Real estate investment is one of the safest investment. It is also the most popular investment option for most people. It requires huge capital to own an asset, and there are bank mortgage loans available that you can use to finance your purchase.
This makes it possible for most of us to become a real estate investor.
It is also one of the hardest investment strategy. It requires lot of hard work to generate a net positive cash flow from your investment. Unlike stock and gold investment where you can buy the asset and forget about it for considerable amount of time for the asset to grow in value, you cannot do the same for real estate investment. Don't get me wrong, I am not saying it is bad investment in anyway. In fact it is really a great investment if you have the time, energy and passion to do the hard work. Most people glorify real estate investment, but ignore the expenses involved. I am going to do both here. So lets get started.
In addition to hard work, there are lots of expenses to account for, not to just take care of the asset, but also to maintain your ownership even after you paid off your mortgage loan, and fully own your asset. Let's quickly go over the expenses. Let's start with the expense that is right in front of us, it's right there in the name - real estate. The word real comes from the Spanish word 'real' - the royal (or king), and the 'estate' refers to the land or property. In other words, everything belongs to king or in modern days The Government. So if you want to own any property, you need to pay what is called the property tax, not just at the time of purchase, but every month in order to maintain the ownership of the property.
Now you must be wondering, how much you have to pay as property tax ?. Good question, it is usually between 1% and 1.5% of the market value of the property. To make things simpler, let's average the property tax to be 1.25%, this results in property tax of $12.50 per year, or $1.04 per month for every $1000 dollars. Let's put this in perspective, for the real estate investment worth $250,000, you have to pay $3125 per year, or $260 per month. For Californian friends living in the Bay Area, the real estate property lingers around 1+ million dollars, this translates to a property tax of $12,500 per year, or $1041 per month for every 1 million dollars.
Next expense is the interest payment on your mortgage loan. In US, we are at a historical low rate when compared to other countries. A typical 30 year fixed mortgage loan rate ranges from 3% - 5%. Let's average to 4% APR(Annual Percentage Rate), this results in a payment of $40 per year, or $3.33 per month for every $1000 dollars of the mortgage loan. For a $200,000 mortgage loan, interest payment is $8000 per year, or $666.66 per month.
The next inevitable expense is home insurance. Typically the cost ranges between $300 and $1200 per year. Average home insurance cost for a single family home is around $750 per year.
Next major expense is towards home maintenance. It is a wide open category, but it starts with garden service, occasional plumbing or electrical issues to be taken care etc.,. For a single family independent house, the cost averages around $200 per month, or $2400 per year.
In the case of a condo or a town house, there is no need for garden service, but it is replaced with HOA fees also called as Home Owners Association fees. The fees depends on the community and the services offered, typically ranges between $100 and $500 per month. Let's average it to be $300 per month, or $3600 per year. HOA’s are criticized excessively for their restrictive rules and regulations on how the home owners conduct themselves and use their property. HOA is legally binding contract, and any violation of their rules and regulations will get you in trouble, so please be aware.
Now these are the expenses that you need to pay for just owning the real estate asset. Then there is an optional management fees - If you are someone like me who prefer to hire a management company to find and service your tenants, then this will free you up from all the hard work related to servicing your tenants request. The fees usually ranges from 6% - 10% of your monthly rent, the amount is negotiable. So let's average it to be at 7% of the monthly rent for our calculation.
Now in order to have a positive cash flow from your investment, your monthly rent should be able to cover all the above expenses and leave additional money for your savings. If you have a net positive cash flow then it is truly considered an asset, otherwise the same property becomes a liability for you to maintain. Yes it is true that you are building up your equity as you pay off the loans, but it is important to maintain a positive cash flow at all times in order to grow your investment portfolio.
Ways to Invest in Real Estate:
There are many ways to invest in real estate. The two popular ones are, direct ownership of real estate property, and the other way is to investing in REIT trust. Each has its own advantages and disadvantages in investing.
Direct Ownership : Investing in physical real estate asset can be very expensive. You need large amount of money as down payment, plus all other expenses related to owning a real estate property. The only way you can make money of this investment is by renting out this property. Now the rent amount is usually driven by the market value in neighborhood area. The prevailing market rental rate will give a good idea about your rental income even before you buy that property. Now the next question is, is it a good investment ? Most people don't think about it, but that does not mean that is the right approach.
I use P/E ratio to determine the worthiness of the investment. Before going any further, lets understand what is P/E ratio. It is one of the most popular metric to evaluate the worthiness of a stock in the world of stock investment. P stands for purchase amount, and E stands for earnings(earnings per year). For example, let's say the real estate property you own was purchased for $240,000, and you are ready to rent it for $2000 per month. Then your P/E ratio is 10 (240,000/24,000 = 10). There is no magic number to determine the best P/E, but generally the lesser the P/E number, the more attractive is the investment. Most real estate properties has a P/E ratio between 10 and 20. Evaluate your comfort level before proceeding with the real estate investment.
I love P/E ratio mainly because it gives me information about how long does it take the cash flow to pay off the underlying asset. In our example scenario, P/E ratio tells me the cash flow generated by the asset pays itself off in ten years time. Now that is a good indicator to determine the attractiveness of an investment. This is true for any cash flow generating investment.
Real estate is secure but expensive asset to hold. The reason I say it as expensive is because, even after assuming you will be renting the asset for a long time without any major gap, there are considerable amount of expenses needs to be taken care. You will be responsible for expenses such as property tax, dwelling insurance, home maintenance such as repairs, garden service, etc. so please consider all expenses before coming to realistic conclusion on the asset investment.
Investing in REIT : Investing in REIT takes away all the hard work and associated expenses out of the investment. There are different types of REIT investments. To know more about this investment, check out my blog about REIT. This type of investment is similar to stock investment, so you need to know lot more about the business, its revenue/expenses, profitability, and the growth strategy before you consider investing in any REIT trust. Now that you are familiar with P/E ratio, that can be a good start but that alone is not good enough. You really need to look their past performance (ideally at least 20 year chart), and the financial numbers closely. You should also consider the dividend amount and dividend yield associated with the investment.
Note:
Dividend: It is the money( dollar amount) paid directly to the shareholders from the profit earned by the business. The payments are made at regular intervals, typically quarterly(in some cases monthly).
Dividend Yield(%): Annual dividend amount expressed as a percentage of current share price.
Investors mainly invest in REIT for three main reason, 1) investors looking for a hassle free investment and high cash flow 2) invest in real estate assets and/or mortgage loans without the hassle of any overhead expenses such as property tax, maintenance, insurance and dealing with renters issue. 3) last but not least, it is a liquid asset. It can be sold in the market place and you can get your money back almost immediately.
Benefits of Owning a Real Estate Investment:
Use of leverage: The use of leverage is what attracts the most investors to real estate investment. Let's say you are interested in buying a real estate asset that has a P/E potential of 10. You know it's a great investment, but you don't have enough money to buy it. That's when you use debt by taking a mortgage loan against your property. This way you will shell out at a maximum of only 20% of the total amount towards the down payment, and you can own your cash flow producing asset in full. This is the beauty of leverage. The cash flow from the investment will pay off the remaining mortgage amount in 10 years. After paying off the mortgage, this investment will become a cash cow for the rest of your life.
Asset appreciation: In most places, real estate property keep raising over a period of time. That is because the population is increasing, and there is only finite number of places to live. So as the demand increase, the price of the underlying real estate property also increases. This situation will also increase the rent which in turn increases your cash flow. The beauty of this investment is the appreciation of the asset value. For every 10 or 20 years, depending on the market, this asset class doubles in value. You don't have to do any work for the asset to increase in value. When you think about it, in 10 or 20 years, this asset not only pays off its debt by itself, but also doubles its value while maintaining a steady and gradual increase in cash flow every month for the rest of your life, and that's priceless.
Tax benefits: income from your rental considered passive income, and therefore this income is not subjected to self employment tax. This is a major tax advantage.(note: in U.S., self employment tax refers to social security and Medicare taxes). Moreover the government allows to depreciate your property value from the rental income, thereby reducing your tax liability on your rental income.
Repairs, interest payment, taxes, travel mileage, asset depreciation are some of the tax benefits of owning a real estate property.
Cash flow: cash flow from rentals are steady. They rarely fluctuate based on market conditions, and provides a consistent cash flow year after year to its landlord. This is one of the main reason people get attracted into real estate investment. You can reinvest the money from the cash flow to buy more assets in the future, and the cycle continues for ever. Remember, all you need is at a maximum of 20% of the asset value as down payment to acquire your next rental property.
Growth potential: there is tremendous growth opportunities when it comes to real estate investment, but it is going to be slow and steady growth. It requires lot of patience and financial discipline to grow and prosper. Like any investment, there will be up and down period. Make sure your asset is truly an asset and not a liability. When you have a positive cash flow then it is truly an asset, when you have a negative cash flow then the same asset becomes a liability. It's not a bad thing, you just need to find a way to become a positive cash flow. Growth comes with time and effort. If you can be discipline about it, you can see a tremendous growth in not just your investment, but also to an investor within you.
Have fun: this is very important, have fun building your assets. Learn to enjoy every aspect of your investment - cash flow, mortgage rate, property tax, maintenance, taxes, garden service, ROI(Return On Investment), appreciation, etc., If you closely look at it, everything boils down to some numbers. Every number is telling you something. This is not just data, but information about your asset. The important part is to learn to look at the numbers with its context to know and understand the story behind it. All other aspects are just noise. Reduce the surrounding noise, and listen to what matters to you the most. If you can do so, even a wind blow will be a tune to your ears. Have fun, and enjoy investing.
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| Image courtesy of Anoop Krishnan at FreeDigitalPhotos.net |
It is also one of the hardest investment strategy. It requires lot of hard work to generate a net positive cash flow from your investment. Unlike stock and gold investment where you can buy the asset and forget about it for considerable amount of time for the asset to grow in value, you cannot do the same for real estate investment. Don't get me wrong, I am not saying it is bad investment in anyway. In fact it is really a great investment if you have the time, energy and passion to do the hard work. Most people glorify real estate investment, but ignore the expenses involved. I am going to do both here. So lets get started.
In addition to hard work, there are lots of expenses to account for, not to just take care of the asset, but also to maintain your ownership even after you paid off your mortgage loan, and fully own your asset. Let's quickly go over the expenses. Let's start with the expense that is right in front of us, it's right there in the name - real estate. The word real comes from the Spanish word 'real' - the royal (or king), and the 'estate' refers to the land or property. In other words, everything belongs to king or in modern days The Government. So if you want to own any property, you need to pay what is called the property tax, not just at the time of purchase, but every month in order to maintain the ownership of the property.
Now you must be wondering, how much you have to pay as property tax ?. Good question, it is usually between 1% and 1.5% of the market value of the property. To make things simpler, let's average the property tax to be 1.25%, this results in property tax of $12.50 per year, or $1.04 per month for every $1000 dollars. Let's put this in perspective, for the real estate investment worth $250,000, you have to pay $3125 per year, or $260 per month. For Californian friends living in the Bay Area, the real estate property lingers around 1+ million dollars, this translates to a property tax of $12,500 per year, or $1041 per month for every 1 million dollars.
Next expense is the interest payment on your mortgage loan. In US, we are at a historical low rate when compared to other countries. A typical 30 year fixed mortgage loan rate ranges from 3% - 5%. Let's average to 4% APR(Annual Percentage Rate), this results in a payment of $40 per year, or $3.33 per month for every $1000 dollars of the mortgage loan. For a $200,000 mortgage loan, interest payment is $8000 per year, or $666.66 per month.
The next inevitable expense is home insurance. Typically the cost ranges between $300 and $1200 per year. Average home insurance cost for a single family home is around $750 per year.
In the case of a condo or a town house, there is no need for garden service, but it is replaced with HOA fees also called as Home Owners Association fees. The fees depends on the community and the services offered, typically ranges between $100 and $500 per month. Let's average it to be $300 per month, or $3600 per year. HOA’s are criticized excessively for their restrictive rules and regulations on how the home owners conduct themselves and use their property. HOA is legally binding contract, and any violation of their rules and regulations will get you in trouble, so please be aware.
Now these are the expenses that you need to pay for just owning the real estate asset. Then there is an optional management fees - If you are someone like me who prefer to hire a management company to find and service your tenants, then this will free you up from all the hard work related to servicing your tenants request. The fees usually ranges from 6% - 10% of your monthly rent, the amount is negotiable. So let's average it to be at 7% of the monthly rent for our calculation.
Now in order to have a positive cash flow from your investment, your monthly rent should be able to cover all the above expenses and leave additional money for your savings. If you have a net positive cash flow then it is truly considered an asset, otherwise the same property becomes a liability for you to maintain. Yes it is true that you are building up your equity as you pay off the loans, but it is important to maintain a positive cash flow at all times in order to grow your investment portfolio.
Ways to Invest in Real Estate:
There are many ways to invest in real estate. The two popular ones are, direct ownership of real estate property, and the other way is to investing in REIT trust. Each has its own advantages and disadvantages in investing.
Direct Ownership : Investing in physical real estate asset can be very expensive. You need large amount of money as down payment, plus all other expenses related to owning a real estate property. The only way you can make money of this investment is by renting out this property. Now the rent amount is usually driven by the market value in neighborhood area. The prevailing market rental rate will give a good idea about your rental income even before you buy that property. Now the next question is, is it a good investment ? Most people don't think about it, but that does not mean that is the right approach.
I use P/E ratio to determine the worthiness of the investment. Before going any further, lets understand what is P/E ratio. It is one of the most popular metric to evaluate the worthiness of a stock in the world of stock investment. P stands for purchase amount, and E stands for earnings(earnings per year). For example, let's say the real estate property you own was purchased for $240,000, and you are ready to rent it for $2000 per month. Then your P/E ratio is 10 (240,000/24,000 = 10). There is no magic number to determine the best P/E, but generally the lesser the P/E number, the more attractive is the investment. Most real estate properties has a P/E ratio between 10 and 20. Evaluate your comfort level before proceeding with the real estate investment.
I love P/E ratio mainly because it gives me information about how long does it take the cash flow to pay off the underlying asset. In our example scenario, P/E ratio tells me the cash flow generated by the asset pays itself off in ten years time. Now that is a good indicator to determine the attractiveness of an investment. This is true for any cash flow generating investment.
Real estate is secure but expensive asset to hold. The reason I say it as expensive is because, even after assuming you will be renting the asset for a long time without any major gap, there are considerable amount of expenses needs to be taken care. You will be responsible for expenses such as property tax, dwelling insurance, home maintenance such as repairs, garden service, etc. so please consider all expenses before coming to realistic conclusion on the asset investment.
Investing in REIT : Investing in REIT takes away all the hard work and associated expenses out of the investment. There are different types of REIT investments. To know more about this investment, check out my blog about REIT. This type of investment is similar to stock investment, so you need to know lot more about the business, its revenue/expenses, profitability, and the growth strategy before you consider investing in any REIT trust. Now that you are familiar with P/E ratio, that can be a good start but that alone is not good enough. You really need to look their past performance (ideally at least 20 year chart), and the financial numbers closely. You should also consider the dividend amount and dividend yield associated with the investment.
Note:
Dividend: It is the money( dollar amount) paid directly to the shareholders from the profit earned by the business. The payments are made at regular intervals, typically quarterly(in some cases monthly).
Dividend Yield(%): Annual dividend amount expressed as a percentage of current share price.
Investors mainly invest in REIT for three main reason, 1) investors looking for a hassle free investment and high cash flow 2) invest in real estate assets and/or mortgage loans without the hassle of any overhead expenses such as property tax, maintenance, insurance and dealing with renters issue. 3) last but not least, it is a liquid asset. It can be sold in the market place and you can get your money back almost immediately.
Benefits of Owning a Real Estate Investment:
Use of leverage: The use of leverage is what attracts the most investors to real estate investment. Let's say you are interested in buying a real estate asset that has a P/E potential of 10. You know it's a great investment, but you don't have enough money to buy it. That's when you use debt by taking a mortgage loan against your property. This way you will shell out at a maximum of only 20% of the total amount towards the down payment, and you can own your cash flow producing asset in full. This is the beauty of leverage. The cash flow from the investment will pay off the remaining mortgage amount in 10 years. After paying off the mortgage, this investment will become a cash cow for the rest of your life.
Asset appreciation: In most places, real estate property keep raising over a period of time. That is because the population is increasing, and there is only finite number of places to live. So as the demand increase, the price of the underlying real estate property also increases. This situation will also increase the rent which in turn increases your cash flow. The beauty of this investment is the appreciation of the asset value. For every 10 or 20 years, depending on the market, this asset class doubles in value. You don't have to do any work for the asset to increase in value. When you think about it, in 10 or 20 years, this asset not only pays off its debt by itself, but also doubles its value while maintaining a steady and gradual increase in cash flow every month for the rest of your life, and that's priceless.
Tax benefits: income from your rental considered passive income, and therefore this income is not subjected to self employment tax. This is a major tax advantage.(note: in U.S., self employment tax refers to social security and Medicare taxes). Moreover the government allows to depreciate your property value from the rental income, thereby reducing your tax liability on your rental income.
Repairs, interest payment, taxes, travel mileage, asset depreciation are some of the tax benefits of owning a real estate property.
Cash flow: cash flow from rentals are steady. They rarely fluctuate based on market conditions, and provides a consistent cash flow year after year to its landlord. This is one of the main reason people get attracted into real estate investment. You can reinvest the money from the cash flow to buy more assets in the future, and the cycle continues for ever. Remember, all you need is at a maximum of 20% of the asset value as down payment to acquire your next rental property.
Growth potential: there is tremendous growth opportunities when it comes to real estate investment, but it is going to be slow and steady growth. It requires lot of patience and financial discipline to grow and prosper. Like any investment, there will be up and down period. Make sure your asset is truly an asset and not a liability. When you have a positive cash flow then it is truly an asset, when you have a negative cash flow then the same asset becomes a liability. It's not a bad thing, you just need to find a way to become a positive cash flow. Growth comes with time and effort. If you can be discipline about it, you can see a tremendous growth in not just your investment, but also to an investor within you.
Have fun: this is very important, have fun building your assets. Learn to enjoy every aspect of your investment - cash flow, mortgage rate, property tax, maintenance, taxes, garden service, ROI(Return On Investment), appreciation, etc., If you closely look at it, everything boils down to some numbers. Every number is telling you something. This is not just data, but information about your asset. The important part is to learn to look at the numbers with its context to know and understand the story behind it. All other aspects are just noise. Reduce the surrounding noise, and listen to what matters to you the most. If you can do so, even a wind blow will be a tune to your ears. Have fun, and enjoy investing.
