you begin shopping for loans and comparing the terms offered, you'll see that the differences can be quite amazing. In Chapter 9, we'll explore in depth the strategic importance of how you finance your income-property purchases.
Leverage, one of the most significant advantages of investing in real estate, refers to the practice of using a minimal amount of cash to buy a property while financing the balance for the longest term possible at the lowest available interest rate. Leverage is one of the most important tools in building wealth through investment real estate. For starters, it makes real estate affordable. Most investors couldn't make such a significant investment if they had to come up with all the cash at once. Wealthy real estate moguls know the power of leverage.
And leverage, which is, of course, intrinsically linked to the ability to borrow – or access money that is not your own – carries another important advantage. While interest rates on home mortgages have been low, homebuyers generally have no room to negotiate the amount or the terms of the mortgage. In commercial real estate, negotiating the right loan is part of the deal. Commercial financing is discussed in detail in Chapter 9.
Leverage is an extraordinary tool that exists because lenders believe in the stability of choice income properties. They recognize these properties as solid investments. For investors with a strong credit rating, they are happy to make loans for up to
75 percent, and in some instances 80 percent of a commercial property's value, provided it is a choice property in a top location. I know of no other investment where you can put in as little cash and get as high a rate of return.
Income-producing properties carry special tax advantages. Land is not depreciable, but the buildings that sit on it are. Under the concept of depreciation, the Internal Revenue Service assigns a useful life to buildings, 39 years for commercial property and 27.5 years for residential property, including apartment buildings. The assumption is that as buildings get older, they decrease in value each year. But when properly maintained, most buildings actually increase in value over time. Depreciation is a bookkeeping expense and not an out-of-pocket expense. Therefore, if you have a net income from a building of $100,000 and the depreciation is $30,000, the net income now becomes $70,000. If you are in the 25 percent tax bracket, you will save $7,500 in income taxes ($30,000 × 25 percent = $7,500).
In the foregoing example, you may be able to substantially reduce your taxes on the net income by using a method known as segregated cost depreciation. Under this method, the IRS will permit you, based on a qualified engineering report, to divide the cost of the building into four components. One component would be the building itself (the real estate), based on either a 39-year or a 27.5-year useful life. The other three components can be classified as personal property based on a 5-year life, a 7-year life, or a 15-year life.
Because of the faster tax write-off under the preceding formula, your depreciation reduction would be significantly higher during the initial seven years of ownership using segregated cost depreciation. And that would reduce your income tax obligations dramatically. If you have already invested in real estate and haven't used this method of depreciation, you can go as far back as 1986 and calculate the additional depreciation you could have taken under segregated cost depreciation. You can state it as a deduction on your current income tax return without amending any previous returns. If you are a real estate professional (not necessarily a broker or agent) and active in the operation of the building, you can take any losses generated by depreciation as a deduction against your ordinary income – which lowers the amount of income tax that you pay. The resulting income tax savings would, in effect, increase your cash flow and, accordingly, your cash-on-cash return.
Meanwhile, exchanging one investment property for another investment property defers capital gains taxes until a subsequent property is resold (1031 Exchange). Those are just examples of the many tax benefits that are available on real estate investments. Later, as we explain different financing options and property sales approaches, we'll also discuss their tax advantages.
Real estate is an investment characterized by openness and quick access to information. Real estate sales are part of the public record, so it's easy to track sales histories and the financing details of a particular property. Local and national property listings, sales of tax liens, details on sheriff sales, and foreclosures are among the volumes of information available on the Internet. There are public records on how neighborhoods are zoned, and Census Bureau information details the demographics of different locations. There are simple formulas as well as statistics in trade publications that help determine the annual costs and expenses of a building.
One of the other pluses of real estate investment is that when a downturn takes place and some real estate is at a standstill or declining in value, there are still opportunities to make money. For example, you can invest in properties (e.g., medical buildings) that remain profitable despite market forces. Or you can do condo conversions of apartment buildings in response to market demands. (The process for converting apartment buildings into condominiums is explained in detail in Chapter 13.) When owners sell properties, for whatever reason, during down markets, they will often agree to deals that they wouldn't otherwise consider. For example, if an owner was selling you a building for $500,000 but you thought the building was really worth $525,000, you could ask for a one-year option with an option fee of, let's say, $5,000. If within six months you then found a buyer willing to pay $525,000, you could exercise your option and make a $25,000 profit – on an investment that cost you only $5,000. In addition, the $5,000 option money would be credited to the purchase price. In effect, you've engineered a deal that brought you a whopping 500 percent return based on a six-month holding period and an annualized rate of return of 1,000 percent.
There is a risk, of course. But that risk would be that, if you didn't find a buyer within the prescribed period of time, you would forfeit the $5,000.
The lesson here is that real estate is not an either-or investment arena. There are easy formulas and fixes for weathering its ups and downs.
If real estate is such a great investment, why aren't more people investing in it? The answer is simple: Fear gets in their way. Of course, it is normal, particularly for a first-time investor, to be wary. In fact, no investor, whether inexperienced or experienced, is completely immune. Some of these fears may be self-imposed, while others come from external influences. But there's a single antidote for all of them: knowledge. The better you understand the “fear factors,” the less intimidated you'll be. Let's explore the principal “fear factors.”
No-Money-to-Invest Fear
This may be the biggest obstacle for many would-be investors, but it's also the easiest to overcome. That's because it's an ungrounded fear. Although people may look at their bank account balances and immediately assume they don't have enough to get started in real estate, they're wrong. You don't need a lot of ready cash. That's the joy of income-producing real estate. Besides, you likely have assets that you didn't realize could be turned into the seed money you need to get going. Chapter 4 will help you identify your hidden assets and show how to make them work for you.
Fear of Inexperience
Every real estate investor was inexperienced at some point. That's no reason not to take the first step. One of the best ways to handle this fear is by seeking out a trusted person who has been successful investing in, say, apartment buildings. Ask whether he or she would consider letting you become a partner in the next investment. That way you learn the steps involved and get your feet wet while under the guidance of someone who knows the ropes. Once you have a deal or two under your belt, you'll have the confidence – and peace of mind – necessary to invest on your own.
Price Tag Fear
All investors have
