Why Invest in Residential Real Estate?
As an investor, you have the choice of a variety of investments, including real estate. Residential real estate offers advantages unavailable with most other investments, including:
- Leverage of your investment
- Rental income generates cash flow
- Little or no savings to get started
- Tax advantages
Unlike most other investments, an investor can purchase a rental property with a down payment of twenty percent of the purchase price, or in some circumstances even less. Therefore, a relatively modest investment permits the investor to control a valuable rental property. Further, as the value of the investment increases, the investor’s return on his investment increases at a multiple of the increase in the values of the property.
For example, assume that an investor purchases a rental home for $100,000 with a down payment of 20% or $20,000. Five years later, the investor sells the property for $110,000, for a net increase of $10,000. Over the five-year period, the value of the property has increased a modest 10%. However, the investor’s return on his initial investment of $20,000 is 50%; all because the investor was able to leverage the initial investment.
The above example ignores a variety of costs associated with the purchase and ownership of rental property. But, with today’s low interest rates, it is quite realistic to presume that rental income can cover mortgage payments, insurance, taxes and necessary repairs.
While the preceding section addresses leverage, rental property also creates cash flow. Cash flow can be defined as the excess of rental income over expenses. Cash flow from a rental property will be maximized when the property is not leveraged and minimized when the property is highly leveraged.
To go back to the example above, presume that the investor has purchased a rental property for $100,000. The property generates $750 per month in rental income. Taxes, insurance, estimated repairs and maintenance, and estimated vacancy reserve cost $200 per month. Therefore, the property generates a positive cash flow of $550, before payment of principal and interest on the mortgage. The net cash flow generated by the property is dependent of the principal and interest payment; or in other words, how highly the property is leveraged.
If the investor has an $80,000 thirty-year mortgage at 7.00 %, the monthly principal and interest payment is $532 with a net positive cash flow of $18 per month. If the investor has a $60,000 mortgage with the same terms, the monthly payment is $399 and the rental generates a positive cash flow of $151 per month.
No matter what the cash flow generated by the property the first years, it can safely be presumed that the cash flow will increase over time because the principal and interest payment is fixed and rents have historically increased over time. Further, should the investor hold the property until the final mortgage payment is made, the cash flow generated by the investment will greatly increase because the principal and interest payment is by far the largest portion of the expense associated with ownership of the property.
The conventional method of purchasing rental property is to make a down payment of at least 10% of the purchase price and finance the balance with a twenty to thirty year mortgage. There are, however, a variety of other ways to purchase rental property including real estate contracts, seller carry-backs, lease purchases, and lease options. A full discussion of these methods of purchasing rental property is outside the scope of this discussion; however, it can be safely said that it is realistically possible to purchase quality rental property with little of no money down.
All income generated by rental income is taxable and must be reported to the Internal Revenue Service. However, all expenses associated with the property, including depreciation, are deductible. The IRS presumes that the property, excluding the value of the land, has a useful life of 27.5 years and allows the investor to deduct this presumed decrease in value as an expense on the investor’s tax return. Because depreciation is a non-cash expense, it is very possible for a rental property to generate a positive cash flow and a taxable loss at the same time.
Going back to the prior examples, presume that an investor has purchased a rental property for $100,000. The value of the land on which the rental sits is $10,000. Total income generated by the property is $9,000 per year ($750 per month x 12 months). Actual expenses excluding mortgage interest was $2000. Mortgage interest was $6,000.
Depreciation was $3,272 ($90,000 divided by 27.5). The investor’s income statement for the year is:
While the investor’s income statement shows a net loss, the investor actually had a positive cash flow of $1,000 for the year. In addition, the net loss has the effect of decreasing total income taxes due. The investor should, however, consult with a tax professional with regard the tax consequences of any investment.
Rental property has historically increased in value, with values doubling every ten years in many markets. Coupling steadily increasing property values with the cash flow generated from steadily increasing rents provides the investor with an excellent opportunity reap meaningful returns with less risk than other commonly available investments.