Real estate and land have built countless fortunes over time. Think about Manhattan Island, and how it was purchased for what would equal roughly $600 in today’s money. It’d be hard to say just how much the island is worth now, but Peter Minuit, who purchased the island, definitely didn’t overpay.
Even when statistics show that the rate of return for the stock market over the past few decades has been better than that of the real estate market; there are other factors to consider. Real estate payments factor into our budgets and can build equity over time. They cannot be quickly converted into cash, but despite that inherent illiquidity, they can be leveraged. Any homeowner can tell you that a home doesn’t need to be secured with the full purchase price, a percentage will do, and that’s an important advantage.
Your Primary Residence
For many, the most basic type of real estate investing is the ownership of the primary residence.
If you rent, then every month your money goes toward someone else who uses it to pay off their home. Renting, however, can often be safer than buying during volatile markets. Likewise, some can’t afford to buy, and so renting is their only option.
For many renters, the point where they decide to buy a home comes from some of the frustrations that can accompany renting, or dramatic life changes like marriage and children. For retirees, the purchase and eventual sale of a home can provide a source of income, as the kids will grow up and move away, meaning that the homeowner can downsize and money gained from the sale can supplement social security payments.
Beyond that, there are many other advantages to home ownership:
- Appreciation Potential – Appreciation is never a sure thing, but real estate is about as close as you can get. Real estate has historically been reliable in that regard. The U.S. economy has consistently grown in the past due to a large and productive labor force, a stable government, and advances in technology. By holding on to your property, these things can benefit you.
Location has a lot to do with it as well. Say, for instance, you have an apartment in a place like New York City. If something like a luxury food market is added to your building, then all of the apartments in it suddenly become more valuable. Likewise, property value would go up if a company built its corporate campus near your home, increasing demand for property in the area. In the opposite, other factors can decrease demand or value of real estate. Real estate investors take these things into consideration.
- Income Potential – Some people buy homes to live in while others buy them for the potential to produce income. There is also the option of buying something like a two- family home and living in one half while renting out the other. As long as your tenants cover their mortgage obligations, it’s a strategy that can work out. As long as the real estate market holds steady, the home will likely appreciate in value and the owner will have a nice profit to look forward to when the home eventually sells.
- Leverage – Say, at a young age and with a good-paying job, you managed to save money to buy a condo that costs $350,000. You put down a 10% payment and live there for six years, deciding to move when you and your spouse have a child. You sell the home $600,000. Over those six years, your payments totaled $172,800, much of which was interest paid to the bank. While the interest can hurt, it’s the tradeoff you take for having lived in the home. After you give the bank $305,000 (what you paid minus the paid down principal) and paying your broker $10,000, you walk away with $285,000. That’s leverage.
You can then use some of that profit to put down a payment on a bigger home. Even though you only made a small down payment, you still benefit from the home’s appreciation. Home’s don’t always appreciate quite so quickly, but with a good location and some patience, you have the potential to earn money.
- Lack of Liquidity – A home can take a long time to sell, which many would consider to be a disadvantage, but psychologically speaking, it can be an advantage in that it will be held for a long time because of that difficulty. It’s for that reason that some financial advisers refer to homes as “forced savings vehicles”. The longer payments are made toward the house, the more equity builds in it. It all goes back to the leverage I noted in my last point.
What You Need to Know About Real Estate Investing
Even with what I’ve just told you, you don’t necessarily want to go diving into real estate investing just yet. If you don’t know what you’re doing, you can easily lose money before ever walking into a new home.
I’ve met a lot of people who are so sure real estate is a sure thing thanks to hot markets of the past. While past markets have been hot, that doesn’t guarantee success in the future. Compared to the stock market, real estate has the advantage of an investor owning a real, tangible item. Whether you’ve purchased a house or land, there are risks that come with real estate investing, and they can include:
- Maintenance – As a homeowner, you are responsible for making repairs to the home. Roof repairs, replacing appliances, all of these are necessary fixes you will have to make at some point. They can raise the value of the home, but will cost upfront. Home equity loans can often finance these repairs, but you want to think long and hard before borrowing against something that can depreciate.
- Tenants – If you own a home with the intent of renting it out, you may be thinking of charging an amount that covers the mortgage and all other costs so that the home will appreciate and you will ultimately profit as people make your payments for you. Own a building long enough, and you will have a stable secondary source of income.
In the words or 20th century real estate legend Lewis Rudin, “never sell, keep debt low, and stay liquid.”
What he’s saying there is that you shouldn’t sell something that produces income because it will remain a source of income after it has been paid for. You just need to make sure you have the right tenant. We’ve all at least heard stories about nightmare tenants who do things like hold their landlords responsible for every little thing, including things their not responsible for. As your income from the building increases, you’ll be able to hire a property management company but, when you first start out, dealing with tenants will be your responsibility.
- Taxes – As a property owner, property taxes are not something you will be able to avoid. They go towards things like schools and improvements to your neighborhood. The cost varies depending on the area and, for many, are bundled in with the mortgage payment, so they don’t even notice. Property taxes are why some retirees choose to move to places like Virginia or North Carolina, which have lower property taxes than places like New York. As a homeowner, lower property taxes could influence your decision on where to live but, as an investor, places with higher taxes may prove to be better investments.
- Lack of Liquidity – Like I said, this can be a disadvantage as well. If you need fast access to cash, selling your home can be a messy affair. You may need money to make a big payment for something else and decide to sell your home as a result. Any number of things can happen with a home sale, like a buyer may have to back out, forcing you to lower your asking price so that you can meet those other payment obligations. These things happen all too often.
In coming up with net worth statements, I always find it better to err on the side of a conservative estimate as far as home value goes, rather than higher values that people tend to put on their homes. This helps hedge against life’s little surprises. Regardless, you will want to hold on to your primary residence for as long as possible so that it has greater potential to appreciate and you can pay down the principal. Likewise, when making multiple low-ball offers on homes low-balling can help you to get a quick closing and a good deal.
These are just some of the things you want to think about when it comes to real estate. There are many ways to increase profit potential, with buying and holding being the most conservative one, but hardly the only one.
Take quick flipping, for instance, which can be a way to make quick money when the real estate market is hot. It’s happened in the past; buyers would purchase a house with a low down payment, pay for a few months, then flip it. They hoped to make some profit without making major payments in the home. In time, it proved to be a dangerous strategy as prices weren’t moving up.
Some buyers went with fixer-uppers, where they would buy a property that could be had at a discount, often a foreclosure that a bank wanted to get rid of, because it was in a state of disrepair. It might cost tens of thousands of dollars to fix things like the roof and floors, but would increase the value of the home by a great amount when it came time to sell. Some people make their living through this type of real estate investment, but it involves having the right financing and access to people who can make the necessary repairs. Whatever type of real estate investing you do, having a strong credit score can go a long way, as can buying when interest rates are low. You also want to consider the length, amount, and type (variable or fixed rate) of mortgage.
If you have questions about how real estate can fit into your financial plan, feel free to contact me today and let me know how I can help.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The examples presented are hypothetical example and are not representative of any specific situation. Your results may vary. Pence Wealth Management and LPL Financial do not offer mortgage services. The examples presented are hypothetical example and are not representative of any specific situation. Your results may vary.