Second homes and investment properties fascinate investors, who turn to Inman’s weekly Property Portfolio email newsletter as well as agents who work with this special class of client. This month, we’ll go deeper on everything from the latest at Airbnb and Vrbo to the changes investors are making to their portfolios in a shifting real estate market.
Smart investors are contrarians — they sell when property values are increasing and buy when they are decreasing. According to Realtor.com, major cities such as Austin, Charleston, Denver, Phoenix and Las Vegas have plunged between 7.9 percent and 10.3 percent since June.
As prices fall across the country, 2023 to 2025 may be the best time in two decades to invest in real estate that creates cash flow now, as well as generating revenue to fund your retirement.
Did you know that over the last 200 years, 90 percent of the world’s millionaires built their fortunes by investing in real estate? As President Franklin Roosevelt observed over 80 years ago:
Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.
Real estate vs. the stock market
From my perspective, key benefits of owning real estate, as opposed to stocks, include:
- Real estate is a hard asset that you can live in or rent.
- Virtually all U.S. real estate has historically kept pace with and/or exceeded the rate of inflation.
- You build equity as prices increase, paying down your mortgage each month, and/or making improvements to the property.
- Stock trades are conducted by sophisticated algorithms at the nano-second level that can result in massive gains or losses in just a few minutes. In comparison, real estate moves at a snail’s pace roughly cycling through seller’s and buyer’s markets about every 10 years. These long-term cycles make it much easier to capitalize on market shifts.
- In the four previous downturns I’ve experienced, including the worst one in the early 1990s where the L.A. market plunged about 35 percent in a little over six months, when the market swung back up, prices jumped to the pre-downturn levels in only a few months.
- Stock market and financial services fees consistently eat away at your profit margins. According to Investopedia, the typical financial planner charges 1.02 percent annually on the total amount of assets under management.
For example, if you have $500,000 in your 401K that generates a 6 percent return ($30,000) you would be charged $5,100 in management fees. That’s a whopping 17 percent of your profits and that doesn’t even take into consideration taxes or inflation.
Two cases studies: Stocks vs. real estate
The two following case studies illustrate the effect of holding stocks vs. real estate through market downturns.
Case study no. 1: Stocks
In 2000, my brother and I invested $200,000 we inherited with two large, well-managed funds. At that time the DOW Jones Industrial Average (DOW) was at 20,324 and bottomed in 2002 at 9,859. Our investment plunged to only $80,000 in a few short months.
To get back my original investment of $200,000 using reduced base of $80,000, would require the market to increase by 250 percent.
According to the DOW Jones Return Calculator, if I had stayed in the market for the last 20 years my $80,000 would have increased 278 percent with an average return of 6.875 percent, Today’s current value would be $222,400. That’s only $22,400 total over 20 years or a return of 1.12 percent, and that’s without any brokerage fees.
If you adjust this investment for inflation based upon the CPI, if I stayed in the market, my return over the last 20 years would have been 4.282 percent or $114,256. In other words, due to inflation, my $200,000 initial investment would now be worth the equivalent $114,256 in 2002, a decrease of $85,744 or 43 percent.
Case study no. 2: Real estate
While the value of your investment property may go up and down as the market shifts, if you pay off your property in 15 to 30 years you will have an asset that has cash value that also functions much like an annuity. Here’s a real-life scenario to illustrate this point.
In 1992 I sold a duplex in the San Fernando Valley to an old friend who still owns the property today. His goal was to use this investment to create additional cash flow for his retirement. Here are the transaction details
- Purchase price: $245,000, with 20 percent down ($49,000).
- Financing: 15-year fixed interest rate loan at 8.25 percent with monthly payments of $1,901 per month.
- The property required minimal repairs.
- Cash flow: Negative $700 per month because the buyer was subject to Alternative Minimum Tax. If he could have taken the normal depreciation and other allowable deductions, his negative cash flow would have only been $100 per month.
- Even with the Alternative Minimum Tax in place, it took less than five years for the property to break even.
When the loan was paid off 15 years later:
- Property value: $550,000, more than twice its original value.
- Operating expenses: $12,000 per year including reserves for repairs, taxes, vacancies, and other miscellaneous expenses.
- Gross rental income: $36,000 per year, net income $24,000 per year.
As of today (30 years later):
- The property is worth $1,090,000 (almost 4.5 times the amount of his original purchase price.)
- Gross rental income is $60,000 per year with operating costs of $18,000 per year. Net income is $42,000 per year.
Comparing this to other types of investments:
- A CD at 2 percent would require $2.1 million dollars to generate $42,000 per year.
- A stock investment with a net 6 percent return after brokerage fees would require a $700,000 investment, provided the stocks never lost any value during the 30 years.
My client is ready to retire
The buyer is now at retirement age and would like to maximize the cash he has tied up in his real estate investment. The two options he is considering are:
- Sell the property and pay the capital gains tax.
- Do a 1031 tax-deferred exchange for a single-family residence that he rents out for the first 12 to 24 months he owns the property. He can then move into the property and live in it as his primary residence. When he sells, he and his wife could take $500,000 of the money from the sale and pay capital gains only on the amount above $500,000.
The downsides of residential real estate investments
Tenants can be a nightmare and a vacant or damaged property can quickly eat up cash reserves. Furthermore, like any other investment, real estate investments can decrease in value. Also, it’s difficult to predict what the tax consequences will be in terms of capital gains, dividends and Alternative Minimum Tax requirements.
Despite these issues, the 1031 exchange provisions are an important plus. Because owners can exchange up (i.e., buy a more expensive property), they can continue to grow their wealth more quickly because they are able to defer their taxes until they cash out.
Most importantly, because real estate is a hard asset that keeps pace with inflation, it’s one of the most powerful hedges available to protect the growth of your investment.
Would you like to know more about how to identify a great real estate investment? If so, see Part 2 of this series, Secrets for maximizing your profits from your real estate investments.
Bernice Ross, president and CEO of BrokerageUP and RealEstateCoach.com, is a national speaker, author and trainer with more than 1,000 published articles. Learn about her broker/manager training programs designed for women, by women, at BrokerageUp.com and her new agent sales training at RealEstateCoach.com/newagent.