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Real Estate Investing In Addition to Your Primary Home
Owning real estate is valuable for the roof it puts over your head, the enjoyment you get from living in your home, the increased net worth you gain from home ownership and the extensive tax breaks you get during that ownership. Directly investing in real estate other than your primary home can make a key additional contribution toward achieving your long-range financial goals. Making smart real estate purchases and buying investment properties can increase your net worth significantly. The experience you have gained from buying and living in your home gives you an excellent background for taking the next step of buying additional properties, should you decide to do so. We strongly recommend you consider having a lifelong real estate investment plan -- beyond owning your primary residence -- as a way to diversify your assets and maximize your long-term wealth and that of your heirs.
Most types of investments are broken down into three general categories: fixed income investments, equities, and direct ownership of real estate. Fixed-income investments include certificates of deposit (CDs), money market funds, notes and bonds. These investment options provide you with a safe place for your savings. Equities include the direct ownership of individual stocks, owning a "group" of stocks through mutual funds, owning REITS (Real Estate Investment Trusts), buying stock put and call options or buying "preferred" stocks. Also, you can own real estate-residential or commercial property- directly. Let´s take a few moments to compare these alternatives.
Certificates of Deposit, money market funds, notes and short-term to intermediate-term bonds-all fixedincome investments -- offer the safest opportunities for investing, but they also provide you with a low return on your investment. Most folks will never become rich if they rely exclusively on these forms of investing. Nevertheless, these types of investments should play a role in your long-range financial goals.
The second avenue -- equities -- has been an enormously successful investment for many. Overall (and over the very long term), the stock market has returned annual gains that are superior to any other form of investing. Note, though, that the long-term trend has included enormous stretches of time when the stock market return was basically flat. For example, from 1964 to 1982, the Dow Jones Industrial Average traded in such a narrow range that there was no capital gains at all if you owned and held on to each stock in the DJIA during that 17-year period. Conversely, there was an enormous increase in the value of equities between 1982 and 2000, but many of those gains-especially in the more speculative "Over the Counter" market-quickly evaporated in the implosion of many technology stocks. So if you are an investor who is convinced that you can beat "Mr. Market" over the long term, be careful. The bottom line, at least from my perspective, is that many folks may rely too heavily on their stock portfolio (or their 401k plan invested in stocks) and may not achieve the fine life in their retirement that they so richly deserve.
Direct investment in real estate in addition to your primary residence covers various investment options, including residential and commercial real estate as well as land itself. You should be fully aware up front that a direct investment in real estate (other than land) requires a lot of attention and needs active management. Remember, when you invest in real estate, you are investing in your future. You should anticipate your future needs and those of your family when buying and selling property.
You want to make your investment work for you!
Your initial direct investment in real estate will have the potential to skyrocket, thus giving you solid gains for your retirement without having to worry about the risks of stock ownership for that portion of your diversified assets. No other investment provides the security and cash flow that real estate does. If you are in it for the long haul, regardless of market swings, investments in property almost always pay off. The benefits of homeownership, obviously also hold true for investing in investment properties -- especially the leverage and the tax advantages that will bring you a great return on your investment over the years. In fact, there are additional tax breaks related to investment properties (including depreciation). Granted, directly investing in real estate is different from other forms of investing, because it requires more attention and needs active management. But in my estimation the benefits far outweigh the time and effort required.
There are three major advantages to buying rental property.
A real estate investment can provide a great deal of leverage. Today, you can purchase a rental property in many locations in the United States for as little as 10 percent down, thus obtaining a 90 percent mortgage loan.
The tax code provides significant tax benefits for your annual return - including depreciation, deducting interest on the mortgage payments and writing off operating expenses and any investments you make in improving your investment property.
The tax code also provides significant benefits for the long term when you decide to sell one investment property and invest in another. IRS Section 1031 - commonly referred to as the "Starker Exchange" - allows you to defer long-term capital gains tax even if you buy and sell numerous investment properties over the years. A 1031 exchange allows owners of certain types of income property to sell their property and buy similar property without paying any capital gains tax. The "similar kind of property provision" of Section 1031 is quite broad, and it includes land, rental properties and some commercial properties. Any of these can be exchanged for another version of the same type of property without being taxed. The rule requires the owner of the property to use a "qualified intermediary" as a safe harbor to hold the proceeds while the exchange is in progress. A qualified intermediary is a professional licensed to hold funds for transfers of real property. There are also strict time limits. For example, you must identify a new property within 45 days after the close of the primary property, and the closings must occur within 180 days of each other. It should be noted that Section 1031 does not apply to "related party" transactions. The many other rules and restrictions can be outlined for you by either an accountant or a qualified intermediary. The bottom line is that a 1031 exchange allows investment property owners to benefit from buying more expensive income properties without being taxed on the appreciation of the properties they´ve sold.
Envisioning Your Investment Property
If you decide to invest directly in real estate beyond your primary residence, I suggest that you break any potential purchases into three categories. First, you may want to buy a second home -- a vacation residence. Second, you may choose to purchase land in an area where you might want to retire -- but you should invest in that land well before your actual retirement. The third approach is to buy a condo, townhouse or detached home or apartment building (or multiple sites) as an investment with the goal of increasing your total net worth and providing an additional source of income. Of course, there is nothing precluding you from doing "all of the above."
Buying a vacation home may indeed fit into a wellthought-out financial strategy. One of my sons recently went to a financial planner who analyzed his family´s overall financial situation. The objective of the exercise was to develop a wide-ranging plan that took all aspects of the family´s financial situation into consideration, ranging from getting proper insurance coverage to setting up 529E college savings plans for the children and making rough estimates on the eventual value of his 401k and corporate retirement plans. I found it interesting when my son mentioned to me that the financial advisor´s final report suggested that the purchase of a vacation home should be given strong consideration as a component of an overall long-range financial plan.
Obviously, investing in a vacation property is very personal. Individuals, couples and families have widely ranging interests and desires for their recreation properties that could include ski lodges, golf resorts, lakeside or oceanside properties, hunting areas or a condo in a metropolitan area. If you vacation often, paying exorbitant rental prices or hotel fees season after season can be very expensive. Investing in a vacation property can end up saving you money while giving you a comfortable place in which to spend your vacations.
The purchase of a vacation home can also pay off profitably in terms of the money you will make from renting your home out to other vacationers when you are not there. If you purchase a vacation home in a desirable resort area, you can rest assured that people will always compete for rentals, especially during peak seasons and long weekends. There may be additional mortgage interest deductions for your second home, too. (These deductions should first be verified by your accountant.) The value of your vacation property may also increase significantly over the years if you select it wisely.
You might consider buying a lot or land in a community where you plan on retiring at some future date. If that interests you, I would like to mention an option that may be attractive to some. The editor of Forbes, Richard Kaargland, recently wrote a book that hypothesized that the "next big thing" in residential real estate might be the rapid growth of home values in "university towns." He notes that home prices are so high in the cities where many of the largest corporations are headquartered that those corporations are encountering trouble when they ask employees to move to those locations. After all, many people would find it difficult to give up a nice four bedroom colonial on an acre lot in a city in the Midwest to make a lateral move (at least in terms of home value) to a greatly downsized residence in some major metropolitan areas.
On the other hand, university towns or cities -- such as Madison, Wisconsin; Ann Arbor, Michigan; Charlottesville, Virginia; and Chapel Hill, North Carolina -- offer a lively social setting and an appealing, "youthful" environment. The real estate costs in many of these areas are modest. Kaargland projects that corporations may begin to relocate to these moderate sized but dynamic cities where universities are located. He anticipates that these locations may very well see a rapid increase in real estate values.
Various magazines have featured articles about people who decide to retire (or semi-retire) in the town or city where they attended college. They have the advantage of already being familiar with the community and probably have made at least occasional contacts with these cities by returning for class reunions or homecoming football games. If returning to your college town for your "golden years" appeals to you, you might consider buying a properly zoned lot or other land in that town, or its environs, well before your actual retirement begins. Many people hope to retire to more typical locations -- North Carolina, Florida or Arizona, for example. If that happens to be your plan, I would still recommend looking into investing in those locations well before your actual retirement -- whether it be in a lot, a townhouse or a detached home that you may eventually want to live in.
A Theoretical Case
Let´s address a hypothetical case. You are 50 years old, and your long-range goal is to retire at age 65 with a very comfortable lifestyle. You have a modest 401k plan and you´ve been contributing to Social Security over the years. At age 50, you decide to diversify your assets to help achieve your long-range financial goals, and you purchase a rental property -- let us say a townhouse. You take out a 15-year mortgage on that investment property.
During the first five years of this investment, you have a slightly negative cash flow, even after the tax breaks you get from depreciation and deducting the interest payments on your mortgage payment. During the next five years of your 15-year mortgage, you basically break even. In the last five years of the 15-year mortgage, you see a modest monthly profit, but you reinvest a portion of that profit into the property because you make upgrades. At first glance, this does not appear to be a very good deal; in terms of cash flow, you´ve basically had a modest profit over the 15 years. What´s the big deal? Why go down that investment road? Here is why!
The Big Payoff!
If the value of property has increased by just an average value of 5 percent at a compounded rate over that 15-year period, the total value of your property is up 100 percent. (Note: This is a very modest assumption in Northern Virginia. In Fairfax County the gains have been in double digits for each of the last five years.) Your "out of pocket" money for this investment over the 15-year period has been basically just the down payment. Let´s go on.
At the end of the 15 years (again, based on rental income examples from townhouses in Northern Virginia), your monthly income from that property in today´s dollars (2005) would be in the range of $1,500 to $1,700. You have no payment (other than taxes and upkeep) to make on the property, because your mortgage is paid off.
If you time your mortgages so that both your rental property and your personal residence are paid off simultaneously (and for discussion purposes, let us also assume a payment of $1,500 per month for your personal residence), your monthly cash flow has suddenly changed dramatically. You no longer have monthly mortgage payments of $3,000 for the two mortgages, and you have a monthly income of $1,500 from the rental property. Let´s take that one step further. Your sixty-fifth birthday also works out to be the time that you begin to receive $1,700 per month from Social Security. Suddenly, based on this scenario, your positive net annual cash flow has shifted dramatically in your favor. These estimates do not include any income you may derive from corporate retirement plans, government retirement plans or IRAs and 401ks.
Many folks get involved in investing in real estate as a way to accumulate assets. They may buy properties that are in default, purchase "fixer-uppers" and then repair them or "flip" properties -- i.e., put an "earnest deposit" down on a property that has not been built and then sell it as soon as it´s complete. There are innumerable books to read or seminars to attend if you choose such aggressive investment paths. I´m simply recommending that you consider broadening your investment horizon to include direct investment in real estate. Over the long term, you may accrue enormous wealth and income from such an investment.
Naturally, I believe that buying real estate should start with the selection of a qualified agent. The same holds true for buying investment properties. You need to make sure that your agent is willing to commit to an exclusive buyer agency agreement with you. Purchasing rental property is actually far easier and less stressful than purchasing your own home. Once you set up your investment objectives and property parameters and get the commitment of your agent, you merely have to wait until a property meeting your investment criteria becomes available. Because you are never going to live in the property, the floor plan needs only to be average for the area.
Rental properties can be an excellent investment in any market. As noted before, few investments can provide you with significant appreciation, a nice monthly cash flow and generous tax breaks. But unlike other investments, you can spend a substantial amount of time and energy managing your investment (i.e., being a landlord). If you are considering buying real estate as an investment - houses, apartments or even mobile homes - here are some landlord-tenant basics that you should know. Under Virginia law, any dwelling place that you rent out to another person must be habitable. Check with your agent on the details of what must be provided. If you are considering buying a "fixer-upper" rental property that needs a new roof, windows or other essential item, be sure that you have the funds to fix them immediately or that you ask the seller to fix them in your sales contract. It is simply illegal to rent a place, even for a short period of time, without repairing such items. The fines you could owe for noncompliance are serious. This chapter is just touching on the basics of owning rental homework on Virginia´s landlord-tenant laws. Rental units must be clean and in good repair when the tenant moves in. Any common areas must be safe for normal and expected use. Whatever appliances you provide must be in working order.
Information Every Landlord Should Know
The number one basic rule -- which is from the Virginia Fair Housing Act -- is that you must never discriminate against anyone on the basis of race, color, religion, national origin, sex, elderliness, familial status or handicap. You also may not refuse to rent to adults with young children. There are exceptions to this rule, with "adult only" communities and buildings. Discrimination is a serious matter in housing and is not taken lightly by the state.
Make sure that you have a written lease with your tenants. The lease can be for a month-to-month period, in which any party can end the tenancy at any time with 30 days´ notice, or it can be for a set period of time, such as six months or two years. You have the right to charge prospective tenants a reasonable application fee. After a tenant moves out you have 45 days to refund the tenant´s entire deposit or to explain to the tenant, in writing, why some of the deposit is being held back. Make sure you are familiar with the items that are allowed to be withheld from a deposit.
If you sell or buy a building with tenants, you are obligated to honor the terms of the original rental agreement. You will also be responsible for returning any deposits when the tenants move, so make sure that you get the deposit money from the old landlord. Although there is no rent control in Virginia, you can only raise the rent at the end of the lease term (or within 30 days, if the tenant has a month-to-month lease). You may charge a late fee if the rent is not received by a stated date in the lease.
You have the right to enter a tenant´s unit, but you must give a verbal or written reasonable notice before entering, unless there is an emergency or a prior agreement to let you enter.
If you have grounds to evict a tenant, you must use the judicial system to get the tenant out of the unit. You can be held legally responsible if you change the locks, shut off the utilities, remove the tenant´s belongings or take any other action outside the courthouse to force the tenant to move. Some lawful reasons for evicting a tenant are as follows: refusing to move after the expiration of a lawful 30-day notice; unlawfully keeping a pet in violation of the lease; being more than seven days late in paying rent; unlawfully renting or subletting the unit or letting others reside in it (not counting temporary guests); and injuring or threatening injury to anyone in the building or any other extreme and outrageous behavior. (You may want to consult with an attorney.)
As someone who has been a landlord over the years, I want to share an important lesson that I have learned: hold on to good tenants! In some of my rental properties, I have not raised the rent for an extended period of time. The tenants were pleased with the property and the rent that was charged. I received a good return on my investment and minimized the costs of finding new tenants. All parties were satisfied.
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Pat Paulas, Drew Paulas and Associates, Realtors Loudoun County Real Estate and West Fairfax County Real Estate
Prudential PenFed's TeamWorks 11864 Sunrise Valley Drive, Suite 101 • Reston, Virginia 20165 703.909.6333 e-mailtheTeam@eLoudounHomes.com
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