Years ago, I wrote a series of columns about investing in real estate. Since I’ve recently gotten questions on this topic, I thought I’d dust off the old columns and bring them out for an encore.
The most important question to start with is this: why should anyone invest in real estate? The answer: because it can pay handsomely.
Typically, most people begin their real estate investing by purchasing a new single-family home to live in and retain the older home as a rental, though there are several options, everything from duplexes, tri-plexes, and four-plexes to apartment complexes (residential properties with five or more residences), commercial real estate, raw land, limited partnerships, and notes secured by deeds of trust. In this column, I’ll talk about single-family homes.
Anytime you purchase a piece of property, whether you plan to live there or use it as an investment property, you’ll want to do your due diligence: complete all recommended inspections and listen to your Realtor’s advice.
When it comes to investing, lower-priced properties have a much better rent-to-price ratio. A $300,000 home will probably rent for $1,500/month, while a $750,000 home will likely rent for $3,000/month. In addition to a better rent (income)-to-price ratio, you’ll probably have shorter vacancies with a less expensive property. More people are in the market for a $1,500/month property than for a $3,000/month property.
Let’s use an example of a $300,000 house in good condition. You should anticipate expenses of 3-4 percent of the purchase price per year; that is $9,000 to $12,000 per year. This includes taxes, insurance, and maintenance costs. Taxes alone are about $3,500. Now, you won’t spend the additional $5,500 – $8,500 every year, but the year you need a new roof, new paint, and new carpet, you’ll make up for any money you didn’t spend in previous years.
On a $300,000 house with 20 percent down, your monthly payment will be about $1,180. I recommend you treat the expenses mentioned above as a monthly bill. Take $450 to $700 per month and put it in a savings account, so you’ve got the money you need when expenses come due.
On the upside, you’ll have depreciation (a non-cash expense) as a tax benefit. Depreciation is a bookkeeping expense that allows you to deduct the value of improvements over time. As long as you take good care of the property, it will last many years past the “depreciable” life. Consequently, depreciation is only a taxable expense, not a cash expense. This means, you have the ability to save on your income tax expense to the tune of $250-350 per month. This savings pretty much offsets your negative cash flow, and income tax savings is a cash savings. You can reduce your withholding or your quarterly tax payments to provide cash to deposit to your savings account for future property expenses.
So now you own a $300,000 rental property that takes no significant time to manage or maintain, and that has about a break-even cash flow. You invested $65,000 (a 20 percent down payment plus $5,000 in closing costs), and your benefit is the potential appreciation in the value of this property. If values rise at three percent a year (keep in mind they don’t always rise), that equates to $9,000 per year on a $300,000 house—that means you made $9,000 on a $65,000 investment or a 14 percent return. This is called leverage. Compared to other investment options, real estate looks pretty darn good!
In addition to the increased property value, rents also increase over time. And while expenses go up with inflation, your mortgage payment (your biggest expense) won’t go up over time. The bottom line is, if you can afford to buy a $300,000 rental today, by the time junior heads to college in 10-15 years, you should have an asset capable of paying for much of his education.
If you have questions about property management or real estate, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 40 years.