In the spring of 1973, I was in 8th grade and attending Charlotte Wood Elementary School in Danville, California. My father suggested I take a class, Money, the instructor’s name was Woody Woodward. Mr. Woodward shared his many money-making ideas over the course of the semester. The one I remember most was buying, fixing and selling homes for a profit (flips.) The moment Mr. Woodward told this story, at 13 years old, the notion of making money in real estate was permanently imprinted in my mind!
Real property is a very different type of investment compared to stocks, mutual funds and other securities. With these differences in mind – here are the essential pros and cons for owning income producing property (IncP):
- Positive Cash Flow – This is the primary reason for buying IncP, a positive cash on cash return from day #1! A $400K property with a 10% cash on cash return delivers a $40K income after all expenses.
- Predictable & Stable – A good investment plan and management practices will keep rents and cash flow coming in, month after month and year after year.
- Control – Most of the issues that determine success are within control of the investor. There’s no reason to worry about the DJIA, a typhoon in Thailand or financial meltdown in Greece. An investor can improve a property, raise rents and increase market value or defer maintenance into the future.
- Multiple Sources of Return – Returns on real estate derive from cash flow, principal pay down (through mortgage payments) and appreciation. If one source under-performs, a change in strategy might increase returns from the other sources. Investments can be structured in a variety ways to support an investor’s need for income, equity accumulation or tax benefits.
- Leverage Experience – Buying and managing IncP can be learned, perfected and replicated. Those with better knowledge and skill make more money. Real property is a tangible asset that can be walked, inspected and evaluated prior to purchase, reducing several types of risk.
- Inflation Resilient – Income producing property generally performs well during periods of inflation as rents and values keep pace with the Consumer Price Index.
- Financing Leverage – The use of financing significantly increases the rate of return. In our example, if the $400K building had been financed for 30 years at 5% with $100K down, the cash on cash return would increase to over 20%. If the building value increased 3% in one year, the appreciation component of the total return would be 3% without financing ($12K/$400K = 3%) vs. 12% ($12K/$100K = 12%.) If refinancing is available, this increase in equity can be recovered and used for additional investments.
- Tax benefits – Tax benefits for investors of IncP include both depreciation and use the 1031 exchanges. These provisions allow for the deferment of taxes on current income and capital gains which significantly increases rates of returns and equity accumulation. In addition, passive income (rent) is not subject to payroll tax deductions.
What are the arguments against investing in income producing property? There are a few and most can be mitigated with a good investment plan and careful property management.
- Inexperience – Investors make mistakes so build these costs into the plan. Start small, learn the basics and focus on a property types and geographies that are familiar. Build a good team, partner with people who have more experience and never stop learning!
- Liquidity– Real estate is not a liquid investment and most IncP is held long-term. Some partnership agreements contain provisions allowing the resale of shares, borrowing against equity or refinancing.
- Risks: Physical, Legal, Operating – There are many risks and most can be minimized (not eliminated) through good property management and asset protection strategies and insurance.
- Unexpected Expenses – Funding reserves at the time of purchase and annual contributions will take the financial “sting” out of unexpected expenses.
- Property Management – Property management is easy if the investor has the temperament and determination to be successful. Keys to success: know the law, use good software and learn the fine art of negotiation. Good property managers are hard to find and should be managed in a clear, timely and consistent manner by the investor.
There are a few “get rich quick” strategies in real estate but I don’t recommend them when investing for retirement. Most income producing real estate is held 5-10 years and sold when the tax benefits from depreciation diminish or the investor’s circumstances change. In upcoming blogs, I’ll provide additional detail about each of the bullets listed above, the pros and cons of investing in IncP.
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