Real estate is a great source of regular income, particularly because it often shares a low correlation with other forms of investment and, as a result, makes you resilient in the face of economic hardship.
Real estate can also function well as part of a longer-term investment strategy because it appreciates in value while allowing you to hedge against risk since equity can provide access to low-interest loans.
Real estate affords you access to a lot of tax benefits, which you can see when comparing tax returns from real estate income (particularly from single-family homes [SFH]) vs income from other revenue streams.
What you find is that real estate provides a more stable and greater return on investment (ROI)!
Revenue Inflows and Outflows
Your SFH will be a source of both revenue and cost items, which are also referred to as inflows and outflows, respectively.
What is an Inflow?
An inflow is cash you earn monthly from rent. In order to have a positive income stream the ratio of rent collected to purchase price has to be .8% at a minimum.
What is an Outflow?
As can be expected, you’ll have more outflows than inflows. They will include:
- Insurance: You’ll need insurance on your rental property. Your payments will depend on factors like location, year built, size, and services required (flood, sinkhole, radon, etc).
- Taxes: The taxes you have to pay on non-owner occupied units will vary from place to place.
- Vacancy: Every proper rental budget will factor in vacancies as an expense. Better to have it and not need it and need it and not have it!
- Repairs & Maintenance: This includes both regular duties such as seasonal gutter cleaning to one time big-item purchases like HVAC units.
- Turns: This refers to maintenance done in-between renters and is significant enough of an expense to warrant its own category. While varying between tenant to tenant, some expenses include deep-cleaning, re-painting, re-carpeting, etc.
- Property Management Fees: Expect to pay 6% to 10% of monthly connected rent on property management. While you may forgo property management if you have only a single property, managing multiple units is demanding enough of an endeavor that an outside provider is a good use of your money! After all, they’ll be handling everything from tenant interactions and emergencies to bookkeeping and repairs.
- Leasing Fees: To get tenants you’ll likely have to pay a fee to your real estate agent, which may fall between 50% and 100% of your first month’s rent.
Financing Your Rental Property
There are many different ways to finance your rental property.
Investment property loans from private lenders have stricter criteria because of the increased risk taken on by the institution. After all, if someone’s going to default on a property it’s more likely to be a rental property than a primary residence.
As a result, lenders will want a higher down payment, better credit score, a more in-depth look at your financial history, and may even demand that you have previous real estate experience.
However, the Federal Housing Administration (FHA) can help you secure funding that you may otherwise be unable to afford if you fall short of strict criteria. The downpayment on an FHA mortgage may be as low as 3.5% for a property with one to four units vs the 20% that a private lender may demand (or 25% on a property that’s 3 or 4 units).
Getting a loan with lower interest rates gives you what’s known as leverage, which is the term used when talking about the increased monthly revenue stream enjoyed when your monthly interest rate is lower simply because you’re keeping more of your money (while also building equity faster). Obviously, when your interest rate is greater than what you’re making from your property your financed returns are less. This is hard to sustain in the long term.
Tax Benefits for Real Estate Investment
There are two big ways in which the tax code makes real estate investment more manageable: depreciation and 1031 Exchanges. Depreciation is a tax deduction you take on a yearly basis to make owning and maintaining a property easier. Land does not count toward depreciation because maintenance is considered part and parcel of what owning land entails. So, before you calculate depreciation you have to subtract the cost of your land from the value of your property. Next, you divide the value of your rental asset by 27.5 years, which is the useful life of your property as deemed by the IRS (“useful life” is a technical term that describes how long you can expect to be able to generate positive income from your asset).
So, take your property’s cost basis, which is the amount you paid for it, and divide it by 27.5. That’s how much you’ll be able to deduct yearly. Now, if this math seems like a hassle and like you may want to forgo depreciation as a result, you should keep depreciation recapture in mind, which is a tax collected on depreciation when you sell your home at a rate of 25%. This tax is collected irrespective of whether or not you actually make use of depreciation! That means even if you don’t make that tax deduction that the IRS will treat you as you did, so you might as well do it!
Although, if you want to defer paying depreciation and capital gains taxes you can perform a 1031 exchange. That’s when you take the income from the sale of your rental property and use it to make a purchase of equal or greater value soon after. You can keep performing 1031 exchanges indefinitely. And if you die before putting an end to your run of 1031 exchanges, your heirs don’t have to pay the deferred taxes and get the property on a stepped-up basis, which means that they receive the asset as its value at the time of the previous owner’s death.
After-Tax Return ROI
So, let’s say your after-tax return ROI was 8.7% thanks to depreciation and a low-interest loan. To get a similar return on stock or bonds, you’d need to get a yield of 14.5% [if your tax rate is 40%]. To get that sort of ROI, you’d have to be making investments into either unrated bonds or bonds that are rated as very high risk!
Sure, there are risks and set-backs when investing in real estate. You may have to default on your mortgage if your property fails to generate enough income, which could happen for unexpected reasons like a community-wide economic hardship caused by the main industry in town vanishing. Real estate is also less liquid than stock and bonds, meaning that it takes greater effort to convert your asset into cash.
There are so many ways in which banks and the government are set up to help you invest in real estate that, when coupled with property management services, make real estate a great and accessible investment strategy for everyday people. You don’t have to be a market guru to make a buck, a profit, or a nest egg in real estate!