Why rental property can be a great investment

[Gody]

I wanted to start this thread to detail the benefits of rental property. Whenever I happen to speak to friends or strangers about owning rental property, I often find there is a general thought that owning property can be a difficult and cumbersome investment, especially in comparison to the status quo investment of owning stock or mutual funds. While it is true that there is more to be aware of and track in regards to your investment, I believe there are many huge upsides to using rental property as a way of building wealth/savings. Plus many of the things that people fear about property (dealing with tenants, liabilities, repairs) can often be dealt with by hiring professionals(property management, insurance, handymen) to deal to deal with them and you can still end up with a profitable investment.

There are many places to start but I figured I'd give an overview as to how a rental property provides value. to do that, I'll use one property I bought 5 years ago as an example.:

This is a property I bought in Texas. Its a 3br/2ba attached side of a duplex. The cost at the time was $122K. Buying that property with 20% down required a 24K down payment. I'll be rounding my numbers here for simplicity but there about 2K in closing costs when purchasing the property so in sum my initial investment was 26K.

Now when you have a rental property there are 4 different ways you are accruing more equity for yourself:
1. Appreciation of the property value
2. Increase equity in the home by paying down the principal
3. Rents from the property provide a positive cash flow after expenses
4. Tax benefits allowing you to shelter your own personal income or future income from the property

Let's go through each of these individually:
1. Appreciation of the property value. This is the most common way people think you can get rich by owning property. Buy it cheap and sell it for more. If you are in a hot real estate market then this might be a keystone to your investment however when I invest in real estate, I'm not necessarily looking for the property to shoot up in value, but I do want to know it is in a stable area with good growth potential. For this property I'm not going to assume any appreciation, I want to know I can depend on the other 3 factors to bring me a good ROI.

2. I believe at the time, when I bought the property I had an interest rate of 6% on my loan. My monthly payment came out to about $600 and I was putting about $100 towards principal every month so every year I was gaining $1200 more equity in the property.

3.Here's a quick breakdown of the monthly expenses for the property: Mortgage:$600, HOA fee: $65, Prop Mgmt:$70, Property Taxes: $275. The sum of those expenses is $1010. The monthly rents I was initially getting from the property were $1225/month. Now just to be conservative, lets only take 90% of the rental income to account for potential vacancies or possible repairs needed during the year. That take the monthly rent down to about $1100 and the monthly cash flow to $90/month or $1080/year.

4. Now seeing that we have a positive cash flow on the year most people might think that we're due to owe uncle same based on this cash flow. What most people don't realize is that when you own rental real estate, you are required to depreciate the cost of the property and apply that towards your income/expenses on your Schedule E(real estate profit/loss tax form). Without getting too complicated this means that a portion of the property value(not including the land it sits on) gets to count as an expense over the next 27.5 years of your ownership. So while you get the benefit of claiming an additional expense(albeit an invisible one) on your profit/loss sheet, this does effect the basis value of the property for when its time to sell. For now, based on the property value I get to claim $3000 of depreciation for the year. If I count this against the 1080/year in cash flow, I have a $1920 tax loss on the year. The nice thing about losses from your Schedule E is that they can be counted against your primary income(as long as your income is below 150K, between 100K-150K the amount of losses you can claim against income is phased out and above 150K you can only carryover those losses to use against future capital gains from sale of property). In this case, assuming I am able to claim the loss against my income, that $1920 loss could equate to about a $500 in tax savings(assuming a 25-30%ish tax bracket)

Adding the gains from factors 2,3,and 4 we get: 1200+1080+500=$2780. So in the first year of ownership I have had a 10.6% return on my initial investment of 26K. Remember, this is being relatively conservative and we are not even considering the potential appreciation in the value of the property. With a leveraged investment a 3K rise in property value would be yet another 10+% added to the return. In reality, I've achieved closer to 15% returns, not including appreciation on most of my properties. I find that difficult to do consistently in the stock market.

Here are some quick additional points to make as they pop out of my head:

-If you are disciplined with the cash flow you can reapply those funds to mortgage payments and compound the gains you are making, or even reapplying those funds to different investments will turbo charge your return.
-I didn't really touch on how I went about choosing this property but doing your homework in crunching these potential numbers and finding the right opportunity is important.
-When your investing in real estate, cash flow is what people tend to look for, but if you are trying to build savings or gain wealth, you actually want to find an investment that will help you grow your capital. Often times cash flow in real estate is gotten at the expense of capital growth.


I hope that was a helpful look into real estate investing for those that are thinking about it. I'd be happy to address other details or questions about rental properties if anyone is interested but I figured I'd start here.

 

[Matt]

Great post Gody, let me ask you a couple more:

1. How do you manage liability from your tenants?
2. Are you establishing LLC vehicles and trusts?
3. Are you familiar with depreciation recapture?
4. If you buy out of state are you concerned about ancillary probate?

Cheers,

Matt

 

[Gody]

Thanks Matt.

1. For me most of my liability is covered through my insurance policies for the property. There is usually a liability coverage included on rental insurance policies and there are different levels of coverage you can put in place based on your needs/comfort level. As I have built a larger portfolio of properties I have also considered an umbrella liability policy that would cover all of my properties should I exhaust whatever coverage is available on the individual properties. But I haven't made that switch yet because I feel comfortable with the current coverages.

2. I have not established an LLC since I haven't seen the benefit of doing so and paying annual fees to maintain the LLC when I am comfortable with the protection I have outside of an LLC. I do have the property in a revocable living trust and that offers some liability protection as well as some protection against ancillary probate as well.

3. I am familiar with depreciation recapture. If I were to sell one of my rental properties, while the profit I make from selling the property is generally taxed at the long term capital gains rate of 15%, any profit made due to the depreciation lowering the basis of the property is taxed at 25%. There are a couple strategies to avoid this as well as capital gains on the sale of a property. The first is by executing a 1031 exchange, which allows you to sell your current rental property free of any capital gains or recapture taxes as long as you purchase a like-kind rental property of equal or larger value within 6 months. This allows you to keep on buying larger and larger rental properties without incurring capital gains taxes along the way. The downside to this is when you do this you limit the amount of depreciation you can claim on future properties and thus your future property income may not be as tax sheltered as they could be. Another strategy that some people can use is to apply passive activity losses that have been carried over from previous years taxes. You are only allowed to claim 25K in passive activity losses per year based on rental property, and that amount might be even less depending if you're annual income is above 100K. If you happen to be stockpiling passive activity losses, you can finally apply them against any gains you make when you sell your property and thus offset any capital gains or recapture taxes.

4. At this point a majority of my properties are out of state. I haven't really considered a lot of the probate issues you mentioned but I do use a revocable living trust which I believe helps alleviate those issues should it arise. Knowing these obstacles may exist it might be worth creating a proper strategy for this down the line. I'm in my late 30's now so probate and estate taxes haven't been at the top of my concerns. But with a baby on the way and as time passes, these are things to consider for the future.

 

[Tom Juhn]

I am in the position now where my wife and I make more than the $200k. This completely wipes out the $25k loss write off. This came as a big shocker this year. I am looking forward to the day I sell for those losses to come back to me.

 

[cz606]

Gody,

What are your thoughts on leverage in an investor's real estate portfolio? Do you think it wise to use positive cash flow to deleverage more quickly? If so, do you utilize any mechanisms to then make that equity available to you if another investment presents itself before your cash reserves have recovered from the large down payments?

 

[Gody]

Gody,

What are your thoughts on leverage in an investor's real estate portfolio? Do you think it wise to use positive cash flow to deleverage more quickly? If so, do you utilize any mechanisms to then make that equity available to you if another investment presents itself before your cash reserves have recovered from the large down payments?

My main objective with my properties is to be leveraged in a position to be able to achieve a return of 12+% annually on the equity I have in the property without depending on the appreciation of the property. Given that objective, if I only had 1 or 2 rental properties, I wouldn't necessarily use the positive cash flow to deleverage more quickly unless that was the only or most ideal use of those extra funds. The more equity I build in the property, the lower the potential returns I would have in growing my capital. In the example I gave in the original post, by the time I get to 30-35% equity in the property my ROI starts to approach below my 10% standard. It is at that point I might want to consider either A)selling the property if the market conditions might be favorable to that AND I have a favorable new investment to put the funds toward or B) I could refinance the property and get cash out to releverage the investment to my liking, then use the cash I get out of that towards new property purchases or another favorable investment.

In my current situation I own many rental properties right now, and with current lending restrictions, once you carry 4 mortgage loans, the restrictions to achieve approval for a 5th through 10th loan are more strict and you often have to put a larger down payment down and pay a little bit higher interest rate in order to get approved for a loan. The only way around this is to find private lenders who don't have to work within fannie/freddie restrictions. While private lenders may be able to get you approved easier you will still pay a premium in some way to work with them.

Given that I currently have multiple properties and using funds to acquire new properties is becoming more difficult, I am currently using my positive cash flow from all my properties to pay down each of my mortgages one by one. This allows me to build more room on my plate for more loans in the future. Either that or I could releverage the paid off property by refinancing it and then use the funds for another investment or purchase if possible. But even a cash-out refinance on a paid off property with multiple loans on your plate can be difficult to get approved, so in my situation I am stuck with limited access to loans at this point and my best option at the moment is to deleverage one of my properties. Its not a bad situation as I am getting a favorable return overall but with more access to lending I feel like I could be in a better situation for myself to maximize my returns. This year I have found new investment tools in real estate to help with this situation so hopefully my returns will take a leap to my liking again.

 

[fulthrust7]

The one advantage of a LLC is that the tenant can't come after all your assets if that propoerty is incorporated under its own LLC.

 

[fulthrust7]

Do you mind commenting on choosing the right property? Are you going after foreclosures/short sales which can be attained below value, or regular sales?

 

[Matt]

The one advantage of a LLC is that the tenant can't come after all your assets if that propoerty is incorporated under its own LLC.

This is actually not true. We were having some heated debates about how to bust through LLCs and Trusts recently and an LLC alone is not going to offer the liability protection that many people believe it will. It is especially easy to break the LLC coverage if it is owned by a single member, as the plaintiff will state that without a diverse corporate structure the entity is simply an extension of the individual, and therefore should be disregarded. If the LLC is owned by a consortium of people, or better yet of trusts, then it is much more durable.

 

[KennyBSAT]

Do you mind commenting on choosing the right property? Are you going after foreclosures/short sales which can be attained below value, or regular sales?

My brother and I bought and sold foreclosures for a couple years before the mortgage meltdown turned all the buyers into renters, and we would up renting a house out for 6 years until we sold it this year. Buying foreclosures was a good job but definitely a full-time job.

 

[Gody]

Do you mind commenting on choosing the right property? Are you going after foreclosures/short sales which can be attained below value, or regular sales?

Choosing the right property is a matter of finding the best property to match your investment goals. I believe there are two main strategies in real estate investing. you are either investing for capital growth or you are investing for cash flow. Capital growth requires leveraging your down payment to build your equity as much as possible. A cash flow strategy requires investing in properties that will give you as much month to month income as possible. There is a balancing act between these two strategies as if you favor one strategy you will usually compromise on the other.

I haven't seriously pursued foreclosure sales myself. I have bid on a few foreclosure homes when I was looking locally for a rental property but never had an offer accepted. Foreclosures/short sales can be a competitive market and requires a little bit of experience in order to get yourself first in line when you find a valuable property. In southern California there are a good deal of investors who focus solely on scooping up these properties so I feel like I need to be allied with the right team in order to be successful in that realm.

I try to pursue a capital growth strategy with my properties right now and as my funds grow I am slowly buying cash flow properties as well to offset that and build a passive income for myself. When I look for a capital growth property I am generally looking for a property that I know would have decent rental demand and where the monthly rent would be within a couple hundred dollars of the mortgage and monthly expenses. From there I would run estimates and calculations similar to what I showed in the original post to see if I can establish a conservative estimate of at least a 10% annual ROI from my down payment. If I can then usually I am in a good spot to look deeper into the possibilities for the property. The reason I generally want the rents to be close to the mortgage/expense costs is because I have found when the there is a larger discrepancy between rents and mortgage, there tends to be a reason for it(the properties tend to be more cash flow oriented when there's a positive differential or if its a negative differential the property is in more of a speculative market where home values are rapidly appreciating). I don't want to rely on cash flow and speculating on property values rising is something I don't want to have to depend on when doing my estimates.

So on a macro level I want to know that the city/neighborhood I'm investing in has a steady and potentially growing population. I've relied on Texas for the past many years now because I believe in the growth of jobs, business and population out there . The community I invested in had a lot of medical facilities being built there so I knew there would be jobs coming to the area. The school district was one of the more well respected in the area too so families were eager to be there. I liked those facts and combined with the numbers it made sense for me to invest there.

I have to admit that a lot of my research lately has been done for me because the properties I have most recently been bought have all been new construction(another positive, as there will be much less repair/rehab needed then older properties). I have worked with a builder who scouts out locations and communities with the real estate investor in mind. They have realized that by building homes/duplexes in the right communities with real estate investors in mind they tend to do a lot more repeat business over time once they prove to investors and agents that they know how to find the right communities to build in that investors would appreciate. I have bought through them most recently in Texas and it has worked out well for me so far.

Hope that answers your question, hope I'm not getting too wordy/off track with my responses.

 

[Jig]

I really enjoyed Gody's quick overview of rental investing, and had some additional questions:

1. How easy/difficult is it to find property management companies and handymen that are reliable?
2. Are you finding additional properties with positive cash flow in today's environment, since prices have risen? I know rents are rising as well, but not sure how that is balancing out in your areas of interest.
3. When did you begin investing in rental RE? Prior to the 2008-2009 financial issues or just after?
4. What time percentage of a full time job would you say your RE investing related activities take up? Does it vary with the number of properties?

Thanks for your contributions! Always been interested in the cost/benefit of this type of investing. I have generally felt that REIT investing would provide similar returns with less time and liquidity concerns, subject to greater equity market volatility and correlation.

 

[Gody]

1. Good property management and handymen can be tricky to find. Usually a good property manager will already have a handymen or maintenance crew they trust. A good thing to investigate is how a property manager is structuring their fees. Generally fees are taken as a 5-10% cut from the monthly rents. But in some cases property managers will also charge you a percentage for every service/maintenance call that needs to be made. They might also charge you a leasing fee for renewing the current lease or finding a new tenant(I've seen 30-60% of first months rent). In my opinion, the service call fees and the leasing fees could be considered excessive since the management is already incentive to keep the property rented from the monthly fee they are getting from the rent. I try to avoid managers that have those fees but in some states/areas that fee structure might be the norm so you have to deal with it. Outside of fees, communication is key with property management and you should find a property manager that gives you updates/communication in a manner that you are satisfied with(I say this because some owners prefer not to be bothered with the monthly details of the property while other owners would prefer to hear about every event, so find out what you want and let your property manager know what you expect) .

2. Yes. If I was only looking in southern California I would say no(assuming people are putting 20% down). As long as you are comfortable in investing out of state I feel that you can almost always find a city or market where you can find that sweet spot to suit your investment. Just like there are stocks that can still go up in a down market, there are cities/suburbs that can manage to stay afloat in a housing crisis.

3.I began investing in RE in 2001. I had just bought my primary residence 2 years before and because I was lucky enough to get a good price on my home(the owner was getting desperate to sell) and the market was rising sharply so I suddenly had a lot of equity in my home. I refinanced my own home to unlock the equity and used the money to buy a rental property in a nearby neighborhood that I managed. The market continued to climb so I did it again in 04 and 06. In hindsight, my rental purchase in 06 was not ideal as it is still underwater after the housing slump. At that point in time I was wrong in assuming houses only go up in price after you purchase them. I have since refined my approach in real estate investing and learned that house appreciation is a nice bonus when you can find a hot market but it is much more fundamentally sound to invest in good properties with rental demand in financially sound cities. I moved my focus out of state once I realized that I didn't have to depend on appreciation to drive my investments. Thats why you can see from the example I originally posted, it is possible to post a 10-15% return on my investment property without even worrying if the home will appreciate in value.

4. I would say I could spend 1-4 hours a month dealing with my out of state properties. Most of that time is basically reading monthly statements or writing emails to authorize a repair or figure out an issue with property management, or just doing bookkeeping/paying mortgage. For my local properties that I manage myself it could be anywhere from 1-8 hours a month depending on if I need to show a property, make a visit for a repair or deal with a handyman. Some months can be really quiet and some months could require more of my time. And as you get more experienced you know where to focus your energy. I think with more properties it doesn't necessarily require more time unless you are the one who is managing all the properties. I'm lucky with my local properties. I just had to fill a vacancy for August 1st at my local rental home. I posted the vacancy it on Monday night. Had a showing on Tuesday night with ~30 sets of people coming by, had about 10 applicants, and had my new tenant sign the lease this afternoon. Summertime is a popular moving time so it made this vacancy easy to fill. Not all properties are this easy but if you know where to look you can find places like this where you could foresee demand helping you keep the property occupied with premium rents.

REIT's do offer the benefit of liquidity and and strong returns. The bonus that real estate offers is the many tax benefits and shelters that you can use to continue to grow your capital. So if you don't mind losing the liquidity, investment property can often grow your investment money quicker.

 

[farbster]

I wonder if the owner obtains a mortgage saying that they're living in the property, or are they borrowing money as an investor?

In my opinion, owning one rental might not be worth the effort and more importantly the risk. Image if the place sits empty or the tenant sticks you with a huge water bill. You're on the hook for the mortgage, even if you're not collecting the rent.

The investor also wants to make sure that they are not paying retail for any repairs.

Finally (well, not really), make sure to put money away for any future repairs. People forget about that

 

[redbirdsj]

This is actually not true. We were having some heated debates about how to bust through LLCs and Trusts recently and an LLC alone is not going to offer the liability protection that many people believe it will. It is especially easy to break the LLC coverage if it is owned by a single member, as the plaintiff will state that without a diverse corporate structure the entity is simply an extension of the individual, and therefore should be disregarded. If the LLC is owned by a consortium of people, or better yet of trusts, then it is much more durable.

Matt, can you point me to your source for this? If an LLC is formed in a business-friendly state (like DE) it is usually very effective at limiting the owner's liability to the LLC's assets. An LLC requires fewer formalities to be followed than a corporation and is often a more simple way to get corporation-like liability limiting without some of the hassle.

 

[Matt]

Matt, can you point me to your source for this? If an LLC is formed in a business-friendly state (like DE) it is usually very effective at limiting the owner's liability to the LLC's assets. An LLC requires fewer formalities to be followed than a corporation and is often a more simple way to get corporation-like liability limiting without some of the hassle.

My source for that were two trust and estate lawyers, one of whom was serving on the board of directors for the CFP. I understand the purpose of the LLC, and its value, but it isn't a vehicle that will really protect you from liability by default.

As I understand it, the LLC will act as a bucket, meaning that say you have 100K in a Real Estate 1 LLC and 1MUSD net worth, tenants would only come after you for the 100K, but other creditor issues could see the LLC as an asset, and go after both. However, beyond that it is possible for a lawsuit to pierce through the LLC shield and enter the 1MUSD if a lawyer can make sufficient case for it.

Having multiple owners of the LLC makes it harder for such a lawyer to come after you directly as it is harder to prove that the LLC is just an extension of your own personal wealth.

I'm not saying an LLC is bad, it just isn't the protection for liability that people might think.

We have a number of lawyers on the site now, perhaps one could offer an off the record opinion?

 

[redbirdsj]

You're correct that LLCs do not protect your LLC assets from creditors. If you are personally liable to a creditor, they can come after your LLC interest as well as your other assets. Rather, an LLC protects you (and your non-LLC assets) from liabilities arising from your LLC assets, which is why many landlords will segregate assets into different LLCs so a liability from one LLC (a fire from a faulty wire that injures a tenant) cannot taint other assets in different LLCs.

There is a mechanism to reach through an LLC to its owner for liability which is colloquially known as "piercing the corporate veil." However, this is not as easy as perhaps you've been led to believe in certain jurisdictions. The key to preventing a veil piercing is to maintain the separate existence of the entity from the individual owner, which is often proven by separate bank accounts (no commingling) and separate books, records and operations of the LLC from the personal matters of the owner.

Another often confused matter is that some investors think that if you manage your own properties, your LLC offers no protection. This is only true to the extent that you, in your capacity as manager, are responsible for the liabilities that arose, because all persons are personally responsible for their own tortious conduct, regardless of whether they otherwise own an asset in a limited liability entity or not.

PS: I am an attorney (but nothing here should be construed as legal advice for anyone).

 

[littlenemo]

@Gody - Look into Cost Segregation if you are not already employing this technique.

 

[Confectioneer]

While it's hardly a reason to acquire rental property, our duplex has been extremely valuable for MS.

It's allowed us to open up business credit cards without too much difficulty, so we can more easily build our points balances for travel.

 

[MilesAbound]

This is a great thread and clearly there are some very experienced and intelligent contributions here.

I am just getting into RE investment having recently sold my old house in London (for an admittedly lucky but astronomical profit) and am using the cash to invest here. I am based in NC and plan to only invest in state. My plan was to only invest in my county, in and around Raleigh, but I have started looking a little further afield at lower tier cities such as Greensboro. My strategy so far is to focus on the very low end of the market - townhomes/condos with at least 2 bedrooms that are below $50k that I can acquire all cash. So this is definitely not a leveraged equity play (which don't get me wrong I do love) but rather a high yield play. What I have found is that regardless of the quality of the unit, rental prices move in relatively narrow ranges. Here in Raleigh a 2 bedroom unit goes for between $600 and $1000 a month. There is nothing below the low end and very, very little above the top end. What that means is a $35k 2 bed will go for $600 a month while a $250k 2 bed might go for $1k a month. There is a figure bandied about that you should be targeting properties where the monthly rent is at least 1% of the purchase price, or the way I think of it is that the gross annual yield needs to be at least 12% (gross annual rent / purchase price). When I look at condos I subtract the HOA fees from the potential rent and then calculate my "gross" yield after that (so I can compare apples to apples with single family units). What I am finding is that the very low end of the market I am seeing gross yields (technically net of HOA fees) as high as 20%. This is a very compelling investment. I should add at this price range you attract Section 8 tenants. I have read much debate about this but personally I think it's great. From my limited experience so far it means you are held to a somewhat higher and often arbitrary standard of work for repairs from the local housing authority, but in return you get your rent check (which can be over market rates) on time each and every month without question.

So I acquired one unit and actually hold it in an IRA account. Now there is a lesson in here somewhere but I acquired the unit in March and after looking into it I never got landlord's insurance on the unit. There was a lot of confusion by the agency as to whether they could insure it given the IRA ownership, and the IRA administrators were clueless too. The building itself is covered by insurance taken out by the HOA so if there is a fire and the place is gutted I am covered. But what are the chances right? Well fast forward to last week and: http://www.wral.com/20-displaced-by-raleigh-condo-fire-2-firefighters-injured/13869955/. Yep that building is where my unit is!!! So anyway let's look at the positives... it was not my unit that was on fire, so was not the source of "blame". Phew. Nobody was hurt other than minor injuries to firemen. Great! All the units in the building are now uninhabitable either due to water, fire or smoke damage. Ouch!!! But the HOA insurance is covering a full "recovery" and they will rebuild and put everything like "new"! That is actually great. My unit only had water damage but I will now have it completely refurbed, work that would likely have cost a good $10k if I did it myself. However that landlord insurance would have kicked in and continued to pay my rent had I have had it. However at this stage it is obviously too late to close the stable door but it is also still unclear how to insure a property owned by an IRA. Let's say the fire started in my unit by my tenant and it ended up killing many people... they could in theory sue the owner of the unit for negligence. This goes to the "corporate veil" question above and whether it is the IRA administrator that is ultimately responsible or whether they could pierce this and come after me as beneficiary. I am trying to get legal advice on this but frankly it is quite a niche. So what will make me more comfortable is simply take out a landlord liability insurance policy with owner and beneficiary being the IRA account so that the chances of anyone ever needing to try to pierce that veil is much lower.

And I would feel the same way about LLCs. I am generally familiar with the concepts here from my work in financial engineering and creating special purpose vehicles to shield assets or protect from liabilities. In general it is never going to be black or white and so ultimately I'd rather try and insure my liabilities than try to be clever in shielding them. Or put simply, big umbrella policy is, IMHO, more useful than a well crafted LLC structure. I essentially assume any structure can ultimately be breached by a good/lucky enough lawyer and as such am better off focusing on insuring my risks. Not to mention liability insurance is not really that expensive as the chances of these remote events occurring are slim (but not, as I have found out, none)

Would love to just share experiences and banter with fellow RE investors. REITs are fine and dandy, the firm I work for manage a large one and I know the guys that run it. They are good guys, but to me there is no fun in paying someone else to do all the work

 

[Matt]

Great input @MilesAbound I did consider the IRA route in the past, but I since decided that the combination of convoluted rules plus loss of tax advantages inherent to property means I'll most likely head down the route of non IRA property and using 1031 exchanges. That said, I do like the notion of all that tax free/deferred money....

A running theme tends to be to buy away from your neighborhood - and this makes a lot of logical sense, it is unlikely that your first investment property will be of equal value to your primary residence, and therefore restricting yourself to your locale will be a real hinderance to getting on the ladder. My own hesitation has been finding an area that 'works', I looked at Vegas (North, near the Airforce base) on paper a little, but they weren't offering the returns that you talk about in Greensboro...

 

[MilesAbound]

1031 exchange only applies when you sell a property and reinvest?

having it in the ira means all the rental income goes there tax free, once there is enough built up i will reinvest in more properties.

For absolute sure though a big mistake people make in RE investment is focusing on shit they would actually want to live in. This is just wrong. Most of us live in decent homes where the majority of people can afford to buy their own place. The yields are awful and generally you only have accidental landlords who are renting because they are away for a year or two or some financial situation. The gross yield I would get on the amount I could realistically rent my actual primary residence for is about 6%. Our house in London was actually rented out at a gross yield of 4.7%. These are terrible numbers. But with that said if you live in expensive states like NY or CA it is very hard to find stuff with the kind of yields I can see here. But you have to focus on the numbers, not finding houses you actually like. I have looked at some god-forbidden shit-holes in my quest.

But I really have to say with these kind of yields this is a very attractive investment and something I am thinking more and more is going to be a big part of my retirement strategy.

 

[Matt]

1031 exchange only applies when you sell a property and reinvest?

having it in the ira means all the rental income goes there tax free, once there is enough built up i will reinvest in more properties.

For absolute sure though a big mistake people make in RE investment is focusing on shit they would actually want to live in. This is just wrong. Most of us live in decent homes where the majority of people can afford to buy their own place. The yields are awful and generally you only have accidental landlords who are renting because they are away for a year or two or some financial situation. The gross yield I would get on the amount I could realistically rent my actual primary residence for is about 6%. Our house in London was actually rented out at a gross yield of 4.7%. These are terrible numbers. But with that said if you live in expensive states like NY or CA it is very hard to find stuff with the kind of yields I can see here. But you have to focus on the numbers, not finding houses you actually like. I have looked at some god-forbidden shit-holes in my quest.

But I really have to say with these kind of yields this is a very attractive investment and something I am thinking more and more is going to be a big part of my retirement strategy.

Yep, the 1031 is a Cap Gains shield so you can flip from one property to the next without the capital gains. The appeal of the IRA is indeed that it is tax free inflow, but if you really want to get into RE investing you probably need to get into the leverage side too, run through a LLC not for liability but for deductions.

PS - I am pretty sure you can 1031 your London property too - but it has to go into another non-US property... might be a good time to pick up something in the Maldives to store your dive gear? Deadline is 180 days from sale or by your tax return date, which is about 2 months if you extended.

 

[Gody]

I never saw the appeal for buying RE through a retirement account as usually when you are doing so you are required to put more money down and like Matt mentioned, RE already has so many tax deferred/sheltered benefits that it seems redundant to put it in a fully tax sheltered retirement account.For example while a normal real estate investor can usually put 20-25% down to buy a property, if you are buying property through a retirement account I believe most lenders require you to put at least 30-35% down and have a certain amount of cash reserve available within the account. The extra money you have to put down pretty much dilutes any type of capital growth strategy with the investment.

The cashflow yield MilesAbound is getting from his property is quite impressive though. Usually I don't see those type of yields unless the property is old and in need of much repair. Since there is such a great return from the loan free property it does make more sense than normal to have it in an IRA as to shelter that cashflow. I'm curious how old the properties you are buying are? And is there an adequate rental demand in those areas you are looking? In California, you definitely don't see those yields without a lot of red flags.

Retirement accounts can also come in handy if you are purchasing property with a speculative strategy. I've seen hard money lenders and flippers use retirement account to purchase properties so that all of their capital gains from resale of their properties are tax . Its a nice strategy to use to be able to grow capital quickly without taxes cutting into the sales profits.

 

[MilesAbound]

Yes I should clarify that if you are investing through a tax sheltered account such as an IRA then financing is very difficult. The reason is under self-dealing rules you are not allowed to "support" the property yourself in any way, otherwise the IRS essentially views you and your IRA as one and the same and you stand to lose the tax benefits of the entire IRA plan. What that means is you cannot for example manage the property yourself. Not so much as go and change a light bulb. You have to hire an independent property manager. And you cannot use the property for yourself or your family. So no having a condo in an IRA and letting your kid use it when he goes to college. And then you cannot take a traditional mortgage against the place. Why is that? Well because every single traditional mortgage provides the lender with recourse to you personally. If the property is held in an IRA, you cannot provide that recourse. You can get non-recourse loans from certain specialist lenders but yes the down payments are usually higher and the interest rates are more in the high single digits which to me kills the economics. So yes IRA investing is, in my view, a cash only business. And yes I do keep a decent cash buffer in the account. There is no requirement to do so (maybe a non recourse lender would impose this) but I keep around $10k in cash in my IRA to cover unexpected costs and this amount grows as income comes in from the units. The idea will be once I have enough cash in there I just buy another unit then build up again.

When I wrote the paragraph above I also enlightened myself on the weakness of any LLC structure. Let's say I own a condo below one you bought and your tenant set fire to the building and it ended up killing my tenant and their family is now suing me for negligence. Well I am going to turn around and sue you. But you think you are sitting all smuggly with the condo owned by "My Condo Unit 123 LLC", a Delaware LLC. Well I'm going to be on the phone with my litigator pointing out that you - or an affiliated entity "My Property Management Co" that only provides services to your properties - provides all the property management services. The register of deeds shows that the property has a large mortgage which is undoubtedly guaranteed by you personally. Upon "reason and belief" the property is wholly owned by the LLC and your are the sole member of that LLC. The LLC is just a sham, with significant "punctures" leaking back to you personally, and a good litigator is going to have a field day.

Back to the investment side, at the price point I am dealing at financing is rarely an option anyway. If you are buying a condo for $35k there are few lenders who will lend such small amounts. I mean 25% down means you are looking for a loan of $26,250 and most banks have minimums much higher than that (a friend of mine who works for BofA's workout group tells me their average cost to foreclose is $30k in fees, so wtf would they lend that amount to anyone?) It's a market dominated by cash buyers so even if you find a bank willing to deal with such small numbers most sellers would rather deal with the cash players. Now this also works in my favor because now I am not subject to - no offense intended - guys like you are buying based on a long term leveraged yield. You guys are simply willing to pay more for properties than us cash buyers are, who just look at the unlevered income yield. So yes that is a big part of why the raw yields are better. I have seen this in my professional career a lot - any asset that you cannot get leverage on trades at significantly cheaper prices than those that can be levered. In any investment the absolute most important factor that will drive your return is the price you pay on day one for the asset you are investing in. Sure you can eek more money out later by streamlining costs and what-not, but overall your acquisition price is the biggest driver of return. Over pay and you will not get the returns. I don't think you guys necessarily overpay using the levered models - something where you are looking at at least 10% returns over a 15 year mortgage period is a great investment - but relative to the cash model it is overpaying.

My intention is to try to acquire around 15 units at the $30-40k price range that can consistently yield $400+ a month each over the long term (that means gross yield of $650+ to cover hoa fees, vacancy, management costs, maintenance etc). That means an overall investment portfolio of around $500k yielding around $72k a year, which is a good number for me in retirement once mortgage and other liabilities are all paid off.

 

[MilesAbound]

Yep, the 1031 is a Cap Gains shield so you can flip from one property to the next without the capital gains. The appeal of the IRA is indeed that it is tax free inflow, but if you really want to get into RE investing you probably need to get into the leverage side too, run through a LLC not for liability but for deductions.

PS - I am pretty sure you can 1031 your London property too - but it has to go into another non-US property... might be a good time to pick up something in the Maldives to store your dive gear? Deadline is 180 days from sale or by your tax return date, which is about 2 months if you extended.

LOL yeah no interest in holding foreign properties. With all the Chinese plowing in I can only imagine how ridiculously overpriced Maldivian real estate is right now. A lot of Chinese guys going to lose a lot of money....

 

[Matt]

Good to see the details on self dealing mentioned here too. I agree about the veil puncture through the mortgage, that is a reason why I suggest multiparty LLCs, as that makes it harder to put the blame on any one person.

We should also note that you can have a strong cash buying market outside of an IRA, and you can be competitive by purchasing all cash then backing out with cash out mortgages. HELOCs or other tools - that gives you the power of the cash buyer and the leverage of the tax advantages.

 

[MilesAbound]

HELOC will work but a cash out mortgage requires 6 months seasoning... unless you can afford to be without the $$$ for 6 months that does not work. Been there, tried that

 

[Matt]

Yep, and either way you somewhat (barring some nifty BT work...) need the cash in the first place... but it is a way to spin out into subsequent properties faster.

 

[MilesAbound]

Yep, and either way you somewhat (barring some nifty BT work...) need the cash in the first place... but it is a way to spin out into subsequent properties faster.

True - the other possibility when you have a large enough portfolio is regular commercial loans. Say I own 10 units each with FMV of $35k, I could probably borrow say $200k of that on pretty reasonable terms from a commercial bank. If the portfolio as a whole is spitting out enough cash to pay the loan at a decent pace and some room to spare that can be a great play. Definitely in my sights for further down the road.

 

[Matt]

True - the other possibility when you have a large enough portfolio is regular commercial loans. Say I own 10 units each with FMV of $35k, I could probably borrow say $200k of that on pretty reasonable terms from a commercial bank. If the portfolio as a whole is spitting out enough cash to pay the loan at a decent pace and some room to spare that can be a great play. Definitely in my sights for further down the road.

But will they give you a commercial loan to properties inside your IRA?

My brother in law does commercial RE lending, it's actually an interesting leverage proposition as it focuses on inflows (rent roll) of the property rather than the originator of the loan. Good for 5 unit or mixed use buildings (I think a different thing from what you are saying here though)

 

[MilesAbound]

But will they give you a commercial loan to properties inside your IRA?

My brother in law does commercial RE lending, it's actually an interesting leverage proposition as it focuses on inflows (rent roll) of the property rather than the originator of the loan. Good for 5 unit or mixed use buildings (I think a different thing from what you are saying here though)

Yes these commercial loans are generally non-recourse. As you point out lender is going to look at cash flow and the value of the collateral. Cash flow is how he is going to get paid back, and collateral is what he is going to have to sell if things go tits up. However I should say that not all of my RE investing is planned to be inside an IRA due to the limits on how much money I can get into IRAs (that is why PFD's post on the mega-backdoor piqued my interest). I plan on 6 figure investment outside of the IRA too.

And while I did say no to anything foreign I do have a big stash of cash sitting in various UK pension plans and because of the convoluted tax laws there is no way to bring that money over here. I am still allowed to see tax deferred growth and then future distribution will just add to my US income. Currently it's all invested in a variety of index funds but I am going to look into UK self directed pension plans. It is possible I could use the money in those plan to invest in "foreign" real estate (i.e. foreign to the UK), or I could invest in the UK. But UK yields absolutely suck. Landlords get excited if they can yield 5%. You' b be better off investing in dividend stocks IMHO, but maybe there is some stuff over there that could work

 

[MilesAbound]

Actually just looked into it and apparently SIPPs ("Self Invested Pension Plans") do not allow investment in residential property in the UK, only commercial. All the issues around it are similar to the issues that the self-dealing rules and administrators of self-directed IRAs have already addressed over here so maybe the politicos should look West for their answers. I do not know the faintest thing about commercial real estate!

 

[Matt]

Actually just looked into it and apparently SIPPs ("Self Invested Pension Plans") do not allow investment in residential property in the UK, only commercial. All the issues around it are similar to the issues that the self-dealing rules and administrators of self-directed IRAs have already addressed over here so maybe the politicos should look West for their answers. I do not know the faintest thing about commercial real estate!

Yeah, sometimes its not worth the hassle to figure it out either... maybe you can just send the kiddies to Oxbridge (its actually pretty reasonable...)

 

[MilesAbound]

Yeah, sometimes its not worth the hassle to figure it out either... maybe you can just send the kiddies to Oxbridge (its actually pretty reasonable...)

Oh trust me my "college savings plan" relies on the face that my kids can go to any school in the UK for 3k GBP (Oxford, Cambridge, Imperial, LSE, Sunderland Poly...) or Canadian institutions like McGill for $5k CAD a year. Worst case they go to UNC in state. There is absolutely no version of events where I pay $30-60k a year to any school....

But actually I would love to put that UK money to work in real estate over here but does not look like it works for now.... but seems there is enough discussion and debate it may happen in the future. Ironically you can "invest" in all kinds of stupid shit like copyright proceeds, pharma royalties, derivatives... i.e. they are quite happy to let you "invest" in shit that will just blow up