The following article is a summary from the book, “Realtor for Life”, written by Duane Duggan.
Most people consider their single-family home they live in as an investment in real estate. In fact, when they fill out a financial statement, it is even listed as an asset. It’s true that the home will likely go up in value over the years, and as the loan is paid off, it could represent a significant part of a person’s net worth. However, in the truest sense of the word, the personal residence is really a liability rather than an investment.
Think about it: for your home, you are paying the mortgage payment, taxes, utilities, maintenance, etc. It all adds up to a pretty good amount of money being expended each month with no money coming into the equation from the property. It really is a liability.
Now think of a single-family rental property. If you have an amortizing mortgage on it and the rent pays the mortgage and expenses, each month you build equity via principal reduction. Eventually rents go up and the property becomes free and clear. It produces cash flow that you can use for buying groceries or daily purchases, for example.
Potential for Appreciation
Residential real estate has proven to be a good investment over the years. Over the long term, values have continued to rise in Boulder County. However, there certainly have been times when market conditions have slowed sales and prices dipped. An old saying says, “Buy real estate and wait.” In Boulder County, if you bought in the 1980s, you would have bought and waited. In the 1990s, appreciation was much stronger and a profit could be made after only waiting a short time.
Job Growth Drives Appreciation
The primary reason appreciation occurs is job growth. If job growth is occurring, new families move and need a place to live. When job growth stops, the real estate market will level off. Job growth is even more important than interest rate levels on the overall market. Lower interest rates will stimulate the local move-up market. If someone doesn’t have a job, it probably doesn’t matter what the interest rate is.
Every month when a payment is made on a mortgage, a certain amount goes towards principal reduction. If one of your goals is to own real estate free and clear with no mortgage payment, a payment schedule can be created on a 30-year loan that will pay off the loan in whatever timeframe is desired. In the case of an investment property, rent is covering the mortgage payment. Each month that goes by, the tenant is helping pay off the loan and equity builds.
The concept of leverage is what is known as using “other people’s money” or OPM. When investing in real estate, it makes the most sense to get a loan for a good portion of the purchase price. To illustrate an example of leverage, let’s say you had $100,000 to invest. You then used that money to purchase one $100,000 condominium. If the real estate market were appreciating at 5% a year and you held the property for five years, the condominium would be worth $122,347 or a gain of $22,347. Now let’s say that, instead, you took that same $100,000, put $20,000 down on each of five $100,000 condominiums. You now own $500,000 worth of real estate. If the market appreciates at the same 5% per year for five years, your real estate would be worth $638,140 or a gain of $138,140 on the same $100,000 investment. As you trade up, it is important to keep your equity position at a level that allows you to survive downturns in the rental market.
Everyone should consult a tax advisor on how ownership of real estate will affect them personally. The 1986 Tax Reform took away many of the major benefits of owning real estate and made real estate “pay for itself.” Today, there is no “doubling declining depreciation”. We still have depreciation, but it is subject to income limits and other rules. Depending on how someone fits in with the IRS rules, they could potentially get a tax break for a property’s depreciation. Depreciation is a tax concept whereby you get a write off, but don’t have to spend the actual dollars to get it. For example, on a $100,000 purchase, an accountant may choose to declare 80% of the value as depreciable. You can’t declare the whole value as depreciable because some of the value is attributed to land and land doesn’t “depreciate.” Therefore, in this example, $80,000 would be depreciable. Under the current IRS rules, you can take the $80,000 and divide it by 27.5 years for an annual depreciation deduction of about $2,900. In addition to depreciation, real estate taxes and other expenses of the property can offset rental income. The bottom line is that real estate, in the early years of ownership, will show a loss, which results in a tax deduction and tax savings. There are limits as to the amounts that can be deducted due to real estate losses. Depreciation can also be “recaptured” at time of sale, which means that there is a higher taxable gain. You need to consult a tax advisor to determine how all the IRS rules will affect you personally.
In the early years of ownership, especially in Boulder, it is difficult to achieve immediate positive cash flow. In other words, when a property is first purchased, the rental income probably won’t cover the mortgage payment and all the expenses. If the cash flow is about break-even on a month-to-month basis, after taxes and appreciation factors are considered, the overall cash flow is positive. After owning the property for several years, rents should go up while the mortgage payment on a fixed rate mortgage stays the same (except for increases in taxes and insurance), and the monthly cash flow increases. In terms of liquidity-conversion to cash, real estate is not a “liquid” investment compared to many other investments available. If someone needed to sell a property to generate cash, market conditions will dictate how marketable a particular property will be. Generally speaking, individual housing units, whether single family or condo, have been readily saleable in our marketplace. However, one does not need to sell a property in order to generate cash. If you have owned the property for a while and its equity has increased, you can refinance your loan to pull cash out. With refinancing, you don’t have to pay any selling expenses or pay any tax on the cash pulled out. The money can be used for daily expenses, other investments, or for the down payment on another rental property.
Single Family Home for Appreciation
In Boulder, rents compared with value don’t create much cash flow. So why do people still buy them as investments? They hope that the appreciation rate will cause the value of their house to increase so much that the monthly cash flow may not be important to a particular investor.
Multi-Units for Cash Flow
Typically, a single-family residence will have a higher gross rent multiplier. The gross rent multiplier is simply the annual gross rent compared to the purchase price. The lower the gross rent multiplier, the greater the return for the dollar invested. The greater the number of units in a building, the lower the gross rent multiplier typically is. When trading a single-family for multi-units you usually won’t see much change when moving up to a 4-unit. The best increase in cash flow comes when making the jump to 20-plus units in one location.
Real estate has proven to one of the best wealth building investment opportunities. Most people just don’t make the first step to get started.
About Duane Duggan: Duane Duggan has been a Realtor® for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. He has been awarded two of the highest honors bestowed by RE/MAX International: the Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, REALTOR® for Life. Also see his video podcasts about real estate topics on RE/MAX of Boulder’s YouTube channel.
For questions, email Duane at DuaneDuggan@BoulderCo.com or call 303-441-5611