Mistakes made by real estate investors have real and hard consequences. The good news is you do not have to make the same mistakes as others who have come before you. There is beneficial wisdom out there to help you make excellent investment choices with predictable outcomes, while being aware of and privy to the challenges and potential setbacks of the real estate business. Below are some initial situations and wisdom to consider along your path to becoming a wealthy, successful and stress-free real estate investor.
1. Overlooking the REIT Option
There are three primary ways to invest in real estate and, before you invest, it is important to consider all options and choose which one is best for you. These choices include the REIT option, becoming a real estate dealer, or becoming an investor. The distinctions between the three are simple, yet significant and not always well-known.
REIT stands for real estate investment trust and refers to companies that own or finance real estate assets for profit. They operate like mutual funds and allow investors to be part of a company instead of working independently. Like mutual funds, investors can create a portfolio of real estate investments that are purchased and managed by the company and then benefit from the income produced by the company’s investment. It is most common to receive dividends generated by rental income from leasing agreements of various property investments.
Being an investor in a REIT is much more stable and requires less involvement from investors. It is often a great option for those interested in getting started in the real estate business, but seeking a first step to better understand the process.
2. Avoid Dealership
One common error investors tend to make is not understanding and actively choosing to be either a real estate dealer or an investor. The IRS makes a simple determination between the two and different treatment of capital gains tax can be significant depending on which distinction you fall under. A real estate investor is an individual who intends to make long term investments in real estate. A long-term investment is considered to be the ownership of a real estate property for more than a year. A short-term investment is the ownership of a property for less than a year. If you intend to sell real estate within the same year, you will be considered to be flipping property, much like a car dealer. If you hold the same real estate asset for 13 months, you are considered a long-term investor. This distinction is crucial when it comes to paying long-term and short-term capital gains taxes, as well as FICA taxes.
3. Getting Straight on Capital Gains Taxes
One important to tax consideration in real estate is capital gains taxes. If you eventually sell your investment, you will have to pay a capital gains tax, or a tax on the profit made from selling a property. Understanding the difference between short-term capital gains and long-term capital gains is important because the percentage of capital gains tax you pay is significantly more for short-term capital gains. Short-term capital gains are considered any earnings made within a year and will apply to real estate dealers. Real estate investors selling their assets will benefit from long-term capital gains, or earnings acquired beyond a year.
Long-term capital gain tax averages around 15% of your overall profit. This percentage varies depending on your tax bracket and will range from o-20%. Short-term capital gains tax, however, will be a much higher percentage, an approximate average of 30% of your profit. This means that by keeping your property for over a year before selling it, you may save between io% and 20% on capital gains taxes.
4. Tipping the debt scale
Real estate investment can be a gamble and, for most investors, it will involve some form of debt. The purchase of a property comes with realtor costs, closing costs, hidden fees and a lifetime of mortgage and loan payments. Related debt can easily get out of hand and, if the economy takes a sudden and unexpected turn, real estate investors can be left with few options. Despite this risk, investing in real estate does not have to be an unmanageable risk. Smart real estate investors use a couple basic rules to maintain the debt scale to a reasonable and manageable situation. At the onset, look to answer basic questions before investing: Can the property pay for itself predictably each month? Over the course of the year? Can you avoid big balloon debt that could be due all at once? Can the debt be paid within a reasonable timeline?
As a general guideline, carry 6 months of total costs, including principal, interest, taxes, insurance ready for an emergency. In the event that a tenant leaves unexpectedly or for some reason the asset’s profits are cut off, having 6 months of cash available will protect you from a major crisis. Beyond this, being honest about debt by looking at capital rates and positive leverage options can also help to make the debt you accrue manageable.
5. Ignoring the cap rate
While it can be tempting to invest in a property for many reasons, being clear on the numbers will help clarify whether a deal is actually going to work. Before deciding on a property, it is crucial that you compare the cap rate of your options first. The cap rate is a percentage that symbolizes what percentage of your total costs you will be making in profit each year. Cap rate is the net operating income or NOI over the total value of the asset. So, if a property will bring in $36,000 and the total cost of the property was $360,000, then the cap rate will be 10%. The cap rate can be used to compare how the asset will fare as an investment against other real estate investment options. Predicting the cap rate for a number of properties and then evaluating which property has the highest cap rate will allow you to make smarter investments.
There are a few important considerations in determining a cap rate. To determine the NOI, you will need to reasonably estimate how much revenue the asset will bring in and deduct any reasonable predictable operating costs, such as predictable repairs, utilities, etc. This is just the cost of the property itself on a yearly basis and does not include any loan payments or financing. After the NOI is determined, you will also need to identify the total cost of the asset. This should include the final sale price of the property in addition to things like closing costs or immediate improvements you had to make in order for the property to be used. This figure needs to represent the total capital investment required to obtain the piece of real estate. Once these figures are determined, dividing the NOI by the total investment will yield a more accurate cap rate that can be compared to other potential investments.
Comparing cap rates of all your options will show you the opportunity cost of investing in one option over another. Ultimately, you are looking for the highest cap rate of all of your options. Generally speaking, a 12% cap rate is excellent and a very safe investment.
6. Don’t let financing cloud your vision
Many people get caught up in financing options and lose track of the actual economics of the business of real estate. Mitigating this tendency is important so that you understand what you are investing in upfront. Ultimately, financing is a separate beast from the decision to select a particular property and the two need to be compared honestly to understand the overall economic health of an investment. This is where positive leverage comes in.
7. Negative Leverage Mistake
In the confusion of capital rates and financing, the basic principal of maintaining positive leverage is often overlooked. Positive leverage means that you are bringing in more money than you are spending on paying off the debt. Mathematically, this can be compared by comparing the estimated cap rate to your financing cost. This comparison will help you determine the most sustainable and safest financing plan.
Here’s how it works: you will need to know your cap rate first. Once this has been determined, you will then need to compute your financing cost. Financing cost includes any cost associated with long term debt you are responsible for. This number will include whatever portion of the principal and any interest you are paying in total over the year. What you pay in one year will then be divided by the total debt you owe. So, if you pay $7,000 on a mortgage every year and the total amount you have financed is $80,000, the percentage representation of your financing cost is 8.7%.
As long as your cap rate is larger than your financing costs, you will be bringing in more than you are pushing out in a year. If your cap rate is lower than your financing cost, you will have a negative leverage and you will be pushing out more money than you can bring in.
8. Forgetting about liability
One mistake new real estate investors make is allowing too much fluidity between their asset and their personal finances. Creating some boundary between an asset and yourself provides important protection against lawsuits and judgements against your personal assets. Broadly, there are two kinds of liability to consider for any asset: internal liability and external liability.
Internal liability is any liability generated by the property itself and external liability is any liability posed as a potential threat from an external source. A real estate property itself will always come with potential liability. For instance, any injury incurred by a resident while on the property could potentially become the liability of the property owner. Likewise, if you are personally caught in a lawsuit, any assets that belongs to you personally can be seized to satisfy the judgment. By creating a separate entity to own your investment property, you can limit your exposure of personal liability in these situations.
There are several ways to do this including choosing to be an investor in a REIT company or creating an LLC, S-corporation, or other business entity that distances your personal assets from your real estate investments. Even if you are not considering making a business out of your real estate, you can still create some protection to your personal assets by putting real estate in a trust. Generally, operating as a sole proprietor is not suggested because there is very little legal protection provided in this choice.
9. Missing out on Tax Benefits
Many investors of real estate are discouraged from purchasing properties that may need renovation work, significant maintenance, or general rebuilding. They may also be unaware of some big ways to save when they invest in maintenance or improvements. The IRS is interested in having private owners rent buildings to mitigate the need for the government to take on the burden of residential housing or general business rentals. As a result, there are significant tax benefits available to real estate investors for properties that need work, including depreciation and maintenance write offs. Furthermore, these expenses are viewed as a cost of doing business.
Depreciation is the IRS’s recognition that buildings and structures break down over periods of time. For residential real estate, the depreciation mark is 27.5 years, while for commercial buildings it is 39 years. Essentially, each year, 1/27.5th or 1/39th of the total worth of the building can be depreciated from the overall worth of the building or structure. In addition to this, any renovation or improvement to a property can also be considered for depreciation tax deductions. So, if you make an improvement by putting in a new driveway that will depreciate over 15 years, the cost of the driveway can be deducted from your taxes over the course of 15 years.
Writing off maintenance performed on a property or structure is also acceptable and can be done in full the year it is performed. For example, if you replace part of a leaky roof, the cost of replacing that portion of the roof qualifies, in full, as a tax deduction.
10. Investing in a Sinking Ship
A property can be attractive for a number of reasons that may not actually have anything to do with the projected success of an asset. We can be persuaded by the look and feel of a place, have sentimental attachment to an area or property or any number of other side-tracking thoughts and feelings. However, investing in the right market is important. A market that is projected to do well is often characterized by several significant signs including a diversified economy, the quality of the neighborhood or surrounding area and the asset’s current cash flow.
A diversified economy means that the financial stability of the surrounding area is supported by many different employers and sources of economic activity. Areas that are largely built on one economy, like a single tech company, may seem stable but could collapse overnight if the company collapses. The quality of the neighborhood also can help predict the soundness of the investment. Areas with high crime or violence rates are generally poor investment areas. Any area that supports many renters, however, is fair game and often it is these areas that over time develop into more expensive and lucrative neighborhoods in town. One last marker of long-term success is the property’s current cash flow. While there are many ways to scrutinize this particular fact, determining quickly what percentage of the overall worth the property is currently renting for will give a rough idea of its viability. If these three criteria are met, it is likely that your investment will fare well in any market and will survive the ups and downs of the economic landscape.
A Clearer Path
Walking into real estate investments with the knowledge to discern what options are available and how the investment will develop over time gives a beginner investor a huge advantage. The mistakes made by seasoned investors do not need to be repeated and investing can be a smooth, enjoyable process with the weight of confusion lifted. Keeping to the numbers, being aware of the advantages hidden in taxes and looking for signs of a healthy investment can help guide us in what would otherwise seem like the Bermuda Triangle at night.
Mr. Bowman is a Partner with Anderson Law Group in the firm’s Las Vegas office. He received his Bachelor of Science degree in business from Arizona State University. After spending five years in the computer industry, Mr. Bowman received his Juris Doctor from Seattle University School of Law and is licensed to practice in multiple states. His experience includes commercial and civil litigation, construction defect law, complex real estate transactions, and business law.