Did you know that 10% of the Forbes 400 Richest Americans obtained their wealth directly through real estate? It is estimated that 90% of all Millionaires in the US derived their wealth through real estate also.
The fundamental benefit of investing in income producing real estate is the opportunity to own a tangible asset that has the ability to both grow in value and generate income. In addition, consider the advantages of owning an asset where the bank may be willing to finance up to 75% of the purchase, the tenants help pay the monthly mortgage, yet you reap all of the benefits, ie. A growing stream of income, future appreciation, and potential tax advantages. As for risk, while it certainly can be present in the short run, an owner’s risk tends to gradually diminish over time as the mortgage balance is paid down, rents are raised annually, and property values increase over the long term.
Investing in income property also allows you to take full advantage of the powerful investment tool known as “financial leverage”. Leverage is the ability to purchase an asset of much greater value than the initial amount invested. For example, if you were to invest $250,000 in a stock or mutual fund and than investment appreciated by 10%, your gain would be $25,000. If you were to take that same $250,000, apply it as a down payment on a $1,000,000 apartment building, and it appreciated by the same 10%, your gain would be $100,000, or four times greater! Refer to the “Income Property vs. Stock Market” graph below.
There are some significant tax benefits that exist for investment property that do not apply to other investment markets (eg. Stocks, mutual funds,) including:
IRS allows tax write-off of property depreciation over 27.5 years.
Deferment of Capital Gains Tax - When you sell an investment property, if you made more money than you bought it for, that's called your "Capital Gains" and Uncle Sam will tax you on that gain. However, the government allows you to transfer that gain into another "like kind" property by using a 1031 tax exchange. This allows you to bypass taxation by deferring the financial gain into your next investment.
“Step-Up in Cost Basis” – When the investor passes away his or her heirs will receive a step-up in cost basis equal to the fair market value of the property as of the date of his or her death, or the heirs can elect an alternate valuation date six months after the date of his or her death. The heirs could immediately sell the property without incurring any depreciation recapture and/or capital gain income tax liabilities.
Example: A father bought real property for $150,000 (his original cost basis). When the father died the real estate had a fair market value of $650,000 on the date of his death.The real property was inherited by his son. The son will receive a step-up in cost basis on the property equal to the fair market value on the date his father died, so the son's cost basis would become $650,000 (the son's new cost basis). The $500,000 in capital gain while the real estate was held by the father is not subject to capital gain income taxes. If the son were to immediately sell the real property for $650,000 there would be no capital gain income taxes owed by the son. If the son were to sell the real estate later for $1,000,000 the son would only owe capital gain income taxes on the $350,000 gain.
However, the fair market value of the real property is included in the father’s estate and it may be subject to federal, and possibly state, estate (inheritance) taxes. Investors should always consult with an estate planning specialist for assistance in planning for and minimizing his estate taxes.
Now let's factor in principal pay down. Every month your tenants are paying down the principal you owe on the property. Most of that mortgage payment you make goes towards interest, but a small portion goes towards principal. Not only are the tenants generating cashflow for you, they are also paying for your mortgage.
You've heard the expression, "don't put all your eggs in one basket", well the same applies to investing. By investing in real estate (in addition to other investments such as your IRA, 401K, stocks and bonds) you will have a stronger and more stable investment portfolio.
Over the long term, real estate prices in California have appreciated approximately 5%-6% on an annualized basis. Of course, there is no guarantee as with any investment. For example, between 1990-1995 there was a 14% decline, followed by a subsequent 51% gain over the ensuing five years. Then there was the astonishing 124% climb from 2000-2008, followed by a 30%-35% erosion since. Refer to the graph below for a sampling of price trends in some Bay Area Silicon Valley cities. Prices certainly stumbled between 2008-2010 but since 2010, the prices have been stabilizing, which perhaps is an indicator that we’ve hit the bottom and are trending in a positive direction.
The current Prime Rate of 3.25% is once again very close to all time historical lows. Believe it or not, the Prime Rate in December 1980 was an astonishing 21.5%! Conforming fixed rate mortgages for a typical 4- plex are presently around 5.5%, which is one of the lowest levels the market has seen in years. If an investor is trying to time the market and wait for another 10% decline in prices, that decline may be offset by an increasing interest rate. For example,
The monthly payment on a fully amortized $500,000 loan at 5.5% for 30 years = $2,839.
The monthly payment on a fully amortized $450,000 loan at 6.5% for 30 years = $2,844.
Thus, from a cash flow perspective, a 10% price decline could easily be neutralized by a corresponding 1.0% rise in interest rates.
If you are a patient, long-term investor, today’s combination of moderating prices and historically low interest rates, coupled with 3-4% annual rent growth continues to present an excellent window of opportunity.