Suppose you have $10,000 to invest. Where would you invest it? In common stocks, bonds, gold, silver, commodities such as pork bellies, U.S. savings bonds, Treasury bills, savings accounts, certificates of deposit, mutual funds or maybe a money market account?
You`ve heard that real estate is a good investment. However, you`ve probably also heard that the 1986 Tax Reform Act took away many advantages of owning real estate. Do you think your $10,000 might earn a bigger profit if you buy real property instead of investing in the popular alternatives listed above?
Before answering that question, consider the four factors involved in any investment. Consciously or subconsciously, shrewd investors weigh these four interrelated considerations before making an investment decision.
— Safety: Where is the safest place you can put that $10,000 and still earn at least a minimal return on it? U.S. government obligations such as bonds, bills, notes and other securities are usually considered the safest place to invest. Next in line are insured savings accounts at banks and S&Ls. Then come uninsured money market accounts. Bringing up the rear in the safety parade are stocks, bonds, gold, silver, mutual funds and commodities.
How does real estate rank in safety? Sound, well-located property rarely fluctuates wildly in market value as do common stocks, bonds and some other investments. Over the long run, real estate usually appreciates in market value. The National Association of Realtors says the typical home appreciated 7.4 percent in market value in the last 12 months.
But homes declined in market value because of local economic conditions in parts of Texas, Louisiana, south Florida and Oklahoma. However, many owners are able to sell before their property loses much value.
Mortgage lenders believe that real estate is a very safe investment and they will loan from 70 to 100 percent of market value for terms of up to 30 years. Please name any other investment that commands such favorable lending terms.
— Yield: The second factor investors consider is yield on their invested dollars. Yield is a function of risk.
But real estate is unique because its yield is often high, while the risk can be low. However, a few high-yield realty investments are very risky, especially new developments where uncertainties to the risk.
Yield is the total annual return on the investor`s dollars from all sources. The primary sources of real estate yield are: (A) net cash flow, (B) appreciation or loss in the property`s market value, (C) income tax savings or taxes payable and (D) principal paydown on the mortgage debt.
To illustrate, suppose you find a $100,000 rental property that can be acquired for $10,000 cash down payment with $90,000 mortgage financing. If the monthly rental income exceeds the expenses by $100 a month, we have a $1,200 annual positive cash flow.
Let us estimate that the property is appreciating in market value at 5 percent annually. That`s $5,000 in this example. Income tax savings from the depreciation deduction will be virtually nil after the 1986 Tax Reform Act, so we can disregard the tax savings yield. But the $90,000 mortgage will be paid down about $615 in the first year to $89,385.
Our annual yield is, therefore, $1,200 cash flow plus $5,000 market value appreciation plus $0 tax savings or taxes due plus $615 mortgage paydown equaling $6,815 first-year yield. As a percentage return on our $10,000 investment, that`s 68.15 percent.
However, since most of this yield is not immediately spendable, real estate is like a forced savings account–money waiting in the owner`s bank until the property is eventually sold or exchanged.
— Liquidity: The third factor to consider in any investment is its liquidity, which means the ease and speed of converting the asset into cash.
Common stocks, bonds, savings accounts, money market accounts, and many other investments are considered highly liquid. However, if you want to liquidate to get cash within a few days, you must take the price the market is paying on the day you decide to sell. The seller has no control over the market price.
Most prospective investors consider real estate to be illiquid, meaning it is hard to convert to cash quickly. That is a common misconception. Most sound, well-located property can be sold at its market value for cash within 30 to 90 days.
Another way real estate is highly liquid is that the owner can refinance with a new mortgage to take out tax-free cash from the property. Since borrowed money must be repaid, no tax is due on cash received from
refinancing.
— Potential for change in market value: The fourth factor in any investment is its potential for change in value, up or down. The possibility of increased market value is the prime reason most people invest.
However, every day millions of savers put money in bank and S&L savings accounts that have no hope of market value appreciation. To illustrate, if on Jan. 1, 1987, you put $1 in a savings account paying 5 percent annual interest, and if we have 5 percent annual inflation in 1987, your $1 will still be worth $1 on Jan. 1, 1988.
However, if you are in the 28 percent income tax bracket, you will lose 2 percent of the 5 percent interest income to Uncle Sam. Your $1 will only be worth 98 cents after one year. You lost 2 percent on your principal investment.
By comparision, sound, well-located real estate shines bright because over the long term it usually appreciates in market value. In some areas homes are appreciating at rates of 10 to 20 percent. But the National Association of Realtors predicts only a 4 percent average increase in market value for homes in 1987. However, as a percentage of dollars invested in the property, this small increase is magnified many times because of the modest cash investment required.
Real estate investments come out very well when considering the four factors in any investment.
