate leases to include escalation clauses permitting the pass‑through of increased costs and increasing rents as the Consumer Price Index increases.
REAL ESTATE ADVANTAGES AND RETURNSPersonal Control (or Responsiveness to Entrepreneurial Efforts)1. Real estate can be improved and renovated by the owners labor and capital inputs causing and rents and sales prices to go higher.2. Examples ‑‑ purchasing and restoring “fixer‑uppers” or converting existing properties, such as an apartment building, to new uses such as condominiums. (See Next Slide)
REAL ESTATE ADVANTAGES AND RETURNSSelf‑Use and Occupancy:1. Investors can acquire real estate for their own use. Examples: a. A single‑family dwelling is a form of investment that provides physical shelter, a tax shelter, and appreciation in property value. The ownership and occupation of a duplex, triplex, etc. b. An investor‑occupant of a manufacturing plant benefits in a similar way. Medical doctors and dentists often prefer to own facilities designed to meet their particular needs.
REAL ESTATE ADVANTAGES AND RETURNSDiversification (Real Estate as a Portfolio Asset):1. An investors risk of loss can be reduced by diversification into investments with different financial characteristics.2. Real estate should be part of a balanced investment portfolio, which can also consists of stocks, bonds, mutual funds, IRA’s and cash.3. This can help offset the losses incurred because when one asset category is declining, another is often appreciating. (i.e., in the year 2000 the Nasdaq 100 fell nearly 50%, the S&P 500 fell nearly 20%, but real estate investments appreciated on average approximately 25%).
REAL ESTATE ADVANTAGES AND RETURNSIncome Tax Factors:1. Depreciation a. The investor can shelter a substantial portion of he property’s income from income taxes. b. For example, if an investor buys a $500,000 apartment building which consists of 60% building and 40% land he/she can shield $500,000 x 60% ÷ 27.5 years = $10,909 each year from his/her income tax. In other words, if the aforementioned property generated $10,900 in annual cash flow, the investor would pay no income taxes on this money.2. Interest on mortgages and property taxes a. The major out‑of‑pocket costs to carry real estate (whether improved or unimproved) are deductible. b. These costs include: interest, taxes, insurance, and management fees.
REAL ESTATE ADVANTAGES AND RETURNSIncome Tax Factors (continued)3. Expensing maintenance and repairs. a. The owners of investment real estate can deduct all costs for repairs, operations and maintenance to keep the property in sound condition.4. Tenant Improvements (T.I.’s) a. If the tenant spends its own money to fix up or improve your property, those improvements made by the tenant do not constitute income to the owner unless the improvements are intended to reduce the rental rate. b. This allows the owner another means of increasing the property’s value when these tenant improvements revert to the owner upon termination of the lease. The owner may thus realize an increase in net worth at no tax cost.5. Flexibility of title and ownership ‑ title to real estate can be held in a number of different ways (corporations, partnerships, LLC’s), depending upon the intent of the parties and their tax objectives.
REAL ESTATE ADVANTAGES AND RETURNSIncome Tax Factors (continued)6. Tax‑deferred exchanges. a. Section 1031 of the U.S. Tax Code allows real estate investors to exchange equity from one real estate investment to another and defer any capital gains, which would have been recognized in a normal sale. b. A 1031 exchange enables (and often times, encourages) the real estate owner to trade his/her equity in a property for equity in a more expensive (and greater cash-flowing) property at no current tax cost.7. Installment Sale a. When selling a property, the owner/seller may carry a note secured by a deed of trust from the buyer, which is payable over a number of years. This note becomes an annuity for the seller. Capital gain taxes are also deferred until the note’s principal is paid in full.8. Refinancing a. An owner may refinance a property and generate cash tax-free.
DISADVANTAGES OF OWNING REAL ESTATE?• ARE THERE DISADVANTAGES TO OWNING REAL ESTATE?
REAL ESTATE DISADVANTAGES AND RISKSLack of Liquidity:1. Real Estate is generally not considered to be liquid. Liquidity is the ability to convert an investment into cash quickly and with little, if any, loss of principal. a. The product is not standardized or traded on an exchange – time is required for a prospective buyer to inspect and evaluate a property. b. Time is required to expose and advertise the property, negotiate the sale, obtain title search, arrange financing, and close escrow.2. Refinancing ‑ Financing may not always be available. Higher interest rates may make refinancing less feasible.
REAL ESTATE DISADVANTAGES AND RISKSNecessity of Management:1. In general, most income‑producing properties require a significant amount of personal attention compared with other types of investments.2. Whether the property is managed by the owner or through a management company, constant attention must be given to the property to maintain its income and value.3. Many investors find property management an unpalatable aspect of real estate investment.
REAL ESTATE DISADVANTAGES AND RISKSLack of Information:1. The information essential to good investment decisions is usually imprecise, hard to find, and likely to be inaccurate.2. Investment decisions are often made with inadequate data and are many times based on “gut feels”
REAL ESTATE DISADVANTAGES AND RISKSLegal Complexity:1. The contracts between parties (e.g., buyer‑seller, borrower‑lender, etc.) are usually complex (and often require expert opinions from attorneys, consultants and brokers), making it costly to buy and sell properties.2. The tax laws that impact real estate are also complex and change frequently and unpredictably.
So, what are some options for first-time investors lookingto invest in real estate? 1. Multi-Family Investments 2. Condo Investments 3. Single-family homes 4. Post Offices 5. Syndications
MULTI-FAMILY INVESTMENTS(Advantages vs. Disadvantages)
MULTI-FAMILY INVESTMENTSAdvantages:1. Good leverage ‑ generally higher loan‑to‑value loans available (compared to office & retail properties); seller carried financing is possible.2. Tax shelter ‑‑ shorter depreciation period (27.5 years vs. 39 years); usually lower land/building ratio – so more to depreciate.3. Generally good resale market ‑ may vary, depending on location, number of units, etc.4. Less sophistication required in operating the property as compared to commercial properties.5. Broad rental market.6. Greater variety in sizes (2 units to 1,000+ units).7. Responsiveness to entrepreneurial efforts ‑ short-term aggressive management can have a significant effect.8. Rents are generally not controlled by long‑term leases (disadvantage in down market, advantage in up market).
MULTI-FAMILY INVESTMENTSDisadvantages:1. Relatively low annual operating cash flow potential (initially).2. Larger down payments are required in more desirable locations.3. Higher demands for management time.4. No security of long‑term leases.5. No automatic rental increases tied to C.P.I., etc.6. Expenses not passed through to tenants contractually.7. Master metered buildings can be nightmares. Also beware of properties with galvanized plumbing, “brickers”, and flat roofs.8. Greater exposure to government regulations, e.g., rent control, code enforcement, etc.9. Eviction process can be uncomfortable.
CONDO INVESTMENTSAdvantages:• Most affordable of all investment opportunities.• Great leverage ‑ can finance with as little as 0% to 20% down (depending on your credit); seller carried financing is common.• Typically much more liquid than apartment buildings (they sell extremely quickly in a hot market).• Less sophistication required in operating the property.• Renters usually find these more appealing than apartment units (so easier to rent).• Greater variety in sizes (bachelor units to 4 bedroom units)• Rents are generally not subject to rent control.• Easy to manage (homeowner’s association usually handles most or all maintenance issues).
CONDO INVESTMENTSDisadvantages:• Expect little to no cash flow for the first few years of ownership.• Usually appreciation is less than houses.• Monthly HOA fees are not tax deductible and eat into your cash flow.• You are at the mercy of the Home Owner’s Association (HOA) – they can raise monthly fees without your approval or impose improvement assessments.• HOA may not allow tenants (or restrict the number of renters allowed in the building).• No diversification or continuation of cash flow upon vacancy (if tenant leaves, you have no income).• Difficult to sell in “buyers” market.
SINGLE-FAMILY HOME INVESTMENTSAdvantages:• Typically enjoy the greatest appreciation in value.• Often tenants are family and, thus, more stable and remain longer.• Great leverage ‑ can finance with as little as 0% to 20% down (depending on your credit); seller carried financing is common.• Most liquid of all property types depending on price, area, and condition. Generally good resale market ‑ may vary, depending on location, real estate cycle, amenities, etc.• Much more favorable capital gains “avoidance” than commercial properties (up to $500,000 for primary residences).• Relatively easy to manage.• Good variety of styles and sizes (2 bedrooms and up).• Rents are generally not subject to rent control.
SINGLE-FAMILY HOME INVESTMENTSDisadvantages:• Expect negative to little cash flow for the first few years of ownership.• Houses with deferred maintenance can be costly to operate.• Be prepared for the house to endure excessive wear and tear. Thus, it may require significant renovations should you plan to live there one day.
POST OFFICESAdvantages:• Government tenant – one of the safest and most reliable tenants in the country. Rents are paid via direct deposit.• Tenant typically remains in same location.• Leases run 5 years and include all expenses (except roof). Known as a NNN lease.• Prices start as low as $30,000.• Because of quality of tenant and lease, post offices can be purchased almost anywhere in the country (so investors have many from which to choose).• Generally sell for 7 to 8 capitalization rates so returns are good compared to apartment buildings.
POST OFFICESDisadvantages:• The United States Post Office is a bureaucracy. They are often impossible to negotiate with.• Post office will typically not sign a lease longer than 5 years (although they may renew numerous times).• Little to no financing is available because lenders will only lend against future income streams.• If tenant vacates there are few alternatives for the property.• Appreciates less than residential investment property because increases in value come primarily from rises in net income (and not compressions in capitalization rate).• Inexpensive post offices are not exactly “Pride of Ownership” investments.
SYNDICATIONS What is a Syndication?• A syndication is a group of individuals who pool their capital to make an investment.• A real estate syndicate is organized to acquire a property that produces income or a parcel of raw land on which an income property can be developed.• They can be created by a group of first-time investors looking to buy a larger property than the individual members can afford on their own (i.e., investment clubs).• More commonly they are created by professional investors (seeking to earn a profit) who raise capital through first time as well as experienced investors.
ADVANTAGES OF SYNDICATIONS1. Easiest way to invest in commercial property.2. Initial required investments are as little as $10,000.3. Investor receive same benefits as sole investors (i.e., cash flow, depreciation, appreciation, etc.)4. Because money is pooled, syndicator typically buys larger, more quality, less risky investments in prime locations.5. Most sydnicators are professional investors and managers.6. Properties are managed by syndicator so no management is required.7. Syndicators can invest out of state where returns are more auspicious than southern California.
DISADVANTAGES OF SYNDICATIONS1. Investor has little to no say in the operation of the property.2. Cost of syndication: syndicators charge a fee for their services, which can dilute the investor’s overall return.3. Syndicators sometimes manage and sell the properties they syndicate, which can create a conflict of interest.4. Lack of liquidity.5. Potential for abuse: an unscrupulous or desperate syndicator may divert partnership funds to personal use.