“Anyone can get rich investing in real estate.” This may be true, but it may not be thewhole truth. It sounds too easy when successful real estate investors tell their stories: “My rental properties freed me from having a full-time job.” “I have more income now than when I was in the rat race working.” “I fixed up and sold three homes and now I own seven.” “I can pay off all my mortgages in 13 years and never lift a finger again.”
Real estate is property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights. A real estate investment is termed direct ownership when an investor holds actuallegal title to the property. For example, you can invest directly as an individual or jointly with other investors to buy properties designed for residential living, such as houses, duplexes, apartments, mobile homes, and condominiums. You also could invest in commercial properties designed for business uses, such as office buildings, medical centers, gasoline stations, and motels. You might buy raw land or residential lots, although they are extremely risky.
Current Income and Capital Gains
Following are two key questions for real estate investors:
• Can you make current income while you own?
• Can you profit with capital gains when you sell the property?
Real estate is property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights. A real estate investment is termed direct ownership when an investor holds actuallegal title to the property. For example, you can invest directly as an individual or jointly with other investors to buy properties designed for residential living, such as houses, duplexes, apartments, mobile homes, and condominiums. You also could invest in commercial properties designed for business uses, such as office buildings, medical centers, gasoline stations, and motels. You might buy raw land or residential lots, although they are extremely risky.
Current Income and Capital Gains
Following are two key questions for real estate investors:
• Can you make current income while you own?
• Can you profit with capital gains when you sell the property?
The most important consideration for real estate investors is whether the rental income will be sufficient to make a profit. If you invest in a property and you are paying out more than the rental income coming in, you face three risks: (1) whether you can afford to continue paying out that money every month, (2) whether the price on the property will increase, and (3) whether the property actually will sell for more than what you paid for it.
To measure the current income in a real estate market, investors can begin by using the price-to-rent ratio. This numerical relationship might range from 11 to 26 depending upon local market conditions meaning how high housing prices are. The larger the number, the less likely the investor can make money. In San Diego, California, a condominium renting for $1500 a month might sell for the sky-high price of $390,000 for a ratio of 21.7 (12 x $1500 = $18,000; $390,000 $18,000 = 21.7), while a similar one in Dallas, Texas, might cost only $165,000 for a ratio of 9.17
(12 x $1500 = $18,000; $165,000 $18,00= 9.17). Buying property with a high ratio will provide a profit only with a future increase in the value of the property. Investors also calculate the rental yield on properties. This is a computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Most properties yield about 4 percent of income annually, although the rental yield may be as little as 1 or 2 percent and as high as 8 or 9 percent. Less expensive properties often offer higher yields. The formula assumes half of rental income goes for expenses (other than debt repayment).
To measure the current income in a real estate market, investors can begin by using the price-to-rent ratio. This numerical relationship might range from 11 to 26 depending upon local market conditions meaning how high housing prices are. The larger the number, the less likely the investor can make money. In San Diego, California, a condominium renting for $1500 a month might sell for the sky-high price of $390,000 for a ratio of 21.7 (12 x $1500 = $18,000; $390,000 $18,000 = 21.7), while a similar one in Dallas, Texas, might cost only $165,000 for a ratio of 9.17
(12 x $1500 = $18,000; $165,000 $18,00= 9.17). Buying property with a high ratio will provide a profit only with a future increase in the value of the property. Investors also calculate the rental yield on properties. This is a computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Most properties yield about 4 percent of income annually, although the rental yield may be as little as 1 or 2 percent and as high as 8 or 9 percent. Less expensive properties often offer higher yields. The formula assumes half of rental income goes for expenses (other than debt repayment).
Current Income Results from Positive Cash Flow
In real estate investing, current income takes the form of positive cash flow. For an income-producing real estate investment, you pay operating expenses out of rental income. If the property has a mortgage (a common occurrence), payments toward the mortgage principal and interest also must be made out of rental income. Operating expenses such as vacancies, taxes, mortgage payments, and repairs may eat up half of rental income.
The amount of rental income you have left after paying all operating expenses is called cash flow. The amount of cash flow obtained by subtracting any cash outlays from the cash income depends on the amount of rent received, the amount of expenses paid, and the amount necessary to repay the mortgage debt. Investors usually prefer a positive cash flow to a negative cash flow because any shortages represent out-of-pocket expenses for the investor. Many real estate investments will not generate a positive cash flow, even though they may offer the likelihood of high potential returns through price appreciation. Investors might manage a negative cash flow for a few years while waiting for capital gains to later materialize when selling the property.
Price Appreciation Leads to Capital Gains
The capital gain earned in a real estate investment comes from price appreciation. It is the amount above ownership costs for which an investment is sold. In real estate, ownership costs include the original purchase price as well as expenditures for any capital improvements made to a property prior to sale. Capital improvements are costs incurred in making changes in real property, beyond maintenance and repairs, that add to its value. Paneling a living room, adding a new roof, and putting up a fence represent capital improvements. Repairs are expenses (usually tax deductible against an investor’s cash-flow income) necessary to maintain the value of the property. Repainting, mending roof leaks, and fixing plumbing are examples of repairs. As an example, assume that Andrew Webb, an unmarried schoolteacher from Fayetteville, Arkansas, bought a small rental house as an investment five years ago for $120,000 in cash that he received as an inheritance. He fixed some roof leaks (repairs) for $1000 and then added a new shed and some kitchen cabinets (capital improvements) at a cost of $10,000 before selling the property this year for $160,000. As a result, Andrew happily realized a capital gain of $30,000 ($160,000 minus the $120,000 purchase price minus $10,000 in capital improvements).
In real estate investing, current income takes the form of positive cash flow. For an income-producing real estate investment, you pay operating expenses out of rental income. If the property has a mortgage (a common occurrence), payments toward the mortgage principal and interest also must be made out of rental income. Operating expenses such as vacancies, taxes, mortgage payments, and repairs may eat up half of rental income.
The amount of rental income you have left after paying all operating expenses is called cash flow. The amount of cash flow obtained by subtracting any cash outlays from the cash income depends on the amount of rent received, the amount of expenses paid, and the amount necessary to repay the mortgage debt. Investors usually prefer a positive cash flow to a negative cash flow because any shortages represent out-of-pocket expenses for the investor. Many real estate investments will not generate a positive cash flow, even though they may offer the likelihood of high potential returns through price appreciation. Investors might manage a negative cash flow for a few years while waiting for capital gains to later materialize when selling the property.
Price Appreciation Leads to Capital Gains
The capital gain earned in a real estate investment comes from price appreciation. It is the amount above ownership costs for which an investment is sold. In real estate, ownership costs include the original purchase price as well as expenditures for any capital improvements made to a property prior to sale. Capital improvements are costs incurred in making changes in real property, beyond maintenance and repairs, that add to its value. Paneling a living room, adding a new roof, and putting up a fence represent capital improvements. Repairs are expenses (usually tax deductible against an investor’s cash-flow income) necessary to maintain the value of the property. Repainting, mending roof leaks, and fixing plumbing are examples of repairs. As an example, assume that Andrew Webb, an unmarried schoolteacher from Fayetteville, Arkansas, bought a small rental house as an investment five years ago for $120,000 in cash that he received as an inheritance. He fixed some roof leaks (repairs) for $1000 and then added a new shed and some kitchen cabinets (capital improvements) at a cost of $10,000 before selling the property this year for $160,000. As a result, Andrew happily realized a capital gain of $30,000 ($160,000 minus the $120,000 purchase price minus $10,000 in capital improvements).
Residential real estate values can generally be expected to increase 3 percent annually, about the rate of inflation, or a little above. In some markets, prices might jump 10 percent or more in one year and perhaps continue rising for two or three more years. Prices can decline, too, as even in hot regional real estate markets prices in individual neighborhoods may decline. Prices can drop 10 or 20 percent in one year. In markets in which real estate is hard to sell (too many properties on the market and too few buyers), perhaps because of job losses in a slow regional economy, residential housing prices might decline 2 or 3 percent annually for a long time. If you cannot forecast the future of what you invest in, such as price appreciation on a property in a local housing market, you are speculating. Using a mortgage loan invites more risk. While price appreciation is where the big profits are in real estate investing, you can reduce risk by investing in property for which the expected rental income exceeds projected mortgage payments, property taxes, and maintenance costs
Leverage Can Increase an Investor’s Return
leverage involves using borrowed funds to make an investment with the goal of earning a rate of return in excess of the after-tax costs of borrowing. Lenders allow investors to borrow from 75 to 95 percent of the price of a property.
Suppose that Andrew, instead of paying cash for the house, had made a down payment of $25,000 and borrowed the remainder. What effect would this borrowing have on his return? In the first instance, Andrew paid $120,000 cash for the property and earned a 25 percent return on his investment ($30,000 $120,000) over the fiveyear period, or roughly 5 percent per year. In the second situation, using leverage, he would have an apparent return of 120 percent ($30,000 $25,000), or roughly 24 percent per year. The true return would be lower because of mortgage payments, interest expenses, property taxes, and repairs but would still be a double-digit return. The loan-to-value ratio measures the amount of leverage in a real estate investment project. It is calculated by dividing the amount of debt by the value of the total original investment. For example, because his down payment was $25,000 on the $120,000 property, Andrew had a loan-to-value ratio of 79 percent ($95,000 $120,000), or 79 percent leverage.
Leverage Can Increase an Investor’s Return
leverage involves using borrowed funds to make an investment with the goal of earning a rate of return in excess of the after-tax costs of borrowing. Lenders allow investors to borrow from 75 to 95 percent of the price of a property.
Suppose that Andrew, instead of paying cash for the house, had made a down payment of $25,000 and borrowed the remainder. What effect would this borrowing have on his return? In the first instance, Andrew paid $120,000 cash for the property and earned a 25 percent return on his investment ($30,000 $120,000) over the fiveyear period, or roughly 5 percent per year. In the second situation, using leverage, he would have an apparent return of 120 percent ($30,000 $25,000), or roughly 24 percent per year. The true return would be lower because of mortgage payments, interest expenses, property taxes, and repairs but would still be a double-digit return. The loan-to-value ratio measures the amount of leverage in a real estate investment project. It is calculated by dividing the amount of debt by the value of the total original investment. For example, because his down payment was $25,000 on the $120,000 property, Andrew had a loan-to-value ratio of 79 percent ($95,000 $120,000), or 79 percent leverage.
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