by Graham Updegrove
Ever since I was a child, I wanted to own real estate. Why? Because it is the single best way to generate significant wealth in life. With wealth comes financial freedom and the ability to live life the way you want to live it – without the need to ask your boss for time off, or living paycheck to paycheck. In my early 20’s, I still wanted to own real estate but didn’t have enough income to get the financing I needed. I didn’t let that stop me and found a business partner who wanted passive income and brought in a majority of the funds needed, whereas I was in charge of acquiring, renovating and managing the real estate. Fast forward a few years and we now manage a handful of rental properties which have increased substantially in value while also providing positive cash flow and tax benefits. I realize investing in California and especially San Luis Obispo County can be difficult, but feel it is important to understand the pros and cons of real estate investing. It’s not for everyone, but for me, it’s something I know and love.
Predictability: When looking at a potential real estate investment, the stream of income it generates provides an expected return on investment with high accuracy. You should have a good idea of what that property can be leased for, if any repairs or expenditures will be required, and the total cash needed to purchase the property. With a lease in place, you know the rental income that will be received versus the constant up and downs of the stock market.
Leverage: Financial leverage is a powerful tool in real estate investing. Leverage means borrowing money to fund your purchase, which allows you to buy a much larger investment than if you had to pay 100% of the purchase price upfront. Using other people’s money (OPM) to finance a purchase can help increase the return on investment of your rental real estate.
Cash Flow: If purchased and managed properly, your real estate investment can offer a great opportunity for a monthly profit. Positive cash flow (income exceeding expenses) is the goal of many investors as the real estate investment provides what equates to a monthly dividend, that can be used for living expenses or further investments.
Control: The stock market fluctuates daily based on quarterly earnings, new regulations and global politics, none of which you can control. But, you can control your real estate holdings by changing the amount you charge for rent, whether and when you make improvements to the property and using the property as a fallback if you need to move in to it.
Tax Benefits: Real estate investments offer tax benefits not found elsewhere and on tax returns, real estate investments are reported on a Schedule E which details the income and expenses related to a property. An investor can deduct the following on their taxes: depreciation on the value of improvements over 27.5 years (residential) or 39 years (commercial), interest paid on the mortgage, property taxes, insurance, repairs and other expenses related to the property. This combination of tax benefits has the potential to reduce your taxable income by thousands of dollars.
Appreciation: Real estate investing is not typically a short term plan and when underwriting a deal, I often recommend leaving out potential appreciation from any analysis of a property’s return on investment. In my mind, appreciation is icing on the cake. That being said, most investors understand that over the long term, real estate should appreciate, even if that appreciation rate is minimal.
Tenants: When in the business of real estate investing, there is always a risk that your tenants could cause more problems than the rental income is worth. You may have to answer a phone call in the middle of the night or resolve issues when tenants are complying with terms of your lease. Having a strong tenant screening policy in place should help reduce the chance of this occurring.
Maintenance: Wear and tear to a property is inevitable, especially with tenants who seldom care as much about your property as you do. Occasional repairs or upgrades should be an expected part of your rental business and sticking to an annual maintenance checklist will help you tackle small maintenance items before they become more costly or time consuming. Building connections with trusted service providers (plumber, handyman, electrician) will also streamline any necessary repairs.
Financing: Securing financing can be difficult as most lenders require a 25% downpayment on the purchase of investment real estate. Furthermore, the debt you take on will show up on your credit report and could result in a reduced ability to obtain other credit. While mortgage debt can be good leverage, it also creates a liability that you will need to pay off over the years or by selling the property.
Illiquidity: Real estate is not a liquid asset, meaning a property can not be sold within a day’s time like a stock. When contemplating a sale, most sellers will need to provide their tenant notice, potentially make repairs and market the property before agreeing to a contract, which initiates a typical 30-45 day escrow process. If you need a high level of liquidity, real estate investing may not be the right option for you.
V&C Loss: Vacancy and collection loss are generally part of an investor’s analysis when underwriting a property’s potential. In residential real estate, vacancies can typically be filled quickly, minimizing any loss of rental income, however commercial spaces can take a much longer time to lease. Additionally, there may be scenarios where it is unlikely to collect monies owed from a tenant. During that loss of income, expenses may become difficult to pay if not properly prepared for. While no landlord enjoys evicting a tenant, that lost income is a risk to owning property as evictions can be costly and time consuming.
*Disclaimer – This is not intended as legal or tax advice, but simply as an overview of some risks and rewards to owning investment real estate. Always consult with a trusted professional if you have questions.