Investment property, or rental real estate, is considered by most investment brokers to be a cornerstone to a diversified investment strategy. But it typically is not a “get rich quick” type of investment. Sure, there are the stories out there of “flippers” buying foreclosures at the auction and turning them around and selling them a few months later for tens or even hundreds of thousands of dollars.
But those stories are in the minority, and most Americans’ real estate investment adds up to the equity they have in their home or previous home. Since the 2008 real estate crash, that equity has shrunk. Nevertheless, the soundness of real estate investing remains the same. A quick peruse of Forbes Top 100 reveals that these thoughts are shared by most of the world’s richest people.
Here is a simple example that illustrates the point. It’s called “other people’s money”.
Assume you purchase a home for $200,000. Say you put down 20%, or $40,000, and get a loan for the other $160,000. A year goes by and real estate in your area has appreciated 10%. At the end of one year your chunk of ground on Baltic Ave. or Boardwalk is now worth $220,000. Right?
Suppose for the sake of this example that after one year you decide to sell. Further suppose, for simplicity sake, that there are no real estate commissions or closing costs. So you sell the property for $220,000 and pay off your $160,000 loan. That leaves you with $60,000 gross profit on a $40,000 investment.
That, my friends, is called a 50% return on investment (ROI)! Even Wall Street can’t come close to matching those numbers. Not legally anyway! 🙂 For those of you doing the math at home, you can arrive at the ROI by multiplying the leverage factor ($40K out of $200K is a 5:1 leverage) by the market appreciation (10% in our example).
The savvy investor will immediately counter with: 1) no one holds real estate for just one year; 2) there is no guarantee of a 10% rise in real estate, and; 3) everybody knows that closing costs can be a significant part of any real estate transaction. And he would be perfectly correct on all three accounts. But let’s delve into each of these arguments a little further because they warrant further consideration.
1. Liquidity. You should not go into real estate with the idea of holding for one year and then selling. We’re not talking stocks here. Real estate is an illiquid investment and anyone who tells you otherwise is either lying or a foreclosure flipper. Real estate as an investment strategy is a long-term, “buy-and-hold” deal. We used one year in our example to prove a point. The reality is, just like most other investment, the gains compound over the years. The gains in subsequent years add on top of the gain this first year.
2. Guarantee. We can’t argue this one. There is no guarantee to this investment, or to life. A lot of people who bought in 2007 and 2008 at the height of the recent market found that lesson our the hard way. Markets go up and down. But if you are in it for the long haul then you have history on your side. Just as the Dow Jones Industrial has had recessions and depressions, over the long haul it has continued to go up. So if you stick with the buy-and-hold strategy then you’ll recover from a short-term loss.
3. Closing Costs. The effect of closing costs on a transaction decrease over time. In our example above after just one year a 6% real estate commission would reduce that $40,000 by $13,200. (Still not a bad profit!). But in 5 years if that property rises to, say, $250,000 then the $90,000 profit ($250K – $160K) is only reduced by $15,000. A bigger number to be sure, but a smaller percentage of the gross profit. And would anyone be crying over a $75,000 profit in 5 years?!!
This example is a very simplified example. The reality gets more complicated. For instance, we did not take into account the tax benefits that might accrue from depreciating real property. Nor did we account for the return on principal that occurs every month as a little bit of the principal of the mortgage is paid down. These secondary effects only add to the equation.
Peter Nelson is President of Full Service Property Management in Seattle, WA — a full service property management and real estate brokerage firm providing a fresh, rewarding approach to real property management. Their website has a wealth of information.