Investing in Real Estate

Some Real Estate investors claim that the word Real is derived from royal (royal supposedly means real in Spanish). In medieval Europe, only the King could own the land, and the peasants paid rent or property taxes to use the Royal's land. So, the term Real Estate means King's land. Whether it's true or not, today, just like in medieval Europe, we pay property taxes to the government - The King, which makes the privilege of owning Real Estate an expense. And we are not really owning the land, we merely rent it from the government or state.

The term Real Estate refers to a piece of land and everything permanently affixed to this land, such as buildings. All buildings deteriorate with time losing in value if not constantly maintained. Some houses are build to last for many years, but since building technology progresses, old houses turn out to be energy inefficient, or built with unhealthy materials (asbestos, lead paint, etc.), and must be either torn down or renovated. What appears to be a very good long-term investment, may turn out not to be so some 20-30 years later. But even if the building is worth nothing, the inflation-adjusted price of the land will most probably be worth at least the same. Because most of the highly populated areas tend to expand, when someone buys a property in suburbs and keeps it for several decades, the property may end up being in highly developed area, where Real Estate prices are considerably higher. It's worth to mention, that the capital gain tax will reduce that gain. If the price appreciation was only the effect of inflation, then the investor would lose money on such investment. Thus, investing in land or Real Estate in expanding areas is only a speculation.

Types of Real Estate properties

In general, there are two types of Real Estate properties: commercial and residential. Although this article is about calculating profitability of investing in residential properties only, the same principles apply to commercial Real Estate.

There are two types of residential Real Estate properties:

• luxury: vacation homes and residences with special features like: boat deck, private beach, swimming pool, upscale neighborhood, etc.
• regular: homes and condos providing only simple utility value like shelter.

Practically, it's not so easy to categorize, as the price of even those shelter-type properties depend on such things as: location, proximity to workplace, school and shopping mall, crime rate in the neighborhood, local tax rates, local laws, availability of rental properties in the area, etc.

Real Estate as an investment

An investment is an asset producing cash-flow. The reasons of buying assets are (in order of importance):

1. safety of principal: store of value for one's wealth and protection against inflation
2. cash-flow: regular passive investment income
3. capital gain: potential capital appreciation

In general, there are two types of investing, and investing in Real Estate is no exception:

1. Investing for capital gains (speculating): Investing with expectation of rising house and/or land prices, for example due to a rising demand for housing. This type of investing is for only those people who can afford paying property taxes and maintenance costs for long periods of time without any cash-flow from investment.
2. Investing for cash-flow: Investing for a current month-to-month cash-flow or cash savings.

The definition of cash-flow is a bit different for two main groups of Real Estate owners:

• Homeowner-occupier: the cashflow equals cash savings (rent of equivalent property less ownership expenses)

  For a homeowner Real Estate is a liability, a necessary expense, as the owner receives no income from it. A home is a cash outflow in terms of property tax and maintenance (insurance, repairs, lawn care, pest control, etc.). A Real Estate property may be considered an asset only when it is used and benefits the owner. The benefit must outweigh the cost. Homeowners calculate their return on investment according to the rule "a penny saved is a penny earned". The only benefit they receive from their investment is cash savings. This benefit can be defined as the difference between the cost of owning a Real Estate property and the cost one would otherwise pay for renting an equivalent property. When bought at the right price and in the right place, owning a house may be the best way to protect one's wealth against inflation, and with leverage it allows to have a return on investment even above 15% a year.

• Real Estate investor: the cashflow from renting the property (rent income less property maintenance costs)

  Investing in rental property requires cash-flow with additional margin of safety, because of higher property taxes (no homestead exemption), higher risk of damage and wear by tenants, etc. Investors unlike owners-occupiers may defer income taxes depreciating the value of the house, and increasing the cash-flow. However, upon the sale of the property all these tax savings will be paid back in capital gain tax (unless legally avoided, off course). Most of Real Estate investors require more than 10% return on investment measured by cash-flow only and with a total disregard to the appreciation in the price of the property.

Real Estate investing myths

• Myth #1: God creates new people, but fails to create new land.

  Population in U.S. grows approximately at a rate of 5% a year. And lets not forget, that all those newly created people won't be able to buy houses until some 20-30 years later. According to the demand for houses, homebuilders develop new land and build new houses to accommodate all those new people and to replace damaged houses. There is still plenty of undeveloped land. Think about the Mojave Desert in Nevada, Colorado Plateau, or in global terms - the Sahara.

  The house prices are set by market forces of supply and demand. When the supply matches the demand, the prices of new houses usually stay at 30-50% above the building costs. That 30-50% represents the gross profit margin of building companies.

  Sometimes the demand for housing is rising (usually locally), but not because there's less land. Demand is usually rising only in some areas while declining in other areas because people move. Sometimes, like in recent years, demand and prices rise everywhere because everybody is buying, and everybody is buying because the prices rise. It's a feedback loop. Such situation doesn't make any economic sense. It may seem that the cause is the rising number of households, or any other demographic trend, but it's not.

  Practical tip: In order to spot a developing bubble in price of any commodity or commodity type product, just compare the price of such commodity with the production cost. If the price is twice the cost or more, and the recent price appreciation rate is significantly higher than the inflation rate, then it is a bubble. Be very sceptical and cauciuos when someone recommends buying it as an investment.

• Myth #2: Historically house prices were always rising.

  The home values tend to go up over time, but the question is: By how much?

  According to Robert Shiller (the author of Irrational Exuberance), the home prices, when adjusted for inflation, have produced very modest returns of less than 1% per year. Thus the only way to get rich from Real Estate is renting out the property or buying it for oneself to save on renting costs.

  Both myths are clearly not supported by data. The chart below shows a national average inflation-adjusted single-family house price in comparison to inflation-adjusted building costs and the U.S. population:

  
  Inflation-adjusted single-family home prices since 1890 (chart and data from www.IrrationalExuberance.com).
  
  

  There is clearly no correlation between rising population in U.S. and house prices (Myth #1). When accounting for inflation, investing in housing almost doesn't produce any return (Myth #2). However, Real Estate might be the best place to protect one's wealth against the inflation if bought at the right price. Before 1997 people who sold a house after owning it for many years had to pay capital gain tax on gains in price, that were just the effect of inflation. Only people older than 55 years could deduct $100K from those capital gains on sale of their primary residence. Such situation was clearly unjust. Since 1997 people who live at least 2 years in their house can deduct as much as $250K from capital gains on the sale of their primary residence ($500K deduction for couples). What is more, there is no minimum age required now. This change in the tax code, together with the lax lending standards (banks passing the risk onto investors), and low interest rates were reasons for creating the latest bubble in house prices.

  As of 2009, many houses are still owned by the people who can't afford to own them, and by amateur seasonal flippers who were buying houses with the assumption, that the house prices were historically always rising and always will. During the housing bubble the amount of new houses grew about twice the population growth. This oversupply of houses on the market will be gradually absorbed by the population growth in the following years. However, it will take many years. The downward pressure on house prices may be only partially offset by inflation. This may even produce a new myth, that the Real Estate prices are always falling.

• Myth #3: Buying is always better than renting. Why build equity for someone else, when you can build equity for your own?

  The rest of this article will help determine whose equity is being built.

Buying vs. Renting (Homeowner-occupier)

All people have to live somewhere. Some enjoy living in a camper, some live in motels, but for the most people the only choice is either to rent or to own a house. There are two ways to become a homeowner: buying or building. The building costs for an individual are usually much higher in comparison to the costs incurred by a homebuilding company. On top of that is the hassle of acquiring permits, hiring contractors, etc. - something that corporations perfected over the years. But it's always an option, and checking the building costs before buying is a good way to avoid being caught in a housing price bubble.

In normal circumstances most people have to choose between buying and renting a house. Buying a house makes sense when:

• house prices are low enough, that hiring contractors to build a house is too costly
• the benefit of owning a house is higher than the cost
• rent prices considerably higher than ownership expense
• a buyer expects to stay in the same place for at least several years - to recoup the closing cost

From an economic point of view, a single person needs only a house (or a condo) with 1 bedroom and 1 bathroom. Married couples need 2 bedrooms and 1 bathroom. Families of three, four or more need more bedrooms and bathrooms accordingly. The bigger the family, the bigger their need for space. To a person with low need for space, owning any additional space doesn't bring any benefit. Thus, when calculating the benefit of owning a house one needs to compare the ownership cost with the cost of renting not an equivalent size, but the size sufficient for his needs. For example, a single person buying a 2-bedroom house should compare the owner's costs to the cost of renting 1-bedroom condominium.

Calculating the benefit of owning vs. renting

Renting involves one obvious, recurring cost that can never be recouped: the monthly rent check. Buying, on the other hand, involves multiple expenses, some of which aren’t so obvious. On top of closing costs, there are repairs, property taxes, mortgage principal and mortgage interest. The mortgage-interest tax deduction reduces the interest expense, but doesn’t eliminate it. Homeowners also lose the ability to invest the downpayment elsewhere, like bonds or the stock market (opportunity cost). At first, it may seem very difficult to decide what should and what shouldn't be included in the comparison of owning and renting costs. For example, mortgage principal payments should be treated as an investment, not the cost.

In essence, one needs to find the answers the following three questions:

1. Does owning a house make sense?
2. Can I afford to buy a house?
3. If I decide to buy, will my return on investment be higher than I currently earn?

Thus, comparing cost of renting vs. buying may be done in three phases:

• Phase 1: compare only the costs that go away forever and calculate owner's savings.
• Phase 2: compare owner's savings with mortgage interest payments to decide whether taking mortgage makes sense.
• Phase 3: compare return on investment (ROI) with a rate of return from alternative investment vehicle.

Phase 1: owner's savings

1. Find the average market price of a house that may interest you (add about 6% to include closing costs, etc.)
2. Find the annual cost of renting: Total rental cost = 12 * monthly rent
3. Calculate annual ownership cost:
• property tax (usually 1% of the house price; see the table by state from TaxFoundation.org)
• + insurance
• + repairs and maintenance costs
• + homeowner's association fee
• = ownership cost
4. Calculate annual owner's savings: Total rental cost - ownership cost = owner's savings.

If this number is positive, then it may be better to own. If the number is negative, then it's definitely better to rent. Thus, owning is not always better than renting.

In many parts of the United States, it is significantly cheaper to rent a property than to purchase the same property. In 2007 the national median owner cost is $927 per month, more than the median renter cost of $755 per month. Those living in relatively new buildings (4 years old or less) have a median cost of $1,399 per month (source: census.gov, p.82, Table 2-13. Selected Housing Costs-Occupied Units)

Phase 2: mortgage interest cost

Most people don't have enough money to buy a house in one cash transaction. In order to determine whether using financial leverage (mortgage) makes any sense, one needs to compare the owner's savings with the debt expense. Calculating debt expense (interest payments) is not so easy.

The interest expense depends on the mortgage rate and the amount of mortgage. The 20% down payment requirement makes the calculations a bit more complicated. In other words, a Loan-to-Value ratio (LTV) cannot exceed 80%. However, it is still possible to put less than 20% down with Private Mortgage Insurance (PMI) or a piggy-back loan (usually as a home equity loan).

There are two types of PMI:

• Borrower-Paid Mortgage Insurance (BPMI): insurance premium paid by a homebuyer. Premium amount depends on the amount of mortgage, LTV ratio, etc. Usually between 0.3% and 1% of the outstanding mortgage amount.
• Lender-Paid Mortgage Insurance (LPMI): insurance premium included in the higher rate - this may be a bit confusing, as it looks like ordinary fixed-rate mortgage, the only difference is a higher rate and 5% or 10% downpayment.

Typical piggy-back mortgage is 80/10/10 or 80/15/5. It's a combination of an 80% loan-to-value primary mortgage, a 10% or 15% home equity loan (secondary mortgage) with 10% or 5% down payment. Since 2007 the PMI premium is tax deductible. The mortgage interest payments are also tax deductible. However, if the amount of interest paid is less than the standard deduction, then the homeowner will not get any tax savings from it.

A good article about pros and cons of such loans and the calculator are available from Mortgage Professor's Web Site.

In most cases the additional expense of PMI insurance or interest payments on secondary mortgage is reducing the ROI and makes owning the house more expensive. Despite that many people buy houses for less than 20% down, believing that they are "building their own equity" this way. Because the highest return on investment (ROI) can be achieved at 20% down payment (80% LTV ratio) and to simplify further calculations lets assume a 20% downpayment. Because the initial payments will be almost identical in case of fixed-rate or interest-only mortgage, to simplify calculations lets assume the interest-only type.

The mortgage interest and the PMI premiums (since 2007) are tax deductible. However, if this expense is smaller than the standard deduction, then the homeowner won't get any tax savings.

1. Find the mortgage interest rate for a type of loan than interests you (on the bank's website or BankRate.com)
2. Calculate approximate initial annual interest expense: annual interest expense = 80% * house price * interest rate
3. Calculate interest tax savings: tax savings = marginal income tax rate * annual interest expense
4. Calculate owner's return: owner's return = annual owner's savings - annual interest expense + interest tax saving

If the owner's return is positive, it makes sense to take mortgage to buy a house. However, it still doesn't mean that buying a house is a good idea. One must check the Return on Investment (ROI) before making the final decision.

Phase 3: Return On Investment (ROI)

The amount of owner's return must make up for the lost interest income on the downpayment money. Even if the cost of renting is higher than the cost of owning, and even if the savings on rent are enough to cover mortgage interest expense, then buying a house makes sense only if what's left is more than what the homebuyer would otherwise earn investing his downpayment money elsewhere. For most people, a house must produce equal or even higher benefit than the after-tax income from CDs, bonds, or stocks. Thus, for most people the required rate of return is between 5% and 10%. In general, for most homebuyers the required rate of return is higher than mortgage interest rates. It can be achieved only when the owner's saving rate is higher than the interest rate. That's why knowing the owner's saving rate helps in shopping for mortgage:

owner's saving rate = owner's savings / house price

When owner's saving rate is higher than the interest rate, then the mortgage works in the homeowner's advantage.

In general, ROI tells us what fraction of initial investment we can expect to receive after a year of owning the investment. It's especially usuful in comparing different investment vehicles. ROI can be compared to interest yield from bonds or CDs, or dividend yield from stocks. Because every investor's tax situation is different, it is always expressed as a pre-tax return. Remember, that different investment vehicles have a different tax treatment. What may fit your situation, may not be good for someone else. The Return on Investment (ROI) can be calculated as:

Return on Investment (ROI) = owner's return / downpayment

Downpayment must include closing, appraisal costs and the cost of any initial repairs. When the mortgage works in the homeowner's advantage, as shown on the chart above, the amount of extra money flowing to the investor's pocket is equal to: (owner's saving rate - interest rate) * mortgage amount. The conclusion is: the bigger the difference between these rates and the higher the amount of mortgage, the higher the ROI.

Paying off the principal is similar to investing in an investment vehicle with an after-tax rate of return equal to ROI. Although paying off the principal reduces interest payments, it also reduces the ROI. When the 100% of the principal is paid off, the ROI is equal to the owner's saving rate. For example: assuming 7% owner's saving rate, 5% mortgage interest rate, and 20% downpayment, the homeowner earns 15% Return on Investment. At 40% downpayment the ROI shrinks down to 10%. At 100% downpayment the ROI goes down to 7%. All this is tax-free, so investing any additional money in one's house by paying off the principal is a better choice than investing in any other investment vehicle at a comparable rate. But it's even better to keep the ROI as high as possible for as long as possible.

This type of calculations is useful not only in making "rent or buy?" decision. It's also useful for existing homeowners in making decisions: "own or sell?" or whether to invest in bonds or pay off the principal with any additional savings. The homeowners can't easily go in and out of homeownership. It's not as easy as trading stocks. The listing fees and closing fees add about 10%-14% round-trip "commission fee". And that equals to thousands of hard earned dollars. That's why it is very important to buy only when the price is right and own the house for as long as possible. Real Estate is a long-term investment.

The HomebuyerCalculator.xls contains all the calculations described above. There are many good online calculators, for example this one: CalculatorPLUS.com.

Real Estate investing tactics for a homeowner

In order to keep the ROI as high as possible and preferably above 10-15% level, the homeowner needs to keep the loan-to-value ratio between 60% and 80% (20%-40% home equity). There are two ways to do it:

1. Every several years once the LTV ratio falls below 60%, move in to a larger house. The price of the larger house should be at least 30% higher. This makes sense only if the homeowner really needs the additional space. Most families grow over the years anyway, and so does their need for space. But once the children leave the house, parents have to downsize - cash their Real Estate investment and use it to finance their retirement. If your family doesn't need any additional space, then you have to use the second tactic.
2. Every several years once the LTV ratio falls below 60%, refinance or get a home equity loan or home equity line of credit (HELOC). Use this cash for a downpayment to buy another house or condo, then rent it out. After another several years, repeat the process increasing the number of properties in your portfolio. Once you reach your target retirement age, sell your primary residence and move in to one of your rental properties. Every 2 years repeat the process of selling the primary residence. This way you'll save a lot on capital gain taxes.

Buying or selling a home is the largest financial transaction most Americans will ever undertake. The median priced home cost $222,273 in 2007, and the median commission paid to real estate brokers came to $11,558 (source: U.S. Departament of Justice). Many sellers who choose to sell via For Sale By Owner (FSBO), do so to avoid paying a commission to a broker, typically 6% of the selling price of the property. In many parts of the US commissions can range between 5% and 7%. More and more owners selling their own property are using online marketing companies to advertise their properties. FSBO web sites are now a real part of the real estate market, as the Internet becomes vital in the home-selling process.

Tip: you may want to look for properties that are sitting vacant because it is costing the seller money to maintain an empty house, and chanses are the seller is desperate to deal. Therefore, use this to your advantage.

Investing in Real Estate (Investor)

For an investor buying a house makes sense only when the house price is low enough and rent prices high enough, so the difference between these two produce cash-flow with ample safety margin. Investors require at least 10% return on investment (ROI), and usually even more than 15%. When the Real Estate prices are too high and the ROI too low, then the better choice is to invest in bonds. Even if the financial situation of the homeowner and the investor is similar, the homeowner can pay much more for the same house, than the investor. It's because of different tax treatment and often a lower required rate of return.

Investors face the risk of:

• suing tenant – if the property is owned through a partnership or directly by the investor, then the investor risks losing all his assets.
• tenant refusing to pay and refusing to leave the property.
• tenant damaging the property, so that the cost of repairs exceeds investor's financial ability to pay it.

In order to minimize those risks the investor must screen tenants very thoroughly and even then requires a safety-margin. If the return on investment was lower than a comparable return from risk-free Treasury bonds, then owning the rental property would not be worth the risk. In such case it's better to invest in bonds, and do nothing except for collecting the interest.

Investors have to make several assumptions:

• about two months a year vacancy rate
• put aside some amount of money for regular maintenance: lawn care, carpet cleaning, etc.
• put aside some amount of money for repair costs: broken air conditioner, new roof, repairs due to damage made by previous tenant, etc.

Investors may take advantage of:

• ability to depreciate the property value for tax purposes
• most maintenance costs and repair expenses are tax deductible

Unlike the homeowner, the investor can't use homestead exemption and thus pays higher property tax. On the other hand, unlike the investor, the homeowner can't depreciate the property value. However, the tax savings from depreciation are not included in the cash-flow calculations, because it will be paid in capital gain tax when the house is sold in the future. But it will give the investor more money to invest now, while the future capital gain tax rates are unknown. It's even possible, that they will never be paid due to changes in the tax code.

Investors use a similar three-phase calculations:

• Phase 1: calculate rent income
• Phase 2: calculate mortgage interest payments
• Phase 3: calculate ROI

Phase 1: rent income

1. Annual rent revenue = 10 * monthly check (assuming vacancy of 2 months a year)
2. Calculate property expenses:
• property tax (about 2% of the house price)
• + insurance
• + repairs and maintenance costs
• + homeowner's association fee
• = property expenses
3. Calculate rent income: rent revenue - property expenses = rent income.

Phase 2: mortgage interest expense

As we already know, the highest ROI can be achieved at the 20% downpayment (or 80% LTV ratio) and it goes down with paying off the principal. Thus the investor should compare the rent income with the interest expense calculated for a mortgage amount equal to 80% of the total house price. In order to keep the ROI as high as possible investors often prefer to never pay off the principal, so they look for interest-only mortgages. The rent income should cover the interest expense and there should be enough cash left to produce the ROI higher than the required rate of return.

Phase 3: cash-flow and ROI

• Cash-flow = rent income - interest payments
• ROI = cash-flow / downpayment [%]

Example: REInvestorCalculator.xls.

Amazingly many Real Estate investors properly timed the market during the recent housing bubble. They were buying properties for rent when prices bottomed between 1990 and 1995. Then many of them sold those properties between 2004-2006 just before the burst of the housing bubble. Yet, the only economic indicator they've been watching was their own monthly cash-flow. In nineties they were buying, when the cash-flow produced ROI above 10-15% range, and in many cases it was even more than 30%. They stopped buying and started to sell, when house prices appreciated to such level that the property taxes reduced their cash-flow and the ROI fell below 10%.

According to the data from census.gov since 1965 the percentage of owner-occupied and renter-occupied houses has been about 64% and 36% of total occupied houses accordingly. In 1995 this ratio started to change. During the recent housing boom this ratios shifted to almost 70/30 in 2004, and then reverted – two years before the top in the home price index (source: census.gov). The 2004 was clearly the time when even homeowners-occupiers also started selling because the ownership expense exceeded rent costs. Most probably the only people buying houses were speculators and some naive homeowners and investors who didn't know how to calculate the ROI.

Outlook for investing in Real Estate

Many economists tend to draw the "support" line on the house price chart and tell their projections based on "return to the mean" or some other similar statistical term. They seem to forget about overshooting tendency during market busts. What is more, the house prices will almost certainly overshoot in the downward direction. The reason for that is the oversupply of new homes build during the housing boom. For several years the growth rate in the number of houses in U.S. was about twice as the growth of population. It will take several years for new homeowners to buy that backlog of houses off the market. What is more, some homebuilding companies are still building new homes, because their building costs are still well below the current prices. This creates a very particular situation, because in many areas prices of new homes are lower than prices of old homes. Lets keep in mind, that the current recession and very probable inflation during recovery period will diminish people savings. This together with more strict lending standards or higher downpayment requirements, will only slow any rebound in prices.

The price stickiness is also slowing the price fall, as still there are some speculators and homeowners who keep their houses as an investment are still expecting prices to recover. Inflation is also slowing down the fall.

It's hard to call the bottom, but as of February 2009, we're not there yet. It doesn't matter anyway. Predicting a market bottom is futile. The only way to profit in any market is by using a logical fundamental analysis. Buy when the price is right. Buy, when the cost of ownership goes below the cost of rent.

The author of this article doesn't own any Real Estate property. For the last several years he was saving money for downpayment and waiting for the "right" price to buy. :)