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The recent collapse of U.S. home sales ripped a magnificent bloom
off the rose of real-estate investing -- yet buying rental properties
remains one of the best ways for middle-income Americans to build
wealth. While the rich have a phalanx of investment
advisors to help enrich them further every day,
middle-class Americans
struggle to just set aside enough money in their 401(k)s to secure
their retirement. Real estate offers people of modest means an opportunity to build wealth in an
investment they understand as homeowners and renters themselves.
Studies
show residential real-estate investing returns an average 10 percent a
year ? equal to the historic return for stocks. While it requires
active management of the asset on the investor?s part vs. more passive
stock investing, it can be a rewarding part-time endeavor for those
with a long-term horizon.
Leveraged investing
The beauty of real-estate investing is the ability to leverage other people?s money ? namely, a mortgage lender and renters ? to make money for yourself.
Take,
for example, a $200,000 home bought with 10 percent down and $8,000 in
closing costs. If that property appreciates just 4 percent a year over
20 years, its owner turned a $28,000 investment into a $238,000 gain.
That
scenario assumes the rental income covers annual mortgage, insurance,
property-tax and maintenance costs, which it may not fully in the early
years. But it also doesn?t factor in the likely surplus annual income
in future years when rising rents more than cover fixed-mortgage costs.
Tangible asset
Unlike
stocks, whose value is a matter of perception and psychology, real
estate is a tangible asset and not just a paper stock certificate
(which shareholders don?t even get in hand anymore!).
The steadily rising cost of constructing new homes
protects and ultimately enhances the value of existing properties. That
underlying strength is even greater in metro areas with a limited
supply of developable land within easy commuting distance to the center
city, or well-located properties in desirable coastal and resort
communities.
Direct control
Unlike
the crapshoot inherent in the stock market, real-estate investors have
direct control over their investments. They set the rents, choose
tenants and decide what improvements to make and when.
Rather
than staking their fortunes with corporate executives who can fail to
grow their companies for any number of competitive reasons, real-estate
investors manage their own assets based on local market conditions.
Limited risk
Real
estate values can and do fall as homeowners discovered in Texas in the
1980s, southern California in the early 1990s and various regional
markets throughout the U.S. more recently.
Still,
long-term investors seeking to build wealth for their retirement years
face little downside risk with real estate. America?s rising
population, shrinking household sizes and unfortunately high divorce
rate are expected to fuel increasing demand for places to live for
decades to come.
Diversification
Real-estate
values generally don?t rise and fall in tandem with stocks and
sometimes are countercyclical, moving in the opposite direction. It is
what?s called in the investment world a ?non-correlated? asset.
Diversifying
investment holdings into rental properties provides a solid
counterbalance to stock-laden 401(k) and IRA accounts. A modestly
priced, three-bedroom rental home won?t ever produce the explosive
returns of a sensational stock like Google, but its owner can sleep
easier knowing his or her future wealth isn?t wholly dependent on the
whims of the stock market.
Immediate returns
Self-anointed real estate gurus trumpet the fortunes to be made in buying and flipping distressed and foreclosed properties,
a fast-buck strategy that?s especially difficult to pull off in weak
housing markets where properties languish for sale for months on end.
Still,
smart shoppers can reap immediate paper gains on many properties. At
any given time ? and especially in today?s markets with mounting
supplies of unsold homes ? individual home sellers forced to sell
quickly due to job relocation, divorce or unemployment may accept
below-market prices to facilitate a sale.
Improvement potential
Just
as with the purchase of a first home, it?s wise when shopping for
rental properties to buy the least expensive home in the nicest
possible neighborhood.
The benefit for the owner is
threefold: The better the neighborhood, the less likely the number of
rental properties available within it. Improvements made to modest
homes in nicer areas will yield higher rents. And an owner could simply
maintain the property during the rental period and improve it just
prior to sale to bring it up to the neighborhood standard and command a
much higher asking price.
The benefit of inflation
As
Americans have seen in the last year, rising mortgage rates hurt home
sales and property values. Yet rising rates can have a positive impact
on owners of investment properties.
The fewer the
number of people buying homes, the greater the number of renters, which
heightens demand for rental properties. Since real-estate investment
tends to slow as mortgage rates rise, that also means a tighter supply
of rental homes in the near term.
Interest rate hikes
are the Federal Reserve Bank?s means to curtail inflation by making
borrowing money more expensive. Inflation benefits real-estate
investors who can raise rents accordingly. So while long-term
appreciation suffers from mortgage-rate spikes, the immediate rental
income picture improves.
Tax-deferred gains
Real-estate
investing provides the same type of tax-deferred advantage of 401(k)s
and IRAs. Owners aren?t taxed on the appreciation in a home?s value
until the time of sale ? and even then, they can forestall paying taxes
by rolling their gain into another property.
Add to
that another major tax advantage: The ability under present tax law for
owners of rental properties to move into the home for a total of two
years in any five-year period and pay no tax on up to $500,000 in
capital gains. That opportunity argues for buying rental properties you
could comfortably inhabit yourself for a spell.
Of course, real-estate investing is not without its downsides, which should all be heavily weighed:
Illiquid investment
Unlike
stocks, which can be sold with the push of a computer keystroke,
selling a home can takes months and entails considerable costs. If
you?re not prepared to tie up your money for years to come, best that
you don?t.
The difficulty in quickly selling a
property, however, can work in investors? favor by discouraging them
from running scared in a market downturn and dumping properties. The
relative liquidity of stock investing is actually one of its greatest
drawbacks, since countless investors sell in a panic, often at a loss,
when an individual stock or the overall market drops.
Cash-flow constraints
The
ideal situation is to buy properties whose rental income covers the
monthly ?carrying costs? ? i.e. mortgage and insurance payments,
property taxes and maintenance costs. The run-up in U.S. home values in
recent years has made that scenario difficult to attain in many
regional markets.
New investors today may find
themselves in a negative cash-flow situation, meaning the rent doesn?t
cover their costs. Investors must be prepared financially to cover any
such shortfall or risk losing the property if they can?t foot the bill
? a crushing problem now facing many recent investors saddled with
properties they expected to flip for a fast profit.
Sporadic income and unforeseen costs
However
good the cash-flow numbers may look going in, rental-property owners
risk being squeezed on several unforeseeable fronts.
The
first is tenants who fail to pay their rent in timely manner ? or not
at all ? leaving it to the owner to cover their mortgage payments
out-of-pocket until they collect the back rent or evict a deadbeat.
Next is tenant turnover, which can leave a property unrented for
several months a year, during which time the owner must also cover the
nut. Lastly, there are major repairs that must be done -- such as a new
roof, furnace or septic system ? that can cost well into the thousands
of dollars that must be ponied up on the spot.
Landlording
Finally,
there?s the angst of trying to do right by tenants who don?t
reciprocate in kind. Some may destroy the home you?re improving for
them without any intention of raising the rent. And all catch on fast
to when you?re playing them.
Tenant selection is a
skill rental-property owners need to master fast since it has an
immeasurable influence on success. If you?re suspicious by nature and
have a short fuse, this is no business for you. If you can learn to
recognize great tenants who?ll carry your mortgage for years and care
for your property as if it were their own, you may be wise to never
raise their rent and reap tremendous long-term benefit. |
