Chapter 19

Knowledge of real estate investment is important for real estate licensees so that they may better serve their clients in the purchase and management of income property. Brokers and salespersons, in the course of their activities, are exposed to opportunities in the market and should have sufficient knowledge to make investment decisions for themselves. This chapter examines real estate as an investment, its advantages and disadvantages and the various benefits of owning income property.

Because of its fixed location, real estate derives its value from political and economic forces in its immediate area. Unlike stocks and bonds, there is no nationally organized market, making it a high-risk venture and, often times, unpredictable. However, its natural durability and relative permanency make it ideal as collateral for long-term mortgage debt. As such, it offers opportunities for large and small investors to purchase property with borrowed money and with minimum risk to their own capital.

ADVANTAGES OF OWNING INVESTMENT PROPERTY

The major purposes of investing in real estate are to: (1) preserve capital, (2) earn a profit and (3) obtain tax shelter. Another advantage is that the investor has a high degree of personal control over the capital invested as opposed to ownership of stock and bonds, in which case management and control are in someone else’s hands.

PRESERVATION OF CAPITAL.

Except in recent years, the value of real estate has appreciated at a rate equal to or greater than the rate of inflation. It is for this reason that ownership of real estate is often referred to as a hedge against inflation. Even during difficult economic times, real estate investments have produced a rate of return that is higher than the prevailing interest rates charged by mortgage lenders. Thus, over time, through the use of leveraging (borrowed money), an investment should produce more than it costs to finance its purchase. Leveraging is discussed later in this chapter.

EARNING A PROFIT.

Investment property produces two forms of gains: (1) Annual Net Income and (2) Appreciation.

Annual Net Income.

Annual net income is the profit remaining after deducting operating costs and debt service (payment of principal and interest). Rents should be sufficient, not only to cover operating costs and debt service, but also to provide a sufficient cash flow to show a reasonable return on the cash invested

Appreciation.

Appreciation is the future gain from the increased value of the investment over a period of time. The key factors affecting appreciation are inflation, location, and timing.

Inflation occurs when the value of money decreases and wholesale and retail prices increase. As rents increase, property values should rise proportionately to preserve the capital investment and to act as a hedge against inflation.

Location in a prime rental area of well-kept buildings near business and shopping areas creates desirability resulting in more demand for apartments and higher rent levels. The right location with the proper features and amenities will increase the property’s intrinsic value resulting in a higher price when the property is sold.

Timing the purchase of investment property is usually best determined in retrospect. Investors who anticipated the huge demand for housing in the 70’s and 8 0 's as a result of the post World War II baby boom benefited enormously. As demand outraced supply, it was not uncommon to see property values growing at an annual rate exceeding ten percent. Even when mortgage interest rates were at an all-time high in the early 1980's, the rate of appreciation was sufficient to justify investing in real estate.

INVESTING IN UNIMPROVED LAND

The intrinsic value of land depends upon its location and future growth possibilities of the surrounding area. As such, land investment is highly speculative and best left to experts as a source of investment. Obtaining financing for the purchase of unimproved land is very difficult because of the risk factor. Profitability depends upon whether the land will appreciate in value sufficiently to produce a profit after covering the acquisition costs, real estate taxes, lost interest on the cash invested and broker's fees. Also, since land does not depreciate, the investor does not benefit from a tax write-off.

TAX SHELTER

Tax shelter refers to the tax advantages available to real estate owners and investors. These advantages include deductions for expenses, real estate taxes, interest and depreciation. Other advantages include postponement of taxes, preferential tax treatment of capital gains and the ability to offset real estate losses against the taxpayer's ordinary income. The Tax Reform Act of 1986, which became effective in 1987, significantly reduced many of these tax-sheltering advantages. Tax shelter is more fully discussed in Chapter 16.

PYRAMIDING THROUGH EQUITY BUILDUP

Equity is the value of an asset in excess of its total debt. Equity may be built up through principal payments on a mortgage and may gain in value due to appreciation. Equity buildup is like money in the bank since it may not be realized until the property is sold. However, by using the equity for refinancing, an investor can generate cash for the down payment on other properties without having to invest any additional capital. Refinancing a property to generate cash for the purchase of additional investment property is called "pyramiding."

DISADVANTAGES OF REAL ESTATE INVESTMENTS

Unlike other investments, real estate is relatively difficult to sell over a short period of time. This low liquidity means that a quick sale would most likely result in a loss. An owner of listed stock can convert assets to cash when funds are needed simply by telephoning his or her securities broker. Although cash can be generated in real estate by financing a portion of the equity rather than selling, it could take weeks or months before the transaction could be completed.

Investing in real estate requires a personal commitment to management decisions, such as setting rents, selecting tenants, handling maintenance and making capital improvements. Although many of the burdens of the day-to-day operations may be taken over by professional management, small investors may be expected to personally perform physical tasks in order to reduce overhead and increase cash flow.

Investing in real estate requires a personal commitment to management decisions, such as setting rents, selecting tenants, handling maintenance and making capital improvements. Although many of the burdens of the day-to-day operations may be taken over by professional management, small investors may be expected to personally perform physical tasks in order to reduce overhead and increase cash flow.

CASH FLOW

Cash flow is the annual spendable income that remains after deducting operating costs, taxes and mortgage payments. Ideally, the investment should produce a positive cash flow sufficient to justify the cash invested. Cash flow depends upon the amount of rent received, expenses and mortgage payments. Rents should be examined frequently and kept in line with competing properties. Reduced operating expenses and low monthly mortgage payments will increase cash flow. An example of an annual income statement is shown in Figure 19:1.

Prior to the 1986 Tax Reform Act, many investors in high tax brackets were content to ’’break even" or end the year with a negative cash flow, which would offset taxes on other income. Because of the reduced tax advantages, it is now more important for the investment to produce a positive cash flow or at least cover the expenses.

LEVERAGING

Leverage is the use of borrowed money to finance the major portion of the purchase price of investment property. To produce the maximum return, the investor should try to make a small down payment and obtain a low interest rate mortgage with the lowest possible monthly payments. The effects of leveraging can substantially raise the actual return on the investment.

Through leveraging, other benefits are possible. Since mortgage interest is a deductible expense from annual gross income, the investor should strive to maintain the highest possible mortgage that is feasible. The interest deduction plus the depreciation allowance and growth of value of the property can also increase the rate of return by reducing annual taxable income.

Leveraging increases the return on cash invested. For example, a property is bought for $500,000 with a $50,000 down payment. Five years later it is sold for $550,000, which represents a 10%, profits on the investment i.e. purchase price. The $50,000 profit also represents a 100% return on the cash invested.

A highly leveraged investment can be risky when values drop or the vacancy rate increases. Reduced income could affect the owner's ability to make mortgage payments resulting in possible bank foreclosure. Lower leverage reduces the risk.

SYNDICATION

A syndicate consists of a group, an association or a combination of individuals who join together to pool funds and to conduct a common venture to acquire real estate investments. Syndications allow many small investors to share in the purchasing power of a large investment organization. Syndications usually take the form of corporations, limited partnerships or investment trusts.

1. Corporation. A corporation is not generally used for syndication because of the double taxation on income and the lack of depreciation "pass-through."

2. Limited Partnership. Prior to 1987 the most popular form of syndications were limited partnerships because of the limited risk and "pass through" of losses to investors in high tax brackets. Popularity of limited partnerships has waned since 1987, since losses from passive business or trade activities may not be used to offset taxes on other income.

3. Real Estate Investment Trust - REIT. A Real estate Investment Trust consists of at least one hundred or more investors, and is managed by trustees who conduct the business of the venture. Since it is unincorporated, the trust pays no tax, provided it distributes 95% of its income to the investors. 75% of the trust's income must come from real estate. REITs are government regulated and thus offer less risk than limited partnerships. Investors receive certificates of interest, not stock, since the trust must avoid being treated as a corporation.

4. Real Estate Mortgage Trust - REMT. Real Estate Mortgage Trusts buy and sell real estate mortgages rather than real estate. Their major income is derived from interest and discounts resulting from buying and selling short-term junior mortgages. They offer the same tax benefits as REITS.

5. Combinations of REITS and REMTS. By combining real estate assets and mortgage loans, combination trusts can offer a greater degree of protection to investors during economic slumps.

TAXES ON PROFITS FROM REAL ESTATE

Until the Tax Reform Act of 1986, the major incentives for investing in real estate were the preferential tax treatment of capital gains, and tax shelter through depreciation write-offs. Although these tax advantages have decreased, they are still worth considering when investing in real estate.

CAPITAL GAINS TAX

Before 1987, a capital gain realized from the sale of real estate was given preferential treatment. If the asset had been held for more than six months, only 40% of it was subject to tax. As a result of the Tax Reform Act of 1986, all capital gains are fully taxable, regardless of how long the assets are held.

TAX DEFERRALS.

Taxation of capital gains from investment property may be deferred by an installment sale and an exchange of properties of like kind, i.e. an apartment building for an apartment building. Installment sales and tax-free exchanges are more fully discussed in Chapter 16.

TAX CREDITS.

Investors who renovate older buildings for low-income housing projects are allowed to take a direct reduction in tax due, rather than a deduction from income before the tax is computed. Investors who renovate historic buildings for reuse as a place of business or rentals are also allowed a direct reduction in tax due. The tax credit is based upon a percentage of the cost of renovating. For a detailed discussion of the effect of federal taxes on real estate investments, including tax credits, installment sales, passive losses and exchanges, see Chapter 16.

KEY WORDS AND PHRASES