So You’re Thinking About Investing in Property

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With the excess supply of properties on the market and prices in decline, maybe you’re one of the lucky few who can turn lemons into lemonade by taking advantage of the housing market downturn. For example, maybe you’ve got a walletful of spare change and you’re thinking about buying an investment property to rent out.

Before you do, there are a few major things you should consider before taking the leap. First off, you’ll need to figure out how you’re going to finance the property.  Rhonda Porter put together a great piece on Financing an Investment Property, where she gives some good examples of the applicable loan rates that might apply to your investment property. For example, since investment properties are Non-Owner Occupied (NOO) dwellings, the interest rates will likely be higher than for Owner Occupied dwellings reflecting the higher risk of the investment property to the bank, even if the downpayment is higher than the standard 20%. Rhonda gives an example of a 30 year fixed mortgage on a $450,000 SFH with a minimum credit score of 720:

Owner Occupied with minimum 20% down:  5.75% priced with 1% origination/discount point (APR 5.904%)

Non-Owner Occupied (NOO) with 20% down: 6.375% with 1% point (APR 6.537%)

NOO with 25% down: 6.250% with 1% point (APR 6.413%)

NOO with 30% down: 6.125% with 1% point (APR 6.289%)

With financing and potential rental income in mind, you should also consider the planned time horizon of your investment. It generally takes time (lots) for real estate to appreciate beyond the transaction costs of buying and selling the property and you should also factor in taxes, insurance, and costs for repairs, maintenance, and even improvements during your holding period. For example, one new roof can easily suck up a year’s worth of appreciation, even in a good market. However, repairs are tax deductible in the year they are made and improvements are added to your tax basis, though you won’t realize the gains from these until you sell the property.

  • http://www.propertyinvestmentsecrets.co.uk/ property

    Thinking to invest in getting a property is always a good idea.Investing on property may some day help you in one or the other way.

  • http://www.teamreba.com/C_home.php Michael P Lindekugel

    I think some clarification is needed.

    “It generally takes time (lots) for real estate to appreciate beyond the transaction costs of buying and selling the property and you should also factor in taxes, insurance, and costs for repairs, maintenance, and even improvements during your holding period.”

    Historically, capital asset growth isn’t the main component of the yield. It is icing on the cake. Investment is about risk and the timing and the amount of the cash flows. Cash flow form operations will probably be the largest component of the investors yield. Occasionally, a property is forecasted to sell for a price equal to its acquisition cost. In essence, the asset lost value when inflation is considered. In hyper capital growth markets such as So Cal, FL, AZ, and to a small extent WA during this decade investors focused on capital asset growth or appreciation mostly because of media hype and gurus and not because of financial or economic fundamentals. And, of course, many people got burned similar to the internet bubble. Real property investment is not rocket science requiring the flavor of the month strategy. Business school fundamentals apply to real estate. Real estate is just another asset class with stocks, bonds, franchises, etc.

    “However, repairs are tax deductible in the year they are made and improvements are added to your tax basis, though you won’t realize the gains from these until you sell the property.”

    I am not real sure what this is supposed to mean. The taxpayer does realize a benefit from capital improvements long before the disposition of the asset. The cost of the capital improvements is added to the cost basis and depreciated over the remaining life of the real property providing a tax benefit each year. With property planning a tax loss with positive cash flow can result. Making repairs and improvements doesn’t necessarily guarantee more gain or a higher sales price upon disposition of the asset. Market fundamentals of supply and demand will determine the assets selling price. The taxpayers situation will determine any realized gain.

  • http://seattle.redfin.com/blog/author/katrina.munsell Katrina Munsell

    Thanks for all the detailed clarification, Michael. Hmmm, I’m not sure that I agree that asset growth isn’t the *main* component of the yield…Sure, it’s appreciation or cash flow or preferably both–that one really depends on what the individual’s investment goals are and time frame, etc, which is why careful analysis of what you are purchasing, the length of time you expect to keep the property, expected costs, etc. is crucial before making the investment. And, as you said, improvements, etc. aren’t much of a guarantee of higher price, etc.

    The tip about depreciation is also helpful. To clarify, I believe improvements are added to the amount paid for the property to determine your tax basis, so if you have a higher tax basis, you will pay taxes on a lower amount when you sell.

  • http://www.mortgageporter.com Rhonda Porter CMPS

    I am noticing more people sticking their toe in the investor waters. There does seem to be a difference than some of those I’ve seen over the past few years: these investors seem more cautious and more qualified.

    Katrina, thanks for helping to get my post and this information out to help consumers. :)

  • http://www.teamreba.com/C_home.php Michael P Lindekugel

    Capital asset growth is not the main component of the yield is a general statement about the historical real property returns. Real estate is very much a local economy as a result the yield components will vary with each MSA. The Puget Sound has experienced high but not hyper capital asset growth fueled by cheap credit, some misinformation, keeping up with the Joneses, many of the same drivers as the Internet bubble. Add a depressed rental market. The main component of yield in the Puget Sound is capital growth with negative cash flow from operations. Other MSAs such as Wichita, KS did not see hyper or high capital asset growth. The appreciation rate runs 1-3% points above inflation. Even with 10-12% vacancy in multi family property and very little capital asset growth, yields run 15-25% after tax outstripping expected returns in the Puget Sound. Wichita didn’t experience the demand pressures for investment property. Other MSAs have an even balance of capital asset growth and cash flow from operations. As mentioned in the comments, the main component of the yield can differ based on the investor’s goals. If the investor has $1M capital loss carry forwards, then acquiring real property in Wichita or a similar market probably makes very little sense. Highly appreciating speculative property can be systematically acquired and disposed for the gain to offset the capital loss carry forwards.

    Following Modern Portfolio Theory (MPT) and Dollar Cost Averaging (DCA), smart investors will diversify and invest on a regular schedule in several MSAs and real property types to hedge the inherent geographical economic risks. Investing in the Puget Sound has recently been characterized with high capital asset growth similar to Internet or tech stocks that pay no dividends and are probably operating in the red. (That worked well everyone in end. Not.) Investing in Wichita, KS or a similar market is characterized with a mature corporation that pays a lot of dividends from earnings and doesn’t increase in value at a fast rate. Forecasting cash flow from operations and dividends from earnings is far easier than forecasting capital asset growth which is more speculative.

    Many new or inexperienced real property investors think there are some magic and secret strategy or analysis techniques. Nope. Good old fashion finance, accounting and economic fundamentals apply to every asset class including real property. The financial statements are the same. The discounted cash flow analysis is the same. IRR is IRR.

    It is correct to say capital improvements are added to the cost basis of the property increasing the adjusted basis (cost basis less depreciation taken) which can lower taxable gain upon disposition of the real property asset Gain = Price – Adjusted Cost Basis. Currently, the capital gains rate is 15%. Keep in mind the component of the gain attributed to the depreciation recapture is taxed at a flat rate of 25%.

  • Looky Lou

    I make investments based on what makes sense. Total inflows must be greater than total outflows, no fancy terms needed.

  • Roland

    Michaels points are well taken. In my experience (10 years as a corporate banker and 15 years in private investment, include RRE & CRE), most people in the last few years have utterly failed to take into account the cost of risk. Michael says hedge geographically, which makes sense, but is hard for smaller investors to do.

    I stopped almost all new RE investments around 1997 because the cap rates actually realized, with reasonable vacancy rates etc, were going to hell. And it is exactly because people – amateurs – were willing to make a purchase predicated on the idea that they’d make a killing in appreciation.

    These people ruined much of the RE market for a long time, in lots of places. It’s just starting to get interesting again.

    The truth is, Lookly Lou, that 5 years ago, your “inflows outflows” method would net you exactly no deals, as most every deal I saw was being done at breakeven or a loss, since people figured they’d make it up in appreciation.

    The peak of this was those idiot “flippers” who would buy a property on credit figuring they could sell it at a gain after holding it for only a few months, hoping they wouldn’t have to make any or many payments as the deal was so underwater they couldn’t afford to hold it for long.

    The market may be approaching rationality again. Maybe. Seattle hasn’t taken a drubbing yet, but the LA market is looking more interesting today.

  • Michael P Lindekugel

    “Total inflows must be greater than total outflows, no fancy terms needed.” It is impossible to review only the cash flows of alternatives to derive the best investment. The sum of those cash flows gives you a net absolute number which is meaningless by itself. This approach doesn’t tell you anything about the rate of risk or return of capital and return on capital. The rate is the amount and timing of the cash flows. The rate or yield can be calculated using discounted cash flow techniques. The calculated yield of alternative investments can be compared to choose the best investment.

    Seattle is one of the top ten hottest markets for retail, office, industrial, and multifamily with record high sale prices, lease rates, and low vacancy. Those pressures are continuing to push or hold capitalization rates down. Less volatile markets can provide good investors returns at capitalization rates of 8-12%……Wichita, KS.

  • http://www.propertyinvestmentsecrets.co.uk/ Andy property

    Your site is providing a good guide line for investors.search for properties that are listed directly by the owners who want to avoid paying errand to the real estate brokers.