Thinking of investing in Real Estate?

Take a look at these Pros and Cons of Investing in Real Estate First

Real Estate investing has really boomed in the last decade.  Books, live-courses, and webinars boast of teaching people to make thousands of dollars per month in passive income with little effort.  While real estate can be a path to build wealth, it takes patience and work.  This post will examine the pros and cons (in no particular order) of investing in residential real estate. 

A couple of caveats up front.  I’ve chosen round numbers for the sake of making the math easier. And while these numbers are made up, I think they’re realistic in some markets – unfortunately the mid-West not San Diego. 

Real Estate Investing Pros

Pro #1 – Leverage

Leverage in the real estate investment world means using someone else’s money, usually a bank, to  cover most if not all of the purchase price of a property.  Using leverage can potentially increase investment return exponentially.  The ability to use leverage is one of the things that makes real estate investing so attractive. 

Here’s a simple illustration of the leverage concept: Suppose you have $20K to invest.  You can put that $20K in a mutual fund and buy $20K worth of shares in that fund. Let’s say your mutual fund increases in value by 8% in year one.  At the end of year one your account is now worth $21,600. You’ve made $1600 without doing anything.  Not bad.

Alternatively, you can buy a house worth $100K.  Let’s say the house increases by just 3% in the first year.  At the end of year one your house is worth $103K so you’ve made $3K this time without doing anything.  Your rate of return on your initial $20K is 15%.  You’ve almost doubled your rate of return just on appreciation!  Leverage will do that for you. 

Pro #2 – Cash Flow

Cash flow in the real estate context is the difference between the rents you receive, and all your expenses i.e. rent – (mortgage, taxes, insurance, maintenance, property management etc).   In the above example of the $100K house – let’s say you get $1000/month in rent.  You pay a property manager 10% so $100/month and you average $100/month in maintenance. Your mortgage, taxes, and insurance costs about $600/month.   That gives you $200/month in cash flow as follows: $1000-$600-$100-$100 = $200/month or $2400/year.  

Pro #3 – Tax Benefits

Real estate investment property gets favorable tax treatment in a number of ways:

1. Depreciation – Even though your property is most likely going up in value, the tax man treats it like it’s going down by allowing depreciation.  Depreciation for residential real estate is calculated on a 27.5-year straight line basis using value on the improvements on the property.  Improvements basically means the structures.  Rather than try to explain what all that means here’s an example using our same $100K property from earlier.  Let’s say we’ve calculated the value of the structure at $90K and the land at $10K (land doesn’t qualify for depreciation).  Straight line depreciation simply means the depreciation is calculated equally each year. So $90K/27.5 = $3,272.72/year.  So that $2400 of positive cash flow – you’ve canceled it all out for tax purposes with depreciation.  

• Taxes deferred –  After you’ve held a property for a few years you’ve hopefully had some appreciation and you’ve pay down some of your principal.  So you have some equity sitting there.  If you sell your property (or stocks) you’d have to pay capital gains on any appreciation you’ve had. Instead of paying taxes the IRS will let you defer them through a 1031 exchange.  Section 1031 of the tax code lets you sell your current property and use the proceeds to buy another property without paying any taxes.  For details on 1031 exchanges click here. 

• Tax deductions – In addition to deducting depreciation, you can deduct repair cost, mortgage interest, property taxes, management fees, HOA fees, utility payments etc.  For those making less than $100k/year in income, you can deduct up to $25K of your expenses from your ordinary income.  This tax benefit phases out completely for those making over $150K.

Pro #4 – Stability

Real estate values are relatively stable as compared to stocks which showed quite a bit of volatility even before Covid.  Real estate on the other hand usually experiences far less fluctuation.  The one glaring exception to this occurred in 2008 – 2010.  However, the stock market lost significant value during that time frame also. 

Pro #5 – Tangible asset

You own it.  You control it. You can see it.  You can touch it.  You can improve it to make it an even more attractive investment. 

Pro #6 – Principal pay down

Every month your tenant is paying down the balance on your loan.  In the above example, you bought a rental property using $20k of your own money and a 30-year fixed rate mortgage at 4.5% (Investment property has higher interest rate).  At the end of year one, your balance will be $78,489.  Your tenants will have paid down $1500 of your loan balance.  

Real Estate Investing Cons

Con #1 – Transaction Costs

Real estate is expensive to buy and sell.  Real Estate brokers take a 5-6% commission right off the top. On the buyer’s side you pay for inspection, appraisal, title insurance and mortgage fees to name a few.  Contrast that to stocks where many brokerages have cut commissions to 0.

Con #2 – Illiquidity

There’s no such thing as quick, easy access to your equity in real estate.  Whereas publicly traded stocks can be liquidated on a moment’s notice, real estate doesn’t work that way.  Most closing periods for real estate take at least 30 days, and that’s after you find a buyer.  Even a refinance will take a several weeks.  

Con #3 – Exit strategy

While you do get to defer taxes and deduct depreciation, the tax man gets his share at some point.  When you sell, you’ll owe taxes on any appreciation at the capital gains rate. That amazing gift of depreciation is recaptured (i.e. paid by you) at ordinary income tax rates.  The real winners are your heirs who get to calculate their basis at the fair market value of the property on your death.  Of course, you’ll be dead. Hopefully kids will finally appreciate you. 

Con #4 – Vacancy

Anytime your property is vacant you’re having to cover that mortgage payment out of your own pocket.  That’s no fun. 

Con #5 – Maintenance 

Appliances break. Roofs must be replaced. Trees have to be trimmed. These expenses add up and can eat away at your cash flow.  See our article on home warranties here. Selection of the right home warranty can help with maintenance costs.