It’s funny how real estate is regarded as an investment. Like Rodney Dangerfield, it gets no respect. While stocks and bonds get the Financial Post and the Wall Street Journal, do a search on "how to invest in real estate" and you'll find all kinds of no-money down schemes that seem designed to sell books and tapes instead of real estate. On TV you'll see Report on Business TV, but for real estate you'll see infomercials or decorating shows. It strikes me as pitiful that such a fantastic investment opportunity gets such shabby treatment.
Of course it is possible to buy with no money down, but it involves arranging a 100% (or more) mortgage, and for rental property you'll only do that if you have other equity. For example, if you have one property bought and paid for its not difficult to arrange a line of credit at prime. A $100,000 apartment would cost about $400 per month, plus taxes and maintenance of about $200. In other words, it would carry itself and give you money to feed the mortgage.
A more normal way to buy real estate is with a down payment. As a rule of thumb is you can make a property carry itself with less than 40% down its probably worth buying. Those sorts of properties are much more common in regular markets.
There are several reasons to own rental property.
Reason #1 to own rental property is because your tenants buy it for you. Even if the other benefits didn't accrue, that alone would make it worth it. But the fact is, there are other benefits to owning rental real estate.
Reason #2 is leverage. The most effective description of how leverage works comes from the book Buy, Rent, Sell, by Lionel Needleman (Needleman is not a gimmick seller; on the contrary, he's a very accomplished author and professor with many books and articles published on housing in Great Britain and Canada. His math and assumptions are a bit simplistic, and need to be adjusted for your particular market, but the book is worth reading).
The author explains leverage this way: John and Mary each buy a house for $100,000. After one year both houses have increased 10% in value. Both investors sell the properties and compare their profits.
John invested $100,000, and now has $110,000, meaning he has realized a 10% return on his investment. Mary, on the other hand, put $10,000 down on her house, and mortgaged the rest for $90,000. Upon sale she paid off the mortgage and counted her money. She also has a $10,000 profit, but since she only invested $10,000 in the property, she's realized a 100% return on her investment. And of course, the real kicker is that while John bought one house, held it a year and then sold it for a $10,000 profit, Mary bought 10 houses, held them a year, and then sold them for a $100,000 profit. They both started with $100,000, but after a year John only has $110,000 while Mary has $200,000. The numbers are simplified in the example, but they clearly demonstrate the power of leverage.
Reason #3 is taxes. In most tax jurisdictions the expenses incurred on rental property is a deduction. What’s more, you can often incur depreciation costs on the property that in effect are paper losses that actually reduce the tax payable. Depreciation works like this: we know that the value of a durable item, like a house, decreases with age. Even if the property is maintained perfectly, an old house is not worth the same as a new house. This loss in value is called depreciation, and you can use that loss (which doesn’t cost you a cash outlay the way maintenance, interest or taxes does) to reduce the total tax payable.
Of course, when we buy rental property we usually hope that it will go up in value, and over the long term it generally does. What happens with the depreciation in that case? The taxman was told the property fell in value through depreciation, but at the end of the day we sold at a profit. The taxman generally will say that you’ve “re-captured” the depreciation and will tax you on it.
Re-capture is no fun. Its like discovering that you’ve already spent the savings that you were planning on spending in the future.
There is a great solution. When you buy the property you divide the purchase price between the structure value and the land value. Without cheating you try to value the land as low as possible and the structure as high as possible (do the math and you’ll see it pays to be reasonable on your estimates). When the property goes up in value and you sell, you tell the taxman that you didn’t recapture any depreciation because the structure did depreciate, while the land went up in value. That profit is capital gain, and capital gain is often taxed at more favourable rates than income like…rent. You depreciate the money you make when it comes in as rent, and pay tax on it when its capital gain.
Owning investment property also allows you to write off the costs of things that you may have bought anyway, from office supplies to a trip to see the property.
Reason #4 is capital gain. Capital gain doesn’t always happen, but it often does. As we’ve seen with leverage, the capital gain can be leveraged. Even better, the capital gain can, in some years, exceed what some people earn in a year.
Reason #5 puts everything together by combining cash flow, leverage, and tax planning. Rental properties generate cash flow. Initially the cash flow may be neutral or even negative, but with time it will usually become positive. When it does you have to pay income tax on the excess rent. The solution to that is to re-mortgage and incur more interest expense, reducing your tax. You also re-leverage the initial property. The next step is to take the extra money and re-invest it in another property. You pay no income tax, incur more depreciation, and continue to earn a capital gain. Even better, with two properties you’ve spread your risk, and when it comes time to sell you can stretch out the timeline and sell the properties in different years to minimize taxes.
It can’t be stressed enough that you need to buy the property wisely. You need to know the location and the potential tenant. Properties that are desirable and are in a desirable area stay rented. “Desirable” doesn’t have to be “mansion”, but clean, warm, dry and appropriately priced are key. Whether you buy a 1 bedroom apartment or a three bedroom house with a suite isn’t critical.
Metrics are. One is price-to-rent ratio. What that means it that you take the price, say $100,000, and divide the rent, say $1000/month, into that. In this case the result would be 100. Numbers between 75 and 175 are great, but remember that projected capital gains and interest rates impact what numbers you go with. Low interest rates allow higher numbers, and solid capital gain projections will command higher numbers. Over 200 is scary in almost every location unless all you want is dependable income, aren’t worried about capital gain or don’t plan on ever selling.
Another good metric is the break even rate. This is the percentage of the purchase price required in order for the realistic rent to carry the property. The rent has to be a) market rent, not “hoped for” rent, and b) net rent, not gross rent. If the house will carry itself at less than 45% down its worth taking a good look at. Obviously, if interest rates are low the net rent will carry more, meaning the break even rate can be high. Remember that low rates don’t last forever, so unless you can lock in very long term you have to assume that the break even rate should be low in low interest rate environments, and can be higher in higher interest rate environments.
If you find a property that has a good price to rent ratio and a good break even rate (and is in a desirable area and isn’t a three legged dog), its worth throwing the numbers onto a spreadsheet and determining the internal rate of return (a real estate investment metric that combines various income streams) and projected cash on sale. There are programs and spreadsheets that can do this, but the key is “GIGO” – garbage in, garbage out. Get the right taxes, the correct interest rates, your projected income tax rate, and realistic estimates of annual appreciation and maintenance costs. Properties in bustling urban areas usually go up in value more than properties in depressed or rural areas. They also often have what appear to be worse metrics – a downtown city condo may have a worse price to rent and break even point than a little house in a remote mill town, for example. However, capital appreciation in the rural area is likely much more spotty. Plotting mortgage pay down and tax benefits on a detailed spreadsheet will allow you to fairly evaluate exactly how competing investments compare.
I would be remiss to ignore the issue of a property bubble, or market collapse. Buying on metrics both helps and hinders. It helps because if you are disciplined with break even rates and rent multipliers you won’t buy overpriced property (underpriced property doesn’t really exist in a bubble, and it doesn’t crash in value). It hinders because you can’t buy on metrics in a bubble, no matter how much you want to, because metric compliant properties don’t exist.
The flip side of this is that when a market crashes there are plenty of metric compliant properties, but generally little financing and plenty of gun shy buyers and stressed sellers.
All in all, a nice stable market is the best for investors, although investors who buy on metrics and exit the market near the top of a bubble often feel like they’ve beaten the world.