(It’s that time again; time to be subjected to get to enjoy another rousing episode of Investing 101! In this edition, we’re going to look at one of the most commonly touted investments: real estate! There’s a good chance that might already have dipped your foot into real estate investing, by buying your own house in which to live. If not, or if you want to expand your horizons and become a real estate mogul, then the first step is start thinking of real estate as an investment.)
Q: Alright, what is real estate?
A: Real estate refers to land and the buildings that sit upon that land; they are real, physical property. In this way, it is distinguished from financial or paper assets like stocks and bonds. Real estate tends to be further divided into residential properties (where people live) and commercial properties (where stores or factories are located).
Q: Why should I invest in real estate?
A: There are several reasons why people choose to invest in real estate. Two of the biggest are for income and for capital appreciation. If you are investing for income, you would rent out the property for an amount higher than your monthly expenses, and pocket the difference. If you invest for capital appreciation, you would buy the property, hold it for a period of time, and then sell it for more than you initially paid. These two methods are not mutually exclusive; you can buy a property, rent it out for months, years, or even decades, and then sell it after it has appreciated in value.
In addition, there are some tax advantages to investing in real estate that are unavailable with other investments. The interest on a primary mortgage is tax deductible and when you sell your primary residence (one you have lived in for two of the past five years), you can pay no taxes on the first $250,000 for singles and first $500,000 for couples, subject to a few restrictions. Furthermore, if you sell a property and buy a similar property, you might be able to avoid paying capital gains taxes using a 1031 exchange.
Q: Sounds pretty good; but if I know you, there’s a catch hiding somewhere. What is it?
A: Well, there are some drawbacks to investing in real estate. First, because it is a ‘real’ investment, real estate requires care and maintenance; you need to either put your own efforts into caring for and improving your real estate investments or pay someone else to do it for you. Second, if you are renting out your propery for income, you will have to interact with your tenants on a regular basis and meet their needs and requirements (or again, pay part of the rental income to somone to take care of such issues). Finally, real estate tends to be both illiquid and local; if your town or region undergoes a downturn, it could prove hard to sell your real estate for a profit.
Q: What about leverage? Isn’t that an advantage of real estate investments?
A: Well, it’s certainly cited by many people, particularly real estate gurus, as a major advantage of investing in real estate. They claim (not without cause) that the leverage opportunities of real estate allow you to amplify your investments, But it isn’t that cut and dried; leverage could boost or hinder your returns, depending on how the investment fares.
If you put a smaller portion of your own money into the down payment, your returns will be amplified if the real estate appreciates in value. For example, having only $10,000 in a property that increases in value from $100,000 to $120,000 will give you a net profit of $20,000 a 200% return on your money (not including the transaction costs of buying and selling the property, of course). However, should the investment value drop, you could find yourself owing more in borrowed money than the house is worth (you would be underwater in your mortgage). So, if the property you had invested in decreased its value to $80,000, you would owe $10,000 more than you could get from selling the property.
Q: Alright, what advice do you have if I want to invest in real estate?
A: Firstly, befitting our last subject, try to limit the leverage you utilize with real estate investing. Typically, when you buy residential property, you only need to put down twenty percent of the purchase price; this is 5 to 1 leverage already, and anything more puts you at added risk if the market turns sour. Second, be willing and able to keep your property for a fairly long period of time (preferably a decade or more). That way, short term downturns won’t cause you to sell for a loss; over time, real estate values tend to keep even with inflation, slowly rising over time. Finally, considering using REITs to get your real estate allocation; they allow you to invest in real estate indirectly, benefiting from real estate investments without most of the hassle and trouble.
That concludes this edition of Investing 101. Turn in next time for more basic investment advice and helpful hints!