I've included this article since it discusses some real life situations you will encounter in real estate and the appraisal business. This article is reprinted with permission from Ken Jones.
Real Estate: The Best Investment
Real estate is the safest, most reliable and most financially advantageous investment one can make. But, don't just take my word for it. Let's examine the cold, hard facts regarding income-producing real estate as an investment. And, let's contrast those facts against facts about other investments. I believe, that after you review all these facts, you'll agree with my opinion.
FACT 1: REAL ESTATE IS WITHIN YOUR PERSONAL CONTROL.
Let's compare an investment in real estate to owning stock. Aside from the problems of being able to understand the complex vagaries of operating a major corporation, then being able to successfully predict its future earnings and profitability, the most dangerous aspect of owning stock is the lack of control you have over the company and the unpredictable change in the price of its stock. Face it. The people who have the greatest impact over the change in the value of a stock is that hand full of professional money managers, each of whom has total control over literally billions of dollars. And, when these professional money managers buy and sell stock, they buy thousands of shares in one company in a single trade. So, on any given day, if a money manager in New York hears a rumor at a cocktail party on Wednesday night that causes him/her to sell a stock on Thursday morning, that single action can, and usually does, drive down the price of that stock.
It happens every day, in a micro-second, and without warning. With a mere push of a computer button, poof! The value of your 100 shares of stock just went from the $16.00 a share you paid yesterday, to $5.50 a share, and you just lost $1,050. Without any visible or predictable cause, some guy you don't even know just wiped out 65% of the value of your investment in the blink of an eye. This also assumes there hasn't been any illegal insider trading or other illegal hanky panky with the accounting, such as Enron, Global Crossing and WorldCom, among others, both known and yet to be discovered.
Yes, while it's true that the value of real estate also tends to be influenced by things beyond the control of the individual property owner, such influences are usually related to financial conditions in the local and general economies. More importantly, these conditions are public knowledge, and are openly and simultaneously available to everyone. Further, these general economic changes also tend to occur over relatively long periods of time (months and even years), giving property owners ample time to make any desired adjustments to preserve the value of their investment.
Well, as we can see, as compared to investing in real estate, buying stock is a very high-risk proposition; not at all a reliable, predictable investment. In fact, buying stock is more like taking your money and going to a gambling casino where anything can happen, and it's all beyond your control.
FACT 2: TENANTS PROVIDE PREDICTABLE, STEADY AND RELIABLE INCOME.
Let's compare the cash-flow from real estate to that from stocks and bonds. Even the highest quality publicly traded companies sometimes reduce, and even eliminate paying dividends (profits) to stockholders. While most people think this only happens in economic "hard times," the fact is, that a company can have financial problems at any time for reasons that have nothing to do with how good or bad the general economy is doing. The recent bankruptcies of such business giants as K-Mart, MCI/WorldCom and United Airlines are just a few of the numerous examples of how a company can run into financial problems in an otherwise good economy.
As for bonds, the present interest rate (yield) on the most recently issued 5-year US Treasury Note is 3.30%, if held the full 5 years to maturity. Likewise, the 10-year US Treasury Bond pays 4.05%, again, if held the full 10 years to maturity. In addition to suffering these meager rates of return, you'll also have to pay income tax on the earned interest, both federal and state (if applicable). So, if you're in the 28% federal income tax bracket, your net profit on the 5-year Note will be only 2.38%, and only 2.92% on the 10-year (before state income tax, if applicable).
Now, using a very simple example of income from investment real estate as a comparison, let's say you bought a 1-family house for investment at a purchase price of $100,000, with $10,000 (10%) down payment, and you're collecting $1,000a month in rent with the tenant paying all utilities. Even after making your mortgage payment of $539.60 a month ($90,000 @ 6% for 30 years), and paying your property tax of about $85.00 per month, as well as paying your homeowner insurance at another $30.00 per month, you'll still have $345.40 to put into your pocket at the end of every month, or $4,144.80 a year. So, your annual return (interest rate, if you will) on your $10,000 of invested cash is a whopping 41.45% (before income taxes).
So, even after paying your federal income tax on the rental profit (using the same 28% tax bracket), you still have $2,984.40 spendable cash in your hands; that's equal to 29.84% annual net on your invested cash. And, that doesn't even consider 1) the increase in the value of your property, 2) the increase in your equity position as a result of your tenant pay down your mortgage, and 3) the benefit of reducing you income tax liability from a little thing the I.R.S. calls "depreciation," that I'll get to in a moment.
Well, what about the change in the value of stocks and bonds compared to real estate? On January 14, 2000, the Dow-Jones Industrial average (DJI) closed at its all-time high of $11,723.00. By March 11, 2003, just over 3 years later, it closed at $7,524.06 having lost over 35% of its value from its all-time high. As of this writing (October 15, 2004) the DJI closed at $9,933.38; it has never reached the $11,000 level to date.
As for the National Association of Securities Dealers Automated Quotations (NASDAQ), the losses there are even worse. Again, on March 11, 2003, the NASDAQ closed at $1,271.47, having lost about 75% of its value from its all-time high of $5,048.62 set exactly 3 short years earlier on March 10, 2000. As of this writing, the NASDAQ closed at $1,911.50, never having reached 50% of its all-time high value to date.
So, what about real estate? Well, the people who bought real estate virtually everywhere in the United States at the same time these stock indexes were setting their all-time highs in the year 2000, now have property that has increased in value by between 50-100%. Plus, they've also had cash flowing into their pockets every month, while their tenants have been paying down their mortgage debt. And, in most cases, these property owners have refinanced their mortgages with lower interest rate loans that have boosted their net cash-flow even more.
FACT 3: LEVERAGING: THE BENEFIT OF USING OPM (OTHER PEOPLE'S MONEY)
In today's market, a buyer with an average credit history can buy a piece of investment real estate with as little as 5-10% invested cash down payment, and sometimes with less. The remaining 90-95% of the purchase money is borrowed (OPM). This is called "leveraging." As a practical matter, leveraging allows you to stretch your buying dollars, reduces your risk (because you have very little invested), and it exponentially increases the overall value of your wealth by creating the opportunity to buy more than one property at one time.
FACT 4: TENANTS WILL PAY OFF THE MORTGAGE, PAY ALL THE EXPENSES, AND PROVIDE YOU WITH CASH EVERY MONTH, EVEN IN ECONOMIC DOWNTURNS.
While the property owner may write the check for the monthly mortgage payment, the tenants actually pay the mortgage (and most, if not all other expenses of the property) with their rent payments to the owner. Remember, people always need a place to live and conduct business, even in economic hard times. And, while most people will sacrifice extras, such as a new car and new clothes, they really can't sacrifice on having a place to live or to conduct their business. And, with the spectrum of government rental housing assistance programs, such as HUD Section 8, you can pretty much depend on collecting the rent to pay your debts (and, put money into your pocket) in both good times and bad.
FACT 5: INVESTMENT PROPERTY OWNERS GET A MAJOR INCOME TAX ADVANTAGE FROM "DEPRECIATION."
The I.R.S. provides owners of investment real estate an accounting expense benefit called "depreciation" which lowers the taxable income from their investment real estate. Although there's a table in the I.R.S. rules that regulates the amount of annual and overall depreciation that can be taken (depending on the type of property), the most important thing you should know is that depreciation is only an accounting procedure, and has nothing to do with the actual value of the real estate.
FACT 6: YOU CAN SELL YOUR INVESTMENT PROPERTY AND LEGALLY PAY NO CAPITAL GAINS INCOME TAX.
That's right! Internal Revenue Code 1031 sets forth the conditions under which owners of investment real estate can sell their property, take the profits from that sale and buy more investment real estate while not having to pay a single penny in capital gains income tax on the profit from the original sale. This type of transaction is commonly referred to as a "1031 Exchange." Again, there are a few rules that must be followed, but it's really a pretty simple transaction that can save you thousands of dollars in income taxes. Using the 1031 Exchange also provides you with the opportunity to buy more investment real estate with higher net cash flows, as well as buying property with a greater potential for future value growth. And, don't be fooled by a common misunderstanding of the term "exchange." When used in the context of the 1031 Exchange, you do not literally have to "exchange" your property with someone else for their property. In the 1031 Exchange, the word "exchange" simply means selling one type of investment property and replacing it with another investment property of the same type. It's also referred to as a "like kind" exchange.
Moreover, it doesn't matter if you own a piece of vacant land and want to buy and office building, or if you own a 2-family and want to buy and industrial building. It's all real estate, and it's all the same, or "like kind" property, which the underlying criterion required for getting the benefit of the 1031 Exchange. And, while there are other criteria required to use the 1031 Exchange, they're relatively simple to understand, and will save you thousands of dollars when you want to "trade-in" your existing investment property for another one.
Let me leave you with this simple truth: If, on January 1, 1974, you invested $5,000 in a stock fund that tracked the performance of the Dow-Jones Industrials, on October 15, 2004 your investment would be worth $58,068. That's a return of 11.61 times our original investment. (This analysis does not consider the benefits of reinvestment of dividends on stocks, nor does it consider the benefits of net cash flow from rent or the income tax benefits of depreciation and the use of the 1031 Exchange). But, if on that same January 1, 1974, you invested that same $5,000 in a piece of real estate worth $30,000 and if the value of that real estate only increased on an average of 5% per year, on October 15, 2004 that property would be worth $134,790. That's 26.96 times your original $5,000 investment, based solely on the increased value of the property.1 Additionally, your mortgage would be paid in full (by the tenants) and you would have had cash in your pocket virtually every month during that 30+ year period. In simple terms, you would have made a profit of $129,790 on the real estate while only making a profit of $53,068 on the stock, or about 2½ times more profit from the real estate investment.1
Finally, when you compare all of the benefits of investing in real estate with those associated with any other type of investment, it seems clear there is no safer, more dependable and financially advantageous investment than real estate.