Buying real estate is about more than just finding a place to call home. In fact, residential real estate has become an increasingly popular and important investment vehicle for many in recent years.
First, people always need a place to live and the “supply and demand” factor still holds true — they’re not making any more land, and there are supply constraints in many parts of the U.S. There’s also a post-recession cultural phenomenon dubbed the “rentership society,” in which interest in renting rather than buying houses and apartments has spiked — especially among the younger demographic.
Buying and owning real estate can be more complicated than investing in stocks and bonds, but there are financial benefits and tax breaks you can take advantage of as a real estate investor and landlord. Here are some of the upsides of selecting residential properties for your investment portfolio:
- Ultimate control. Unlike some other investment classes, real estate gives you unparalleled control. With the right team of advisors, you’re the CEO who decides what to buy, when and for how much.
- Depreciation: a big tax break. For example, say you invest $100,000 in a business and generate $10,000 in revenues after spending $3,000 in expenses this year. You pay the effective tax rate of, say, 30 percent, which means a $2,100 tax on your $7,000 profit and taxable income, leaving you an after-tax profit of $4,900. In the case of real estate, using a 20-year depreciation time frame allows you to write off $5,000 every year, which means you’re taxed on $2,000 of that $7,000 net income. With a 30-percent tax, you pay $600, leaving you with a significantly higher after-tax profit of $6,400.
- 1031 exchange: a gift from the federal government. If you own a rental property and sell it to purchase another, you can roll the entire gain into the next investment rather than pay the capital gains tax on that sale. And unlike the home you live in, there’s no limit on how much of the total gain you can roll over. Over time, the compounding profit can be very powerful: If you buy and sell rental property every 10 years over the course of a 50-year period, you can potentially double your value.
- A tangible asset. Real estate is not an abstract asset. Looking at a financial statement, you can get a sense of what’s going on with a business whose stock you own. But when you see a property, talk to residents and scour the market for comparable options, you can actually see what’s going on and pinpoint any problems immediately.
Financing terms and costs differ by loan type and can have a profound impact on how well you do on your investment.
One thing to consider is your ideal investment horizon. Depending on how long it is, some investment structures are more appropriate than others. For example, the interest rates for a monthly adjustable-rate mortgage (ARM) may change periodically, affecting your monthly payments. It’s an option that can pay off in a strong housing market with regular rent increases, but you have to factor in the risk of rising interest rates.
An ARM may be a good choice for those with a three-, five- or seven-year horizon who want a lower an interest rate for a specific period they intend to hold on to the property before selling it and buying another. A fixed-rate traditional loan is the standard, but the interest rates are higher.
How lenders evaluate you
To understand how you can better qualify for a loan on a rental property, you need to be familiar with the criteria lenders consider when evaluating prospective borrowers. These questions can provide some insight:
- Are you buying a residential or a mixed-use property? Terms for the latter are typically less favorable than a true residential multi-family building.
- What’s the rental roll? Who’s paying what in each unit? How many units are vacant? Are there rent-protection rules in that area, or a lot of restrictive laws against raising rents?
- What are your operating expenses? Can you manage the rental property yourself? Or will you need to pay for an outside manager, which will hurt your monthly cash flow?
- What does the appraisal say? Every lender will require an appraisal to judge the property’s value before greenlighting a loan. Keep in mind that multi-family appraisals take longer to schedule and complete than those for single-family homes.
- What is the debt/service coverage ratio? How much operating cash flow from the property will cover the debt?
- What is the loan-to-value ratio? How much net income does the property have to support and pay back the loan? Lenders want to make sure you can cover their debt and still have some financial cushion.
- Is this a recourse versus non-recourse loan? When you guarantee a “recourse” loan, you put your credit and balance sheet up as potential sources of repayment. A lender can look to you to pay them back if you default the loan. A non-recourse loan has a higher interest rate — you pay the lender a premium for taking the risk, but are off the hook and your personal assets are protected if something goes sideways with the property.
Risks to consider
While investment opportunities in real estate can reap returns, you’ll need to understand more than just the terms of your mortgage. Here are three key factors to consider before deciding whether real estate investment is right for you:
- Timing. This is crucial when considering any investment, but particularly in the world of real estate. On one hand, we’ve seen a 30-year downtrend nationwide in falling interest rates and rising rents in many urban markets. In other markets, years of economic expansion have some investors questioning how long the growth can continue. A decrease in economic growth could lead to a decrease in home value, emphasizing the importance of timing when buying real estate as an investment.
- Leverage. It’s crucial to determine whether your real estate goals are short- or long-term. If you’re leveraging 80 percent of your buying power when purchasing an asset, there’s risk involved. If rents go down 20 percent, you’re losing money. Can you ride that out on the timeline you set up for your investment?
- Location. Knowing where to buy is as important as knowing when to buy. If you purchase a property on the far edge of town that looked like a great deal but no one else was bidding on it, for example, be forewarned that there may also be limited interest when you sell. Alternatively, finding a great deal in an increasingly popular neighborhood can help you generate significant returns on your investment in the future.
The right team of real estate advisors
Real estate is a puzzle you have to put together, with many moving pieces and questions to answer. For example: What are you going to buy? What amount can you pay for it? What’s your renovation budget? Who should you lease to? Who should manage your property?
The good news is you don’t have to make all of those decisions yourself. To be successful in this market, you should build a team of advisors and partners you can rely on to make good decisions. Your team should include:
- A real estate broker to help you find the right property
- A banker or mortgage broker to help you determine how much financing you can get
- A real estate attorney and home appraiser to help you in the final phases
These key players can be invaluable in a real estate transaction, particularly during the home inspection and final document review stage. And even though they’re advising you on how to maximize your investment, you still have the final say.
From where to buy a property to the right time to buy it, there are many considerations with residential real estate. And as with any financial investment, there are both upsides and inherent risks, so you need to be mindful of those before putting pen to paper.
The strong tailwind of owning rental properties is a good one to be in front of. Do your due diligence and research, find the right people to build your advisory team and you'll be well on your way to becoming a real estate investor.