Video - Audio - YouTube
Dear Readers, we need to start with a disclaimer. Trying to teach or learn investing in real estate using a book or by taking a college class on investments or even a class dedicated to real estate, for that matter, is very difficult, if not impossible. It is similar to trying to teach someone how to drive without ever putting them behind the wheel of a car or teach someone how to swim without ever having them jump into the water. With stocks, bonds, and mutual funds, we can do most all the necessary research needed to identify, choose, and maintain our investments. We can even practice with simulated portfolios. You simply don’t have that ability with real estate. You must learn on the job. For that reason, we strongly recommend that if you are serious about becoming a real estate investor, work in the industry first. Working for a property management firm, an appraisal firm, escrow company, or title insurance company would allow you to see the real estate world from the inside out. When you do take the plunge, you will have your eyes wide open, a desirable advantage.
It is often claimed that real estate has created more millionaires in the United States than any other investment class. Whether or not this is true is debatable. However, it is certain that real estate investments can be very profitable or very disastrous. Why? It has to do with the way real estate investments are normally made. Do you remember the financial leverage that you get from buying stocks on margin? With real estate, the leverage is normally enormous. We also take a look at Real Estate Investment Trusts (REITs) which are vehicles that allow you to invest in real estate without having to have a large down payment or deal with toilet or tenant problems.
Direct Versus Indirect Real Estate Investments
There are two ways to invest in real estate, directly and indirectly. With direct real estate investments, as the investor, you hold the title to the property. Your name is on the public record down at the local municipality. Examples include your home, your vacation home, rental property, and undeveloped land. When individuals ask about investing in real estate, we often remind them that many people aspire to own their own home. When they do, they will have a real estate investment. Now it’s a home first, an investment second, in our humble opinion. But it does have one major advantage over securities. You will be able to live in your home. You can’t live in a stock, bond, or mutual fund!
Vacation homes have the similar benefits as your principal residence but the tax rules are different so please make sure you talk to a tax professional if you plan to use it more as an investment than a permanent vacation home that someday may become your principal residence upon retirement.
Rental property is a whole course unto itself, and as we mentioned above, is better taught or learned on the job. We will do our best to touch on the major areas of concern that a real estate investor must learn. However, as we have warned you, it is very difficult. The first foreboding omen is that lenders now typically want at least a 25% down payment for rental property. You may ask, “But what about this article on the Internet that says this 26-year-old built her real estate empire with no money down?” Well, what about her? Please read the article thoroughly and when they come to the part where they discuss exactly how said individual was able to pull off that spectacular stunt, copy down the steps they took carefully and send them to me, okay? I will wager real money that this individual did not build that empire in San Diego, California.
The largest gains from real estate come from developing undeveloped land. However, this type of investment poses enormous risks. However, it is best left to those who have many years of real estate experience. Your money is riding on a parcel of land that is not producing any cash flow while you still have to pay the property taxes. To make matters worse, there is often no guarantee that you will be able to develop the land either economically or politically. The old industry adage is, “Never invest in dirt.” Although there are always exceptions to every rule, please don’t make undeveloped land your first real estate investment.
With indirect real estate investments, someone else is in control of the real estate. Your name is not on the title. The largest examples of indirect real estate investments are Real Estate Investment Trusts, also known as REITs. We will discuss REITs in more detail at the end of this chapter. Other types of indirect real estate investment are real estate syndicates and Limited Liability Partnerships (LLPs). These investment choices were hurt by the 1986 tax reform bill. Both real estate syndicates and limited partnerships are complicated and not typically used by retail investors. But what the law taketh, the law giveth. Also in the 1986 tax reform bill was the creation of low-income housing tax credits. These tax credits may be very valuable to high-net-worth and high-income investors and are not usually beneficial to the majority of us investors.
Two investment choices are a blend of direct and indirect real estate investing are equity sharing and investing in first and second trust deed mortgages. With equity sharing, you as the investor provide the down payment for someone else and then share in the appreciation. This type of arrangement is typical within a family where the young adults don’t have the necessary down payment. The parents or grandparents can provide the down payment. However, it doesn’t have to be a familial relationship. An investor can pair with a couple or a single person who wants to buy a house but does not have the down payment. In any event, talk to a competent real estate lawyer who will draft the equity sharing agreement. Don’t try to create the agreement alone!
Investing in first and second mortgages is not an equity position. You play the part of the bank or credit union and are selling a mortgage to the individual or couple who want to buy a home. In some ways, this is similar to investing in bonds, junk bonds. These types of loans are called hard money. They are typically short-term loans, up to three years, but can also be long-term loans. The individual or couple looking to purchase a home cannot get a loan from a bank or credit union. This should tell you something about the risks involved in lending to these individuals. However, because the loan is based on the home, a hard money lender does have the ability to foreclose on the property. Suffice to say, hard money loans are not for the typical risk-averse lender looking for investment-grade bonds.
That is not to say that there aren’t reputable companies that deal in hard money loans. In San Diego, we are fortunate to have one such lender, Federal Home Loans. Your Humble Author was asked to accompany a friend to their presentation. Suffice to say, I was very skeptical at first. After the presentation, my first question was, “May we ask what your default rate is?” It turned out at the time that 1% were in default and another 1% were having troubles but expected to pull through. Those were not bad numbers, especially considering these lenders were receiving typically 10% to 11% from their customers. One of the representatives of Federal Home Loans, Joanna Rivera-Ortega, has spoken to our Investment Club a couple of times.
Residential and Commercial Investment Property
Most individuals are vaguely aware of the prices of residential properties such as condos, single family dwellings, and duplexes in their area. If those prices give you chills, just wait until you investigate the prices of commercial rental property. Commercial rental property includes hotels, office buildings, stores, and many other types of commercial establishments. The typical investor who wants to get started can think of duplexes or small apartment buildings as commercial property but these are still residential properties. In many areas of the country, San Diego included, residential rental property is simply out of the reach of the average investor. Although difficult to comprehend for average investor, commercial property is many times more expensive.
The rule of thumb for both residential and commercial real estate investments is to search for a price that is equal to seven to ten times the annual rental stream of income. In several parts of the country, that is simply not attainable. Do not be surprised if you are looking at negative cash flow for several years. The 2008/2009 turmoil changed the investing landscape for real estate for several years. But now prices in San Diego are untouchable again for the majority of investors. For the readers in our area, if you are so inclined, the South Bay is where the bargains are now.
Who doesn’t want a bargain? If you are handy with home repair and maintenance, a fixer-upper might just be the best way to begin building your real estate empire. Concentrate on smaller properties first. One strategy is to buy a duplex or triplex and live in one of the units. That way, you will know if any tenants are having wild parties at 2 am in the morning. Seek out low down payments and seller financing of rundown properties. The seller may just want to rid themselves of the chore of being a landlord and are now looking for another way to keep the steady stream of income that they enjoyed from the rent. Again, use the services of a competent real estate attorney to ensure that all the documentation is correct.
One issue with rundown properties is that banks and credit unions usually do not want to loan to distressed properties. However, the banks and credit unions are usually more motivated to finance a rundown foreclosure on their books. Our area of San Diego, California, is a very difficult area to search for foreclosures. We have some of the most savvy and aggressive real estate investors found anywhere. In any event, no matter where you are, do not expect your sojourn into flipping homes to be anything like the reality television shows.
One last strategy is to avoid property managers. This is not to say that some investors may not want to take advantage of the services of a competent and reputable property manager. The hard truth is that nobody cares about your property as much as you do and the typical fee for a property management firm is 10% of the rent. Keep in mind, though, that landlords must be savvy dealing with a toilet and dealing with a tenant. If you are not handy dealing with both, then a property management firm might be worth the expense.
Advantages and Disadvantages of Real Estate Investments
Real estate has traditionally been one of the best protections against inflation. Real estate also benefits from a liberal amount of financial leverage, the use of borrowed funds for investment purposes allows you to acquire a more expensive property than you could own on your own. It is very unusual for investors to pay cash for their real estate investments. But as we saw with buying on margin, leveraging can magnify our returns but also magnify our losses. We will take a close look at this phenomenon soon.
For indirect real estate investments such as Limited Liability Partnerships (LLPs) and Real Estate Investment Trusts (REITs), there are no management concerns. Both LLPs and REITs allow for much easier entry than direct real estate investments. REITs allow for easy exit as they trade like stocks and the liquidity is similar to stocks. Finding someone to purchase your LLP can be more difficult hence LLPs can exhibit liquidity risk.
One of the major advantages of real estate used to be that you just couldn’t check the prices of your real estate investments every day as stock investors could. Thanks ‒ or should we say, no thanks ‒ to websites such as Zillow and Trulia, now we can. This is unfortunate as real estate transactions are simply not as numerous as stock transactions so the predictive pricing of these websites is very unreliable and fretting over your investment prices day to day is simply unproductive and can wind up being counterproductive, especially if our emotions get the best of us when markets are falling.
What are the disadvantages? Real estate is the poster child for poor liquidity. Real estate transactions can take months. A thirty-day or less transaction is very uncommon. Also, it may be difficult to even find a buyer for your property or your share of a partnership. Liquidity is not a problem for Real Estate Investment Trusts (REITs) as they are traded on the major exchanges like stocks. When an individual begins investing in real estate, there is a lack of diversification and often everything is dependent upon one property. However, REITs and partnerships do offer diversification. For the real estate syndicates, the passive tax shelter provision in the tax code can be problematic.
The most discussed problems with real estate center around management or tenant problems. Landlords love to get together and relate horror stories to one another or to just anyone who is sympathetic enough to listen about the tenants from Hell. Remember, with real estate, the PITA factor goes through the roof. Although real estate prices have generally risen over decades as the global economy has risen, there are times when property values can decline. During the real estate bubble of the mid-2000’s, excited new real estate investors and even real estate professionals who should have known better were saying that real estate never goes down. These people obviously had not looked at the historical record.
Allow me to relate a story from that time period, it was mid-2006 and our brokerage firm had been offered the ability to engage as mortgage brokers. We now could jump into the mortgage business. Hey, why not? Mortgage brokers were making two or three times what stockbrokers were making at the time. We were invited to a seminar to discuss real estate investing and our newly acquired mortgage products. One of the panel discussions was about whether or not there was a real estate bubble and the panelists were first asked to give their brief comments on the market before being open to questions. The first panelist started his comments with, “Bubble? What bubble?”
That sealed it for me. Although I was already sure that the housing market had entered mania/bubble territory, these events convinced me. We were stockbrokers and we were being pulled into the latest money maelstrom in an area where we had no expertise. Real estate experts were convinced that, “It’s a New Era. It’s Different This Time. Quick! They are giving away free money! Buy a home now and in three years, it will be worth hundreds of thousands more!” Individuals who couldn’t afford $500,000 mortgages were lying about their income and given adjustable rate mortgages with the ability to pay half the monthly payment that conventional mortgages would charge, but only for the first year or two. Then, the payments escalated dramatically. “What are you worried about? In three years, when you can’t afford the payments, your house will be worth $850,000! You can sell. Or we can just refinance with another adjustable rate mortgage!”
For me, this all meant that it was only a matter of time. We didn’t know how long it would last but we knew there would be dead bodies piled up when it did end. However, personally, I was not anywhere near as pessimistic as I should have been. I thought real estate prices would fall around 20% to 25% and that the economy and the stock market would not be overly affected. Real estate and stock prices fell over 50% or more and we entered into the worst economic downturn since the Great Depression. The question for us now in 2022 is how much damage will the cryptocurrency/NFT mania do. Again, I may be too optimistic, but I don’t believe it will damage the economy as much as the real estate bubble of the mid-2000’s. Stay tuned.
However, by far, the biggest disadvantage to real estate investing is realizing the down payment. As mentioned, lenders typically want at least a 25% down payment for investment property. Let’s say that in your area, you can find a duplex for $400,000. This means that the lender will want a $100,000 down payment. You will also need several thousand dollars for assorted closing costs. How many individuals have approximately $110,000 lying about the house? This brings us back to the ubiquitous claims on the Internet about people starting their real estate investment empire with no money down. Again, please investigate these claims and when you find how to do it, either please tell the rest of us or, better yet, keep it a secret and duplicate their success on your own. The nagging question for me is that if anyone really is doing this, why would they tell others how to do it, too? My guess is they want you to enroll in their sure-fire, guaranteed, 5-day, $2,995 seminar on how to invest in real estate with no money down! (I’m not cynical, am I?)
Your Home as an Investment
For the typical individual or couple homeowners, their home is their major asset. Your home offers a hedge against inflation and functions as one piece of your overall diversified investment portfolio assuming that you are investing in stocks and bonds through individual choices or mutual funds. Traditionally, a home produces an after-inflation return of about 2.5 percent a year although in some areas, the return has been much higher. There are also generous tax benefits for homeowners. Along with the ability to itemize deductions on your yearly income tax returns, every two years, you can sell your principal residence and claim $250,000 capital gains tax-free for single people and $500,000 capital gains tax-free for married couples. However, it is a home first, an investment second, in the opinion of Your Humble Author. And unlike stocks, bonds, and mutual funds, you get to live in your home.
“My house is the best investment I have ever made!” is what you often hear from individuals when you find yourself in a discussion about investments. However, when you question them further, you will typically hear, “Of course, it is pretty much the only investment that I have ever made, except for that penny stock my brother-in-law, the ex-stockbroker, conned me into buying but those shares are worthless now. And those gold coins I bought back when the first Gulf War started back in ’91. What did I do with those things, anyway?” Again, in my humble opinion, a house is a home first, an investment second.
“But what about San Diego?!” is another question you will get when discussing real estate as an investment here in our little corner of the world. It is not a secret that California has a housing supply and demand imbalance. However, prices in San Diego have gone down in the past. Ask those who bought in 1990 and then sold in 1993 and saw their prices go down 20% to 25%. Or ask those who in 2007 bought that condo that wasn’t even finished being built yet thinking they would “flip it” before it was time to move in only to watch the price fall over 50% over the next two years. The cycle will repeat. Real estate prices will go down again sometime in the future even though prices are currently skyrocketing. But if you plan on staying here, by all means, buy whatever you can afford. San Ysidro and National City are two of the best values in the region, by the way. Imperial Beach is also a great beach value.
Here is a sign seen over a desk in a San Diego office, circa 1993, after the boom of 1980’s had turned to a bust in 1991 and 1992: “Please, God, let there be another real estate boom and I promise I won’t piss it all away this time!” What do you think? Did they piss it all away in 2006 and 2007?
When I would point out in 2006 and 2007 that real estate was in a bubble, people would respond, “C’mon, Paiano, admit it! Real estate is the ‘Perfect Investment!’ Look at what has happened in the past five years!” Do you remember the warning from Andrew Tobias, “Beware the Permanent Trend?” There ain’t no such thing! But assuming they were able to hold on through the turmoil, even those who bought during the bubble of the mid-2000’s eventually turned a profit. If you plan to hold for the long-term, you should do well. It is not as if real estate in San Diego is becoming less desirable. By the way, there is no “Perfect Investment.” Folks were saying the same things back in 1999 about stocks and they are saying the same things about cryptocurrencies and NFTs now.
Financial Leverage using Real Estate
“But what about leverage?! Huh? What about the ability to make money with other people’s money? Isn’t that what makes real estate such a great investment?” We have already touched on that aspect of real estate investing, haven’t we? Yes, leverage can magnify your real estate investment returns many fold. However, what leverage giveth, leverage taketh away. There are pitfalls. Just as with buying stocks on margin, leveraging real estate magnifies your gains and magnifies your losses.
The following two problems are from a financial planning and money management textbook from around late 2004. We will see that even college textbook authors can get caught up in the emotions of a bubble.
Calculating the Return on Investment. Dave bought a rental property for $200,000 cash. One year later, he sold it for $240,000. What was the return on his $200,000 investment?
Calculating the Return on Investment using Financial Leverage. Suppose Dave invested only $20,000 of his own money and borrowed $180,000 (90% financing). What was his return on investment?
In the first problem, the hero of our story, Dave, bought a $200,000 house with cash. When the price jumped 20% in one year, as housing prices were doing during the mid-2000’s, Dave made 20% on his $200,000 investment for an absolute return of $40,000. In the second problem, however, Dave only had to come up with $20,000, 10% of the purchase price. He financed the rest, $180,000. This time, when the price jumped 20%, he made $40,000 on a $20,000 investment. That’s a 200% return on his investment. That is leverage in action! “Quick! Go buy a condo! They are giving away free money! That idiot down the street just made $40,000 in one year and he only had to come up with the $20,000 down payment. Yeah, go ahead, burn your credit cards. They are only charging 25% per year.”
Do you remember the quote from J. P. Morgan, “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.” He was right. Let’s take a look at a question that was conveniently left out of the textbook because everyone, including the author of the financial planning money management textbook, believed that housing prices would never go down.
Calculating the Return on Investment using Financial Leverage and things do not go as planned. Suppose Dave invested only $20,000 of his own money and borrowed $180,000 (90% financing) … and the property value went down 20%. Now the most important question is, “What is he going to tell his wife?”
Because he leveraged the property, instead of losing 20% on his investment, he lost his entire down payment investment and still owes $20,000 more than the house is worth because the loan is $180,000 and the current market price is only $160,000. The bank won’t let him sell the house ‒ they won’t “release the title” ‒ without Dave paying them the entire loan amount of $180,000 first. He has negative equity. He is underwater. He joined hundreds of thousands of other speculators who bet the farm ‒ bet the house? ‒ and lost everything. Friends and family would ask me how I was doing during the crisis and I would say, “Well, I am not happy about losing 40%. But I sure do feel sorry for those real estate speculators who lost everything and still owe tens of thousands or even hundreds of thousands of dollars.”
Many tens of thousands of real estate speculators simply walked away from their house or went through bankruptcy or foreclosure. Some were able to negotiate a “short sale” with the bank. In the example above, if Dave were able to negotiate a short sale with his bank, the bank would allow the house to be sold for $160,000 and forgive the extra $20,000 of the loan. Along with losing his entire investment, his credit score would be damaged, but that’s not the worst part. The IRS treats a forgiven loan as income. Dave would have to pay taxes on $20,000 that he did not receive! Talk about kicking a guy when he is down! Luckily for the tens of thousands who negotiated short sales during the Great Recession, the United States Congress waived this IRS rule until 2013.
As we saw with buying on margin, leverage can magnify your gains and magnify your losses.
Real Estate and Capital Gains
“Wait a minute. Did you say that there are no capital gains taxes on real estate?” Currently, as the law stands now, as long as the real estate is your primary residence for 2 out of the last 5 years, you pay no capital gains on the first $250,000 if you are single or $500,000 if you are married. In some parts of the country where there are many distressed houses, this is an excellent strategy for those who are handy with house repairs. You can fix up a property and sell it every two years and pay no capital gains taxes on the sale. Buy your home for $200,000. Sell it for $700,000. If you are married, then you pay Federal no capital gains taxes! By the way, capital losses on your primary residence are not tax-deductible.
Have you seen the ads? “Start your real estate empire with No Money Down! You, too, can take advantage of the tremendous opportunities now in the wide-open Real Estate Foreclosure Market! Just buy our Guaranteed, Sure-Fire Real Estate Investment Kit for $3,995. You will be on your way toward Riches beyond your Wildest Dreams!” You think I am exaggerating. Here is a reality television actor who wants you to pony up $34,000 to learn how to flip houses in your spare time and earn $70,000 or $80,000 per year, more if you decide to do it full time.
What is the bottom line on direct real estate investing? Buy a house. Make it your home. After you have digested that purchase, then look for some rental property. But learn as much as you can from the folks who are already doing it, maybe even working for a property manager or other type of company involved in real estate to get the feel for what you will need to be able to do. We wish you the best of luck. Remember, that although real estate investing can be profitable, the PITA factor is very, very high. You will earn every penny!
Real Estate Investment Trusts (REITs)
Okay, let’s say that you don’t want all the headaches that come with owning real estate investment properties. No problem! One of the easiest ways to invest in real estate without all the accompanying hard work is to invest in Real Estate Investment Trusts, commonly abbreviated as REITs. Real Estate Investment Trusts are “pass-through” investments that hold real estate properties and pass through the rent and any capital gains to the investors. In this way, they are very similar to closed end mutual funds. REITs typically own shopping centers, office buildings, warehouses, and apartment complexes.
The managers of the REITs find the tenants, manage and maintain the properties, collect the rent, and pass the earnings on to you. By law, they must distribute 90% of their earnings to shareholders. They legally are not stocks but for all practical purposes appear to investors as if they were stocks. They are traded on the exchanges and their liquidity is very similar to stocks. There is one major difference between REITs and stocks with regard to taxes. The dividends from REITs are not given the same tax preference that dividends from stocks receive. Dividends from REITs are taxed as income whereas dividends from stocks are taxes as capital gains, a much lower rate for most investors.
Similar to mutual funds, the management fees for REITs typically range between 1% and 2% per year. Their returns over the long-term are approximately 7% to 8%. Although not quite as diverse as stocks, there is a wide range of different types of REITs. There are also sector mutual funds that are dedicated to REITs. You can have someone choose and maintain your REIT investments as the REIT managers choose and maintain your real estate investments, both charging their annual operating expenses, of course.