Owning real estate for investment purposes

02.05.09
By Randy Johnson

Owning real estate has always been a good long-term investment. Property values over any twenty or thirty year period of time have always risen at a rate greater than the rate of inflation. This increase has not been constant, as we know from looking at the current housing market. But consider other investments. They vary too, as we see from looking at stock market values today compared with a year ago. Did your 401(k) turn into a 201(k)?

What hasn't gone down in value are investments in fixed-rate income securities, like U.S. Treasury bonds and Certificates of Deposit. Of course, in general the yield on these investments has generally not kept up with inflation, meaning the buying power is eroded over the long term. But over long periods of time, like your career, you can count on both stocks and real estate investments to outperform the rate of inflation.

The nice thing about real estate is leverage. Unlike stocks, you do not need to have the entire price of your investment when you make your purchase. Say you have $50,000 to invest. All you can buy is $50,000 of stocks – unless you buy stocks on margin, but that's for traders, not investors. 

With a $50,000 down payment you can buy a $200,000 home because you can secure a $150,000 loan to finance the balance of the purchase price. Let's say that both stocks and real estate each appreciate at a 5% rate per year for 30 years. At the end of 30 years, the $50,000 will have grown to $197,000 (ignoring taxes). Not bad.

But the $200,000 property will have appreciated to a value of $784,000. Even better, your tenant has paid you rent which has given you the cash to pay the loan off in full. Even better, you have been able to depreciate the value of the improvements for tax purposes, which has improved your cash income.

Now, it seems to me that turning $50,000 into $784,000 is a better deal than turning it into $197,000. Agreed?

But there are significant differences between these two types of investments. Stocks and bonds or mutual funds are passive investments. They don't require management, unless you choose to make investment selections and decisions yourself. That suits some people. Another advantage is that securities are generally liquid. You can call your broker or mutual fund management company and turn your investment into cash almost immediately.

By comparison, real estate is not liquid, as many who wish to sell their homes right now have found out. Not only that, when you have to sell at an inopportune time, you can lose money. That is especially true for the short-term investor. The 'other side' of leverage is that, in our example, the value goes down 20% and it costs you another 6% in real estate commissions to sell, and your $50,000 is gone. That is why we are talking about buying property for the long term.

The other aspect of real estate that is important to understand is that it is not a passive activity. Suitable tenants have to be found. The rent has to be collected every month, and if the tenant is late, you have to come up with the mortgage payment anyway. Things break, homes need repair, even little things like the gardening have to be attended to. And while you can hire someone to do those jobs, contracting workers detracts significantly from the investment's profitability. You may get an education in the perseverance and legal issues related to eviction of a deadbeat tenant; these things do happen.

The clear message is that if you want to be a real estate investor, you need to understand that you have more than an investment; you have a business. Successful businesses require work. If you don't work this business like all others, it will not perform well. 

So why should you do this? Remember that $784,000?!

In the next article I will discuss why buying investment property right now is such a good idea. We'll look at some numbers that will excite you.

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If you want to be a real estate investor, you need to understand that you have more than an investment; you have a business.