Real Estate Investing – An In-depth Guide
Why Real Estate?
Despite the fact that many financial advisors dislike the world of real estate investing, I am a big fan. I have a long history of investing in various types of real estate that includes everything from rental properties to timberlands. But why should we invest in real estate? What is the draw and what do we stand to gain?
There are several good reasons to invest in real estate but let’s keep it simple for the moment. The first reason to invest is that real estate typically increases in value. Average 20-year returns in the commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%. Residential and diversified real estate investments do a bit better, averaging 10.6%. Real estate investment trusts (REITs) perform best, with an average annual return of 11.8%.
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However, timing matters even in data collection. It would be pretty easy to pick an investment that outperformed over a given period. For example, I could pick arbitrary dates when a particular stock outperformed everything else and make it seem like a greater investment than it actually is. According to the Case-Shiller Housing Index, the average annualized rate of return for housing increased by 3.7% between 1928 and 2013. Stocks returned 9.5% annualized during the same time.
Since 1940, the median home value in the United States has increased at an annualized rate of 5.5%. But this is misleading. Homes are significantly larger today, on average, than they were back then. The average home in 1940 was 1,246 square feet, roughly half of the 2,430 average of 2010. Adjusting for home size, the annualized increase on a per-square-foot basis drops to 4.6%. After accounting for inflation, the average home value has risen by just 1.5% per year.
So the point I am making is this. We have just seen three drastically different rates of increase, 1.5%, 3.7%, and 9.5%. Which one is correct? Technically, they all are and that just goes to show that typically, real estate increases in value.
Real estate investments can provide cashflow that you can use before you are 59.5 years old. Why is that number so important? Well, if you’re using a 401(k) and investing the maximum amount into it each year, you’re probably not going to touch that money before you are 59 and a half. With real estate, we can have an income-producing property (rental homes, mining properties, etc,…) where we aren’t limited by that pre-59.5 phase.
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Properties Can Be Improved
This one should be a no-brainer with all of the home improvement shows on television these days. My wife loves to watch Chip and Joanna Gaines take these rundown houses and turn them into beautiful and functional homes. Real estate properties can be improved, thus increasing their value.
I was looking at investing in a rental property at one point and I went to look at the house with my wife, Emily. We walked up the drive to a beautifully picturesque exterior but when we went inside, oh my! This place could have been the set of a 1970’s sitcom. We kind of laughed about it but the place could have easily been improved with some modern renovations.
One thing to keep in mind, however, is that as the city grows, improvements may not always yield the top sales price. I have a client right now who purchased a property in the “country” area of Knoxville, but as the city has grown, that area is no longer in the country. As a result, the house is now sitting in a development zone and the price has waned. It’s value increased but with the changes to the city around it, the value has decreased drastically. So properties can be improved but it doesn’t always equate to top dollar.
Real estate can provide a variety of tax deductions if we invest in the right way. As long as you’re not investing in real estate through your IRA, you can use the deductions that real estate affords. If you’re paying a mortgage, the interest on the property can be deducted. Repairs, maintenance, even travel to and from the property can be used to lower your overall tax bill. This is one of my favorite things about investing in real estate. If I can legally give the government less of my hard-earned money, I am always for it.
Real Estate Is Depreciable
What this means is there is an income tax deduction that enables us to recover some of the cost of the property over time. This is basically a non-cash deduction that states that the property is less valuable tomorrow than it is today. If you have purchased a residential property, you can amortize that property over 27.5 years. A commercial property allows you to do so over a 39-year period.
For example, if you have a $100,000 property, you can divide that by 27.5 or 39, if it’s a commercial property, and that will give you your annual deduction amount.