Real Estate: What is it for? Part 4

One of the things that I have found over the years in working with clients that own real estate portfolios is that people love buying real estate, but they constantly make fundamental mistakes when doing so. The starting point in deciding what to buy and how to buy it should begin with the answer to this question: What is it for?

This may seem like a silly question, but as a financial advisor I need to know the time frame, expectations, and, most importantly, whether the property will be used to create income, for growth, or for growth and income (both).

This is the fourth and final piece in our discussions on the appropriate investment strategy for buying real estate.*

Liquidity for Real Estate Opportunities

So, we have established that one of the biggest mistakes that investors make when buying real estate is leveraging incorrectly, or not at all. But often times, people are somewhat reserved about having a mortgage payment to make. Let me remind you of a couple of basic premises.

A $1M property that appreciates by 5 percent has a 5 percent rate of return (ROR).
A $1M property that appreciates by 5 percent that is half leveraged has a 10 percent ROR.
A $1M property that appreciates by 5 percent that is 75 percent leveraged has a 20 percent ROR.

Most people who start investing in real estate know this and start out their investment strategy using this concept to their advantage. However, as the years roll on and people get comfortable, they start to make the mistake of paying it off. Doing this may be the right thing to do, but often it done by accident. By paying a property off, you may lose many of the great things about real estate: the tax benefits. You may have depreciated a building down all the way which takes away a deduction. By having expenses such as a mortgage, you have a way to offset income. These should not be overlooked.

Using up one’s liquidity to invest in real estate can be tremendously detrimental. Look at everyone you know who fell into the trap of buying multiple properties in Arizona, Las Vegas, and Texas over the past 10 years. Many of them are underwater; that is, they owe more to the bank than what the properties are worth. If there is no cash left behind and all properties are leveraged to the hilt, then there is significant risk.

In instances like this, paying cash for properties can really be a savior. If properties such as these were owned outright, though the value may be down, the likelihood of losing them is small. In fact, they would likely be cash flow positive.  However, it may be argued that if there were a time to buy in Arizona it is NOW! With prices deflated like a porcupine’s balloon, there may be some great opportunities. For those who paid cash for properties, those opportunities may not exist. Getting cash out of a building is far more difficult than never having put it in.  So, perhaps there is a middle ground.

I believe that having the cash to pay them off is a GOOD thing, but to actually do it is the last thing to do, (or last resort). For that reason, we have helped many clients use an insurance based program to create liquidity for opportunities in real estate.** In this program, your capital cannot lose value due to market fluctuations, but can obtain growth type returns and cause a positive “arbitrage” opportunity if used correctly (that is, it can keep pace with or beat the “cost of capital” ). This capital may be accessed tax free under current tax law. What is the advantage of this program? For one, all of your eggs are not in one basket. On top of that, consider the idea that you will have cash available at any time for any reason at all! And while it sits there, growing tax free, you could pay off the property that you choose to leverage instead, and it could grow at 7 percent or more while you are borrowing money at 5.5 percent or so, on a tax-deductible basis. You do the math!

Troy V. Collins, RFC.
President, McKinley Financial Group
Phone: (650) 551-8900
CA Insurance Lic. No. 0B96613
www.mkfinancial.com
 
Registered Representative offering securities through First Allied Securities, Inc., a registered Broker/Dealer Member FINRA/SIPC.
Investment Advisor Representative offering services through First Allied Advisory Services.

* Investing in real estate and real estate investment trust (REITS) may not be suitable for all investors and involves special risks, such as limited liquidity and demand for real property, changes in supply and demand for real property, changes in law, tenant turnover or defaults, loss of investment, competition, casualty losses, and use of leverage. Real estate values may fluctuate based on economic, environmental, and other factors. There is no assurance that the investment objectives of any real estate program will be obtained.

** Most people do not know that one of the most tax efficient investments in our country is an insurance contract issued by Life Insurance Companies. There are risk factors other than market volatility that could cause loss of principle. Not everyone will qualify for insurance through this strategy. Consult your tax advisor for any tax related strategies.

Related posts:

1. Real Estate: What is it for? Part 3
2. Real Estate for Growth* Part 2
3. How can a financial advisor help me as a real estate agent?