The Landlord's Financial Tool Kit / Edition 1 available in Paperback
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The Landlord's Financial Tool Kit
By Michael C. Thomsett
AMACOM BooksCopyright © 2005 Michael C. Thomsett
All right reserved.
Chapter OneThe Nature of Real Estate Investing
Real estate is the most consistently profitable investment choice you can make. As long as you research ahead of time, know your market, and pick specific properties carefully, your investment should grow over time.
Most people start out with residential property investments. A single-family house or small multi-unit property (two to four units) is manageable and affordable, and you can always step up from there to buy additional properties or exchange your initial investment for larger ones. To get started, you want to define what you hope to achieve by purchasing real estate. Property is far more expensive than most other investments, so you will be making a commitment in most cases to a mortgage. The majority of investment value will consist of borrowed money, so you will be depending on rental income to make your investment affordable. Given the potential affordability of real estate (with tenants essentially covering your mortgage payment for you), the consistent historical growth of real estate values, and the exceptionally good tax advantages, the benefits of real estate investing are significant.
An Overview of the Market
Since residential property is, by far, the most common real estate investment, we provide examples of housing as a primary emphasis in this book. Other choices (e.g., raw land speculation, commercial and industrial properties) are much more advanced and beyond the interest of most investors.
The residential housing market can be easily studied in any given area. You can readily find information about the local population, employment, rental occupancy and vacancy rates, and level of new construction under way. These factors add up to the supply and demand for real estate in your city or town. This, then, is the logical starting point if you are thinking of investing in real estate.
Key Point: Information about local supply and demand for rental property can be found through local real estate brokers, appraisers, and bankers. Multiple Listing Service (MLS) publications also provide detailed information about property pricing and trends.
Supply and Demand
The supply and demand for residential property involves two separate markets. One is the market price trends of housing, and the other is demand for rental units. The first can be evaluated in terms of how prices are changing over time. Are houses selling for more this year than last year? What is the percentage of growth?
Housing prices have consistently beaten inflation over many years, putting housing among the strongest growth investments. Assuming, of course, that you've selected property on the basis of good research and sound market analysis, you can expect real estate to be less volatile than the stock market, consistent in its growth rate, and safer by far than other alternatives. In some areas, prices have remained flat or even declined, so using national averages is not a safe way to pick a market. You need to check the regional trend to ensure that real estate in your town represents a viable investment. In areas where employment is strong and the population is growing, real estate values tend to grow as well.
Market value of property is only the first of two important "markets" in real estate. The second market involves demand for rentals. What is the average vacancy level? A very low vacancy rate is a positive sign, but a fluctuating or high vacancy indicates that there is more supply than demand. If that is the case, then the timing would not be good for investment, at least not right in your city.
Key Point: These supply and demand features of real estate are going to vary from one location to the next, often drastically. The next town over may have vastly different real estate features, and even within one city, the supply and demand can (and does) vary from one area to the next. It is essential to understand the population, employment, market value, and vacancy trends-in advance of committing your money.
The Basic Equation
More details on these investigative ideas are covered in later chapters. As an overview, however, this is an important starting point. The short-term market attributes of rental property are going to affect how well you can afford to invest money now. The whole market is likely to look different in a few years, but you want to make sure you have a reasonable expectation of keeping tenants in the property each month. The equation worth keeping in mind is a balance between how much money you receive (in rent) and how much you have to pay out (in mortgage payments and expenses). For that equation to work, you want to keep the property occupied as consistently as possible. Any time the property is vacant represents lost income, but your mortgage payment continues from month to month.
A Landlord's Point of View
The market for residential real estate is not difficult for most of us to understand. Anyone who owns his or her own home knows all about mortgage payments and the importance of being able to afford the house. Anyone who has not yet bought his or her own home knows that landlords expect rent to be paid on time. So the basic economics of real estate are familiar to everyone and are not as mysterious as the market forces at work in other markets, such as the stock market.
In evaluating investments, though, you need to look at properties from a different perspective. When you are shopping for your primary residence, you are interested in comfort features, condition, and size of the property. As a landlord, you might be willing to invest in a property that would not interest you as a primary residence, but that is ideally suited for rental purposes.
Example: You have a growing family and need a house with several bedrooms for your own use. However, you have discovered that relatively small houses make excellent rentals. A two-bedroom house in modest condition is relatively inexpensive compared to other types of properties, and easy to keep occupied. A married couple or single person is drawn to such rentals and can afford what you will need to ask in rent, so such properties are easier to keep occupied than more expensive, larger homes would be.
In this example, your revaluation of the market would be made with rental income and payments in mind, rather than from the point of view of a homeowner. The investment attributes of your decision are going to be far different from your personal requirements.
Key Point: When you search for investment properties, your criteria are far different from what they are for your primary residence-an important distinction to keep in mind.
The real estate market has grown in value consistently over time. This is a national average, of course, and all real estate is local. This means that it is essential to understand the local features of supply and demand before investing. You cannot depend on national averages or even on local trends for the long term. If local property grows in value over fifteen or twenty years in the future, that is a promising feature. At the same time, you need to ensure that rental demand is strong right now, in order to cover your mortgage payments. As you look for potential rental investments, you should be interested in locating properties that are affordable, are most likely to maintain value (and grow in value), and are appealing to likely tenants.
Reasons to Invest in Real Estate
There are many good reasons to buy real estate. Among the most important reasons-assuming the local market conditions make it a viable choice- are the following:
* Diversification and Asset Allocation. Sound investment requires spreading capital over dissimilar investments. You would not want to put all of your capital into a low-yielding savings account, or a single stock, or real estate. You are better off diversifying your capital. You may wonder: If real estate is sure to grow over time, why not put all of your money into rentals? Diversification is important because different investments have different attributes. The stock market is volatile and you can make or lose money quickly; however, your money can be invested or taken out quickly. Savings accounts are very safe but yield very little. Well-selected real estate is going to increase in value over time, but it is very difficult to get your money out if you need it for an emergency. You need to diversify your capital so that you have some funds available as you need them, some funds in very safe investments, and some in investments likely to grow over time.
A somewhat more sophisticated view of diversification is called asset allocation. This is a strategic planning technique in which a portfolio is spread among many different markets or segments. While diversification usually refers to spreading risks within one market (e.g., buying many different stocks), asset allocation is broader. For example, you may want to have some money in ready-cash accounts as an emergency reserve fund; other capital invested in stocks, whether owned directly or purchased through a mutual fund; and yet more of your capital invested in real estate. These three markets represent completely different markets, and each is going to perform according to very different market forces.
Real estate is a superb market for asset allocation because of its strong historic attributes. Your ability to allocate capital among dissimilar markets protects your capital from cyclical changes. In times when the stock market is weak or falling, real estate may be strong. In fact, it is likely. We have seen the offsetting effects of stocks and real estate time and again. When investors want to take money out of the market, they will normally turn to either money markets or real estate. Money markets or savings accounts, for example, are not suitable alternatives if interest rates are low. By contrast, real estate benefits from low interest rates, so it is an excellent market for onetime stock investment capital.
Diversification within a single market, and asset allocation among many different markets, are sensible portfolio management techniques. Real estate is a good fit for strategic asset allocation. It is different from the money market, however. Investors wanting to get out of stocks for the moment, but who plan to go back in a few months later, may park capital in an interest-bearing account and move it around without charge. Real estate is a longer-term investment, though. So if you plan to employ real estate in your asset allocation plan, it should be treated as a longer-term decision. You do not want to buy real estate in March and then look to sell in June to put capital back in the stock market. That would be expensive and, given closing-cost levels, a difficult move to make profitably.
* Long-Term Growth. A second reason to buy real estate is for long-term growth. You can expect real estate to increase in value over ten, twenty, or thirty years. By holding property over that much time, you build wealth for your own retirement, for college education expenses for your children, or for more leisurely living later on. Individual goals dictate how important it will be to accumulate wealth through real estate. Just as different stock market investors will be drawn to short-term speculation in some cases and long-term growth in others, your personal goals and requirements will dictate how you use your investment capital. For long-term growth, real estate has performed historically far above the growth rates of other investments.
* Safety of Capital. Real estate is a safe place to invest your money because it is well protected. You carry insurance to protect against losses from fire and other catastrophes, so if such a loss does occur, you are protected. Maintaining condition also protects long-term value, so you must keep an eye on your property on a regular basis, ensuring that tenants are caring for the yard and building and not trashing the house. Land values continue to rise in areas with a healthy economy. As long as your local population continues to grow and jobs are available, you have every reason to expect property values to climb steadily. This growth further ensures the safety of your capital. If land values are not rising, your cap ital loses buying power because it is eroded by inflation. Well-selected real estate also offsets inflation.
* Tax Benefits. Real estate may be thought of as the last remaining legal tax shelter. You are allowed to deduct losses on your tax return (subject to some limitations) whereas other investors are not. If you invest in markets other than real estate, you usually are allowed to deduct losses only to the extent that they offset other gains; the loss cannot be deduct ed from other income. If you have capital losses through stocks, your annual losses are limited to only $3,000 per year under present rules, a fairly small annual limit. With real estate, though, you can claim up to $25,000 per year in losses in most situations. Because the computation of profit and loss includes depreciation on your investment, it is often the case that you can report a loss and, at the same time, be bringing in more cash than you are paying out. So your paper loss is deductible, but your cash flow is positive. No other investment can match these benefits. Overall, the tax features of real estate make it attractive for many investors, and the comparison to other investment choices is convincing.
* Cash Flow. With most investments, you place cash in someone else's care, then you receive dividends, interest, or capital gains. You are 100 percent invested and there is little or no question of cash flow. With real estate, you usually make a down payment and finance the lion's share of the investment; so cash flow becomes critical. Most real estate investors depend on rental income to cover their mortgage payment. The bad news: If you do not keep the property rented every month, you have to make the mortgage payment from your other funds. The good news: If you keep the property occupied, then tenants' rental payments are used to make those mortgage payments. In this situation-and given no unexpected extra expenses-the property pays for itself.
When you purchase properties at the right price for your local market, and when rents are high enough to cover your mortgage payment, you will have a positive cash flow. When you consider the tax benefits of reporting losses (which are created because you are also allowed to depreciate your rental property), it is possible to have positive cash flow and, at the same time, a net tax loss. This seemingly contradictory situation is quite common.
Excerpted from The Landlord's Financial Tool Kit by Michael C. Thomsett Copyright © 2005 by Michael C. Thomsett. Excerpted by permission.
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Table of Contents
"Introduction The Basic Financial Problem
Chapter 1 Valuation of Property: The Starting Point
Chapter 2 How the Numbers Are Manipulated in Appraisals
Chapter 3 Your Mortgage: The Real Cost of Buying Property
Chapter 4 Investment Calculations: What Is Your Yield?
Chapter 5 The Lease Option: The Leveraged Approach
Chapter 6 Rental Income: Cash Flow Essentials
Chapter 7 Investment Alternatives: Equity and Debt
Chapter 8 Bookkeeping and Financial Statements: Debits, Credits, and More
Chapter 9 Prorated Values in Finance and Taxes: Important Guidelines
Chapter 10 Escrow and Closing: Getting Both Sides in Balance
Chapter 11 Tax Calculations in Real Estate: Reporting Rules
Chapter 12 Land, Lot, and Building Measurements: Calculating Down to the Foot
Appendix A Conversion: Simple Rules, Easy Answers
Appendix B Real Estate Formulas: Summarizing the Essentials
Appendix C Amortization Tables: Monthly Payments
Appendix D Remaining Balance Tables: What Is Left to Pay
Glossary of Terms
Most Helpful Customer Reviews
Author's experience in landlording really comes through. Lots of useful gems here.