The Power of Real Estate Investing
When some people talk about the "returns" of real estate they simply seem to be referring to the historical rates of increase in property values over time which by most measurements have been approximately 3.5-4% per year. To merely focus on this measurement of real estate, especially as a comparison to other investment categories like stocks, is missing a large piece of the puzzle. Some of the many factors which contribute to the power of investing in real estate are:
1. Cash flow: When purchased right, a property should be generate enough rental income each month to pay for ongoing expenses and debt service and still put money in your pocket. The amount of cash flow that each investor will seek may be different, but many investors would target an 8-10% annualized return from cash flow. We would never advocate for you purchasing a property that you would have negative or even neutral cash flow on each month as there are simply better properties to invest in.
2. Appreciation: Historically real estate prices have gone up over time. Sure there can be fluctuations in value in the short-term, but historic returns have been approximately 3.5-4% annually. As mentioned to start with, this is the main return some people talk about when comparing real estate returns to other investments. But as you can see, that is just one of the returns generated by owning property.
3. Depreciation: Although depreciation is considered an expense for tax calculations, this is not an expense that comes out of your pocket each month. However, because of this expense your property might generate a "loss" on paper when tax time comes even though you have received monthly cash flow throughout the year. This is the reason why you may have heard of investors paying no tax on their rental income.
4. Principal pay-down: When you purchase property using a loan, the rental income is utilized to not only pay the monthly expenses of the property but to also pay down the loan with the mortgage payment. Essentially this means that the tenants are making the loan payments for you and paying off your property over time. Each payment increases your equity in the property independent of market conditions or even rent growth.
5. Leverage: When you utilize conservative leverage in owning property, you magnify the effect of the gains you see in some of the other categories. For example, if you purchase a property with 30% down you still get the returns from appreciation and depreciation from 100% of the property. The returns from the 70% leveraged portion do not go to the lender, they go straight back to you. Consider debt as a tool to boost your returns.
6. Evergreen asset: Suffice it to say there will always be a basic human need for shelter and housing. In addition, home ownership rates continue to decline due to the demographics and preferences of the Millenials and downsizing Baby Boomers. Each 1% decline in home ownership rates is estimated to increase the rental demand by 1.1 million units. This, combined with increasing demand from population growth creates an ongoing and indefinite need for rental housing.
7. Tax benefits: In addition to depreciation, there are additional tax benefits from owning real estate. We will go into each of these separately in other articles, but other benefits include mortgage interest deduction, 1031 exchange, and tax-free cash out refinance. A 1031 exchange is allows investors to sell/exchange out of a rental property and roll the proceeds into the purchase of another property with deferral of any tax on the gains. With proper estate planning, those gains may never require any tax to be paid on them once any heirs inherit the property with a step up in basis when the original investor passes away. Even without doing a 1031 exchange, investors can pull equity out of a property that has accumulated over time by doing a cash out refinance. Money received as a cash out refinance is considered a loan and not income, so no tax is due on that money. Another tax benefit is that rental income is considered passive income instead of earned income. As such, it will not be subject to self-employment taxes like earned income, thus lowering the overall tax rate on this type of income.
Understanding Commercial Multi-family Property
Granted, multi-family properties are not the starting point for every investor to get their feet wet, but I just wanted to review some of the factors that make commercial multi-family properties such an appealing asset class. First off, I want to define commercial as sometimes people think it refers only to properties such as industrial space, office buildings, retail stores, etc. Commercial in the residential space simply means that a property is 5 or more units as financing on any 5+ unit property will be done with a commercial loan instead of residential loan.
The commercial multi-family sector has historically outperformed nearly all other commercial real estate sectors (office, retail, industrial) throughout economic cycles. Due to the evergreen nature of housing needs there will always be a demand for this type of housing, not to mention the increasing rental demand due to the impact of the millennial generation and downsizing Baby Boomers (see our article here for more on that). The superior risk-adjusted returns and relatively low volatility of commercial multi-family investments is the reason this asset class has attracted huge amounts of investment dollars from insurance companies.
In addition to all of the benefits of real estate investing mentioned in (this article), some additional benefits of commercial multi-family investments are:
•Economies of scale: With increasing numbers of doors, the per unit cost of doing business generally goes down as you are utilizing the revenue from multiple units to cover the expenses of the entire property. Since many of the costs of operating a property (insurance, maintenance, property management) do not increase proportionate to the number of doors under one roof the property expense ratio is more efficient. In general, this effect goes up with the number of units in the property.
•Vacancy impact: Again, with each increase in the number of units in one property the impact of any one vacancy goes down. For example, if you have a single family house and have one vacancy you have a 100% vacancy. However, if you are invested in a 100 unit property with 5 vacancies your vacancy rate that month is only 5%. This can be significant impact on your returns.
•Valuation: Since the valuation of commercial real estate is based on valuation of the revenue stream (net operating income) it generates, there is the ability to impact the property value by improving on operation inefficiencies to either increase income (increasing rents to market rate, doing property upgrades to capitalize on higher rents or superior tenant mix) or reduce expenses (bill back utility services, renegotiate service contracts, improve tenant experience to maintain longer leases and reduce turnover). Any of these improvements to operation go directly to improving the bottom line of the property operations and subsequently increase the valuation of a property by boosting (net operating income).
•Consistent rise in property values: With significantly lower volatility than other investment classes, commercial multifamily properties have historically increased in value at a rate nearly twice that of inflation.
•Attractive financing terms: Commercial multifamily properties being a stable and low volatility asset class allows the opportunity for many attractive financing options including non-recourse loans.
With all of the many advantages of commercial multi-family real estate, this asset class is definitely something to consider for either your own hands-on portfolio or through passive participation in the category through syndication opportunities.
Real Estate Syndication
In it’s simplest form syndication is pooling investors money together and partnering with a private real estate company to increase the purchasing power of the group to acquire larger assets. The partnership formed between investors and the real estate company is designed to be a win/win for everyone involved. Real estate companies looking to syndicate deals focus on acquiring the best investment opportunities and have well established teams to operate these properties. Investors provide equity to acquire properties without having to do the legwork of acquisition and management and then benefit by recognizing a solid return on their investment passively yet still retain the benefits of real estate ownership. The significant difference between a syndication and a joint venture is that the management of the investment is controlled by the sponsor with limited input from individual investors. For this reason, syndications are regulated by securities law. Under the Securities Act of 1933 any offers to sell securities must be either registered with the SEC or meet one of several exemptions. Many sponsors utilize Regulation D (Reg D) exemptions which include several rules to specify who can invest and how the sponsor can market to potential investors. The more broad the range of investors the syndication is open to the greater the regulations and disclosures are to "protect" such investors. This is why many syndication projects are only open to accredited or sometimes "sophisticated" investors.
Investing in Real Estate with your Self-Directed IRA
Although you probably won’t be presented with the idea by your average financial advisor, there are a lot of other assets outside of stocks, bonds, and mutual funds that you can invest your retirement accounts into. These “alternative assets” are things like precious metals, notes, oil and gas, private placements, and of course real estate. A self-directed IRA is really not that much different than a traditional IRA except the diversity of assets which you can invest in and some IRS rules you must comply with in order to keep your account from being disqualified as a tax-deferred account. Traditional IRA custodians (like Fidelity, Vanguard or the like) do not provide this option so you must utilize the services of a self-directed IRA custodian or administrator. Here is a link you can reference to a number of these companies to look into: https://www.biggerpockets.com/rei/self-directed-ira-real-estate/.
Like any retirement account, there are some strict IRS rules you must adhere to in order to keep your account from being disqualified as a tax-deferred plan. With self-directed investments in real estate in particular, one of the major restrictions is that the investment must be maintained as a passive investment, meaning you cannot manage or maintain the property yourself. For this reason, some people find it easiest to use their self-directed account to invest in things like real estate syndication or notes to make sure not to disqualify their investment by doing something inadvertently that could be considered “self-managing”. Another restriction is that your investment property cannot do business with any of your lineal relatives. For example, you could not rent out your property to your grandchild or parent. For a further list of things to avoid with a self-directed IRA check out this article: https://www.biggerpockets.com/renewsblog/2014/06/06/avoiding-fines-penalties-using-self-directed-ira/.
Custodians vary somewhat in the type of self-directed accounts they administer (Self-directed IRA, Solo 401k), their fee structures, and responsiveness among other things. Check out and talk to several to see which meets your needs for the particular type of investment you are considering. It is also advised to speak with your tax advisor before setting up a self-directed account to make sure you take all tax considerations into account before proceeding.