I have worked with many new and experienced investors over the last 30 years. Although every investor has different goals, timing, experience and so forth, the conversations I have with all of them are similar: We discuss investing in real estate — the benefits and the drawbacks — and I share some insights into a business that has provided wealth to so many people over the years. One of the most frequently asked questions is “Why invest in real estate?”
Real estate offers several advantages that are not available to other investment vehicles: Leverage, interest deduction, depreciation and appreciation are the main drivers, but other overlooked benefits include control over your investment, annual fees (management) and 1031 tax-free exchanges.
Let me briefly explain these terms:
Leverage: This is the use of a small initial cash investment to gain a very high return in relation to one’s investment. Typically for investment properties, banks require you to invest 30 to 35 percent of the asset’s purchase price in cash as equity. Commercial (investment) mortgage interest rates generally are about 1 percent higher than single-family mortgage rates; this is a general rule of thumb, not a banking industry rule. This mortgage will normally run for a loan term of 20 to 25 years with a 5 year call – which means the bank can ask for its money back or renegotiate the loan terms after 5 years.
Interest deduction: The IRS allows investors to reduce their taxable investment income by the amount of the yearly mortgage interest that was paid for the investment property.
Depreciation: The IRS also allows investors to reduce their yearly taxable investment income based on a portion of the value of the real estate investment generating that income. The amount of the annual portion is dictated, via the IRS, by the type of real estate investment.
Appreciation: Real estate investments have increased in value — over the long term. This is called appreciation and adds to your net worth without your doing anything! The appreciation can be from increasing rents or from the market’s valuing the asset higher than it was in the past.
There are several overlooked benefits of owning investment real estate that I would like to highlight now.
Investor control: One of the lesser known benefits is the control the investor has over that investment. When buying a stock, you can’t change anything the company does; your choices are to sell or buy more stock. However, real estate allows investors to fix up the asset, change the façade, change the zoning, get better tenants, increase the rent or reduce the costs to manage the asset.
Annual fees: Most real estate investments require some kind of management or oversight. Some investors hire a management company to take care of the leasing and management of their investment. Other investors take a “hands-on” approach. When you manage your own investment property, you should be charging a management fee every month. And if you structure your lease properly, the tenant pays for this.
1031 exchange: As with any investment, there will come a time when an investor decides to sell the asset. Another benefit overlooked by many first-time investors is the 1031 tax-free exchange. The IRS has a rule (1031 in the code book) that permits investors to sell one property and move that money into another real estate investment without paying capital gains taxes! This allows the investor to “use” the cash that would have gone to pay taxes and invest that money into another real estate investment. This means the investor can purchase a larger property and receive income on the “tax dollars”! There are very strict guidelines. But knowing that this is available to you as an investor can add tremendous value.
Here’s an example: An investor purchases a 7,000 SF single-story, fully leased office building with a rental rate of $20 PSF/year. The investor pays $8 PSF/year for the building operating expenses and property taxes. That leaves $12 PSF/year as net income. If the investor had bought the building with cash, his yearly return would be 8.4 percent on the purchase price of $1,000,000. If the investor had a down payment of 35 percent of his own money ($350,000) and received a bank mortgage for 65 percent loan-to-value ($650,000) with a 4.5 percent interest rate and a 20-year term, his yearly return would be 10 percent. And this does not include interest deductions, depreciation or appreciation!
Real estate investing can be a great way to create wealth. But all investors should have three professionals on their team:
- A real estate broker who specializes in commercial/investment properties,
- An accountant who understands real estate investment tax law and
- A lawyer who has experience in the leasing and sales of commercial/investment properties in the state where you live.
The information contained herein has been obtained from sources deemed reliable. While every reasonable effort has been made to ensure its accuracy, we cannot guarantee it. No responsibility is assumed for any inaccuracies. Readers are encouraged to consult their professional advisors prior to acting on any of the material contained in this report.
As Senior Managing Director of Colliers International in Princeton, Tim has focused on helping his clients achieve their space and investment goals in the Greater Princeton market for the last 30 years. As a Certified Commercial Investment Member (CCIM), Tim has the background and experience to provide effective and creative solutions for his clients.