First let me say that when I speak of investing in real
estate I am not speaking of your own home. I don’t believe, and any financial
advisor worth his/her salt should agree, that your primary residence should
ever be considered an investment. It is after all your home, the place you
return to at the end of your day, the place you raise your kids and grow old
with your partner. Your home is all these things but not an investment or a
part of your retirement plan.
When I speak of investing in real estate I am speaking of
the purchase of a property that is used as a home by another person or family.
This could be a single family house, a condo or a multi-family apartment
building. All of these are types of investment properties when occupied by
someone other than you.
There are usually two basic types of investment properties.
One is the type you buy and hold. This could be any of the types listed above
but the intent of this type of investment is income from the rents paid by the
tenants of the property. The second type is a property that you intend to keep
for only a short period of time usually called a “flip” property.
As you can imagine each of these types of properties has its
own appeal and investment objective. I will write about each type of investment
in future articles. For this article I want to introduce a few basic investment
terms and suggest some reasons to consider adding real estate to your
You will hear several terms used when deciding if a
particular property is a good candidate as an investment property. You will
also need to have some basic math skills to determine if the property makes
good business sense. Notice I use the term “good business sense” when talking
about investment properties. It is very important that your property purchase
be treated like a business transaction rather than a normal home purchase. You
may have decided that your dream home has to have 4 bedrooms to meet your
family needs, but a 3 bedroom house might be a perfect fit for the average family
thus making it a better business decision. Don’t buy an investment property
based on the curtains in the windows, rather as an investment decide how much
useable life is in the curtains and decide if replacing them can figure in your
investment budget. I think you get the picture. You are not buying a home for
you to live in but rather a home for someone else to live in.
You will hear two terms used frequently in investment real
estate, Cap Rate or Capitalization Rate and ROI or Return on Investment. These
two terms and the numbers they represent should make up the basis of your
decision on which home to purchase for investment.
Cap Rate is the rate of return on an investment property.
The formula to determine Cap Rate is very simple. Divide the return on the
property (rent) by the original purchase price of the property and you get the
Cap Rate. For example say you purchase a home for $100,000 and collect $1000
per month in rent. Since Cap Rates are calculated for a year you divide $12,000
by $100,000 and get a Cap Rate of 12%. Investors determine what they want their
Cap Rate to be and then normally purchase a property that will meet that
figure. This is a very simple example and doesn’t include the cost of any
expenses associated with the home during the year.
ROI is a measurement of the performance of an investment
versus other investment options. There is a simple formula used to calculate
ROI. First subtract the cost of the investment from the gain on the investment.
Second, divide the results from step one by the cost of the investment. That
figure represents the ROI of the investment. For example say you purchase an investment property
for $100,000 and you are able to collect rent of $1000 per month on the
property. In this case over the course of a year you collect $12,000 in rent.
Your ROI for this investment for a single year would be 8.8%. For this example
we have assumed you purchase the property for cash and had no expenses
associated with the property. As a measurement of performance a positive ROI
means this would be a good investment and the higher the ROI versus other
investment options the more the investment makes sense.
As I mentioned I would offer a few reasons to consider real
estate as an investment option. In the current real estate market of 2011, the
majority of purchases are being made by investors. In 2004-2007 almost no
investors were purchasing properties. The main reason for this change is the
price of homes today versus 2004-2007. Today you can get a pretty nice property
at 25-50% of the price of the same home from 2004-2007. This makes buying a
home today a pretty good investment. Rents in most major cities, including San
Diego, haven’t dropped and most experts expect rents to increase steadily over
the next 4 years. If the price of the home has dropped by 25% and rents have
stayed the same or increased than simple math will tell you that you have a
better chance of making money or at least breaking even on an investment
property today over 2004-2007.
A second reason to consider real estate investing is tax
laws. If you are not a real estate professional and manage your own investment
property the money you receive from rent is considered passive income. You have
to claim this income on your tax returns but you are able to deduct the
expenses you incur for maintenance and repairs, mortgage interest, private
mortgage insurance, home owner association fees and insurance from this passive
income. You are also allowed to claim deprecation expenses as allowed by law. I
would recommend you talk with a tax specialist or get publications from the IRS
to determine how much you can claim each year for these expenses but each of
these expenses are legally deductible and in some cases can help to offset both
your passive and active incomes.
The last reason I will mention is simply diversification.
Any good financial planner will recommend you diversify your investments. That
is why most people invest in mutual funds rather than single company stocks so
that they can manage drops in the market with a little less risk. Consider real
estate just another arrow in your financial quiver. Rather than an REIT that
you don’t control, owning an investment property gives you more control, and
yes more risk, than having someone else making those decisions for you.