First things first…this exercise does not apply to your home. You need a place to live. Whether it turns into an investment or a liability is secondary.
Long-term returns in real estate have been less than flattering. For the 1890-2010 period, inflation adjusted home prices in these United States were essentially flat. Some areas have done better but other areas have done much, much worse. The long-term tracking of inflation is all you should count on with respect to price appreciation when investing in real estate. If you get anything on top of it, consider it a bonus. Yale professor, Robert Shiller, in his book “Irrational Exuberance”, contends that home buyers are typically influenced by comparing simple returns on real estate transactions. Assume that a home in 2005 sold for 10 times the price it sold for in 1945. While that produces a simple return of 900 percent, the real (inflation-adjusted) annualized return was less than 1 percent.
Nominal prices are before accounting for inflation. Real prices are after inflation prices.
Price appreciation is one thing but there are some other inherent advantages to investing in real estate if done methodically, some of which are listed below.
1. Leverage – or using Other People’s Money. OPM is many times touted as the single most important reason as to why investing in real estate might prove effective over the long term and that generally holds true. You put 25% of your own money down and borrow the rest and let the tenants pay off your note over time.
2. Mortgage interest deduction – mortgage interest is fully deductible against rental income. $10,000 in annual rental income and $10,000 in interest expense will cancel each other out with net rental income of zero dollars.
3. Property tax – 100% deductible against rental income.
4. Maintenance, repairs, HOA dues, insurance and other expenses – 100% deductible.
5. Depreciation – this is another big one. IRS allows you to depreciate the structure of the property (not land) fully and in equal amounts over 27 1/2 years for residential real estate investment. Assume that your acquisition cost for a rental property is $100,000 and out of that the estimated breakdown between the structure and the land is 70:30, that $70,000 / 27.5 = $2,545 can be taken as a depreciation expense against rental income every year for the next 27 1/2 years.
Even with all these benefits, investing in real estate is still not a complete slam-dunk. There is an opportunity cost of the capital invested in real estate and how that capital would have grown if invested in other alternatives. This is an exercise in how to go about doing a quick financial analysis of whether a certain real estate investment is suitable for your capital or are there other better alternatives.
So here it goes. We came across an investment property in Fremont, CA and were trying to decide whether to make an offer on it or not. It is a townhouse in a decent neighborhood, close to public transportation, major freeways, hospitals and all the other good stuff. The list price is $349,000 and assume we make an offer at that price. Some of the considerations used to form an investment thesis are listed below.
Also shown is a snapshot of the analysis.
What will the after-tax return be if this rental property is sold after 40 years? And what if we made an all cash offer instead of taking out a mortgage like what some folks are doing now. Here are the results.
The performance of the balanced fund, large cap equity fund and REIT are based on how they have performed over the past 40 years. The rental property transaction includes a 25% depreciation recapture tax for all the depreciation deductions taken over the years. This is a mandatory tax on investment real estate unless you do a 1031 exchange (for more info on this, Google it). And these calculations do not even account for the transaction costs associated with buying and selling this real estate.
Summarizing the results –
1. You could be about 50% wealthier by investing the down payment in one of the three investment options rather than buying this property. Even a REIT fund (gives you direct exposure to a broad basket of real estate related investments across the country) does better over time than investing in this property.
2. The power of leverage is evident when comparing the results of getting a mortgage versus making an all cash offer. You come in with four times the cash when making an all cash offer but the wealth you accumulate is only about 50% higher.
3. Investing the full purchase price of the property in one of the three investment choices would have knocked the socks off making an all cash offer for this rental property. You could be four times wealthier in these investments compared to buying this rental property with an all cash offer.
In conclusion, comparing all the efforts and hassles involved in owning and managing a rental property, the final wealth equation does not make this a very attractive investment proposition. We might have to pass on this one.
Next time you decide to buy a rental property, get a glass of wine, pull out a spreadsheet and get working.
Image credit – Alon, Flickr