Real Estate: What is it for?

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 appreciation, or for growth and income (both).

This is the first in a series of four discussions on the appropriate investment strategy for each.

Real Estate for Income

When buying real estate for income it is necessary look at the type of income that you purchase. Although for appreciation, single family homes in the San Francisco Bay Area may be a great investment, for income typically they are not. Let me give you an example: A two bedroom home in Burlingame, California that would sell for one million dollars rents for $3,300 per month. Subtracting out the annual expenses of about 8 percent plus the property taxes, it would not be uncommon for this property to net $25,000 after expenses (but before taxes).* So for income, $25,000 on a $1M investment equals 2.5 percent, which is a little better than a CD with substantially more risk and work to maintain. Don’t get me wrong; this investment may be far greater than 2.5 percent due to possible appreciation; however, my point here is to demonstrate that for income, this is not a great investment.

So what might work better? For income, multiunit properties, apartments, or commercial properties may be far superior in terms of income than single family homes. In today’s market, you may be able to find a 6 unit property for $1M. You could rent for approximately $1,200 per month, giving you a total $7,200 per month or $86,400 per year in rental income. After expenses, you may still have $70,000 net income after expenses (but before taxes). On a $1M investment, this is 7 percent net income. Now this, as far as income is concerned, is a very decent investment. As for appreciation, however, multiunit properties and apartments do not typically keep up with single family homes in terms of value.

Other options may include using Real Estate Investment Trusts (REITs)** for income. Generally, nonpublicly traded REITS have a more stable valuation than publicly traded REITs and their goal is to pass along high income: 5 to 7 percent income is not uncommon in today’s marketplace. Using REITs instead of owning the property individually allows for the owner to have less of the management headaches that a landlord may experience.

Using leverage may also allow for additional income on a property. If, by using leverage, you are able to buy a larger building with more income, and the income outweighs the expenses of the loan, then this too can be of benefit.

Bottom line: You need to do some planning prior to purchasing a building. You should consider the types of properties, how to fund the property, whether to use leverage, who will manage the property, what improvements it may need, and what annual expenses it might have, among other issues. The list of considerations is long, but the end result well worth the hard work if done correctly.

Troy Collins

* If this property were bought 10 years ago it would fare a little better because property taxes would be reasonable for today’s standards. However, if it is a property that you are looking at today, property taxes would cost more than $10,000 per year.
** 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.

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.

Related posts:

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