Let me start by saying that, sure, real estate can be a good investment. Real estate provides a hedge against inflation. And real estate often amounts to a forced saving plan. But most of the people who’ve jumped onto the real estate investment bandwagon over the last few years are going to fail. Here’s why:
Ignoring Returns on Investment
When you compare bank accounts, you know that 5% interest means more money in your pocket than 2% interest.
Similarly, you know that a mutual fund with a track record of 11% annual returns has made more money than a fund with a track record of 8% annual returns. Duh.
One picks investments and evaluates investment performance by looking at the return on the investment. This rule is true for stocks, bonds, and everything else—including real estate.
Which means that investors who can’t or don’t know how to calculate the return on a real estate investment—and almost all amateur real estate investors fall into this category— fly blind.
To be fair, real estate return on investment calculations get tricky fast.
First, consider how easy something like a bank CD. If you buy a bank CD for $100 and a year later receive $105 back, the return on investment calculations are pretty easy. Divide $5 by $100 and you get 5%. That’s the return on investment.
But what about a real estate investment that requires a $50,000 down payment and then negative monthly cash flows of $500 for 43 months. If you sell the property in month 44 and net $85,000 in cash, have you really made money with your real estate investment?
You can’t truly know whether this imaginary real estate investment is a good deal unless you compare its annual return to your other options.
It turns out, by the way, that the imaginary real estate investment is a slightly better deal than the imaginary CD—something you need a spreadsheet program like Microsoft Excel to determine. Programs like Microsoft Excel include rate of return calculation tools like the IRR function which you can and should use to estimate returns on investments with complicated cash flows.
Ignoring Real Estate Tax Laws
Here’s another reason that real estate investors fail. Real estate investments dramatically complicate your income taxes. For example, the passive loss limitation rules mean that you typically can’t use depreciation tax deductions except in special circumstances until you sell the property.
Schedule E (which you use to report your real estate investing to the IRS) requires you to prepare profit and loss statements by real estate investment—a bookkeeping requirement that pretty much forces you to use a full blown accounting system like QuickBooks.
Finally, rampant misunderstandings about Section 121 of the Internal Revenue Code mean that while most people shouldn’t have pay taxes on the profit from selling their home, many do pay taxes.
And don’t even get me started on dealing with the unrelated business income tax you’ll pay if you use a self-directed IRAs for real estate. Or on the pitfalls of creating a daisy-chain of like-kind exchanges. Or about depreciation recapture if you segregate property costs into real and personal property components.
Here’s the reality sandwich. For many small investors, real estate so complicates your income taxes that you’re faced with two bad choices. Bad choice number one: Winging it on your tax return or relying on some infomercial, the real estate agent, or your brother-in-law for accounting and tax planning. (This approach means you’ll make all sorts of expensive tax accounting mistakes.)
Bad choice number two: Paying an experienced tax practitioner perhaps a $1000 a year or more to make sure you don’t foul yourself up. This of course pretty much eats up the extra profits you hoped to get from real estate. Which means that while you will have the satisfaction of doing your tax accounting right, only your accountant and real estate agent make money.
My advice to you? Learn how the real estate tax laws work and how to do real estate accounting before you start investing. Then, after you truly understand this stuff and do start investing, do as much of your own accounting as you possibly can.
I really don’t think you’ve got any other good choice as a small real estate investor. Sorry.
Summing Up
As I said in the first paragraph of this little essay, real estate can be a good investment. But the investment is way trickier than most new investors realize. And in order to make a decent return, I think you must understand way more finance, tax and accounting than the typical real estate investor.
Archive for Real Estate Investing Comfort Zone
Is Your Real Estate Investing Comfort Zone Being Threatened?
Have you ever imagined yourself putting through a multi-million dollar deal, going to closing and picking up a check with six zeros? It’s the ultimate dream for real estate investors. But why must it be a dream when it can just as easily be a reality. Every day there are real estate investors making offers on high end houses just as there are real estate investors making offers on median price range houses and below. There are just a lot fewer going after the big game.
High dollar houses naturally instill fear in real estate investors as they feel if they make a mistake they will be sued for hundreds of thousands. Real estate investors perceive they need perfect credit, a high net worth and millions of dollars already to buy million dollar houses, so they exclude themselves as buyers and don’t pursue high end deals. Most real estate investors feel they don’t deserve to buy a million dollar house or to be talking with the people that own them. They have a self image that equates themselves with lower price range houses and the people that own them, so those are the houses they pursue.
All of these reasons are fear in one form or another, and none of them are real. The beings that own high end houses are people, and they get divorced, lose their jobs, go out of business, make stupid mistakes, have bad financial management, and do all of the things that result in financial distress and necessitate a quick sale. The high dollar properties they own are real estate, just like the two bedroom one bath house in the median price range neighborhood, It can be put under contract, optioned, or creatively financed just like any other house in any other price range.
But real estate investors avoid them, and in doing so, prevent their most heartfelt dreams from coming true. The key point all real estate entrepreneurs and investors must understand is that owners of high end houses who are experiencing problems need the solutions that well trained investors can provide. And as with all real estate deals, when done properly, everybody wins. The seller gets the house sold and some cash to move, the bank gets their loans paid off, the new buyer gets a house they love, and the investor makes a profit.
A Six (or Seven) Figure Profit!
Going after high end houses is a choice. Real estate investors can attract these million dollar deals to them by setting up marketing systems that target high end houses only, and leave the lower price ranges alone. By making high end homeowners the only people you contact with your marketing, high end homeowners are the only ones that call in response. And when real estate investors have a steady stream of motivated sellers with high end houses calling them every day, their desks begin to fill up with million dollar deals. Just like a hunter going after big game, the real estate investor who sets their marketing sights on high end deals, and persists, the moment arrives when their real estate investing dreams come true.
