August 30, 2023 | Tyler Ahlburg and Stuart Hipp
The world of real estate investment is as alluring as it is complex, a realm where potential fortunes coexist with risks. This landscape is not for the faint of heart, but - for those bold enough to explore - the rewards can be substantial. This guide, an insider's look at the real estate investment sector, attempts to balance risks and rewards, enabling both newcomers and experienced investors to make more informed decisions.
The Real Estate Investment Game
Understanding the rules of investing in real estate is much like playing a strategy game. A bold, early strategy can sometimes lead to a quick win or a disastrous loss but a slow, conservative isn’t always the answer either. The path to consistent, healthy real estate investment returns is lined with potential risks. These can include property market fluctuations, problematic tenants, or unexpected costs. Being prepared to handle these risks is as crucial as seeking the rewards.
Market Fluctuation: Real estate markets are dynamic and property values are influenced by larger economic trends, interest rates…even political stability. Investors need to be prepared for these fluctuations and make informed decisions to mitigate potential losses.
Consider this: In January of 2020, no real estate forecast took into account a global pandemic that would shut down travel, borders, and supply chains for months at a time. That didn’t mean that short-term rental companies whose housing stock targeted business travelers didn’t go under or that builders and remodeling companies didn’t have to wait 6 months for the right dishwasher to be available. Additionally, no one anticipated the acceleration of the shift towards remote work which has left urban, commercial office buildings with high vacancy rates or propelled the rise of “lifestyle” city growth in the South, the Sunbelt, and the Mountain West. Boise, ID, for example, saw a 56.8% rise in the average house cost from March, 2020 to January, 2022.
Problematic Tenants: In rental real estate, tenants play a critical role in your income stream. Problematic tenants, vacancies, or high tenant turnover rates can disrupt your steady flow of rental income, not to mention the uninvited squatters who can move in when properties lie vacant for extended periods and prove even more difficult to move out than a tenant who stops paying.
Unexpected Costs: Owning a property comes with ongoing costs. Occasionally, unexpected expenses like major repairs or renovations may arise, which could significantly impact returns. One thing some investors don’t consider is the rising costs of taxes and insurance over time, especially around climate or weather events.
To illustrate: I bought a condo as a second home and vacation rental at the coast. We spent a lot of money in upfront renovations and assumed we wouldn’t have many ongoing costs related to the upkeep of our unit. While that has largely been true, we didn’t account for the fact that the buildings were all built in the 80s with inferior copper piping that has been subject to pinhole (and larger!) leaks. Our HOA just replaced all the piping in all of the buildings which came with a healthy special assessment for each owner.
Before you get the wrong impression - that there’s disaster lurking around every bend in the road - rest assured that real estate investment carries a significant potential for reward. Those potential rewards come in the form of capital appreciation, passive income, diversification of a portfolio which most people understand and which are covered elsewhere. Surprisingly, several less-often discussed rewards are leverage, tax advantages, and real estate as a hedge against inflation.
Leverage: Real estate investments are typically purchased using borrowed funds. This is leverage, and most people are aware of how important this is when purchasing a home since most of us are not able to purchase without a loan. Investors take this tool to the next level.
Let’s say Scott buys his first home and after several years decides he wants to rent it to a tenant to buy a larger home for himself. Scott’s improvements to the property, made while he has been living there, along with a location in an affluent part of town, has allowed the property to increase in value by 100k! Scott, thinking as an investor and using “leverage”, asks the bank for a loan of 80% of the total value of the home; this puts a large down payment in Scott’s hand to allow him to go buy his next property.
Hedge Against Inflation: Real estate values and rents often increase with inflation, providing a hedge against the eroding value of currency over time. If you are able to buy a house in cash, this can be even more impactful. Jeff Rohde states, “If you are paying cash for the property instead of taking out a loan, you won’t have to worry about rising interest rates and mortgage repayments. Plus, if the value of your currency starts to decline due to inflation, owning physical property can help preserve its buying power over time.”
Tax Advantages: Mortgage interest deductions-interest paid on your mortgage is a tax write off while absolutely nothing on your rent is a tax write off. Property depreciation- Your tax guy will help you out! The IRS allows you to write off a calculated amount each year, again, rewarding the ownership of real estate. Capital gains tax benefits- If it's your primary then you can avoid capital gains all together when you sell but there are benefits for even those who have just owned the property for a good amount of time. Another reason why a good tax professional familiar with real estate is so important. For the seasoned investor, 1031 exchanges avoid capital gains tax when an investor is upgrading their property. Homes to hotels, to use a popular board game analogy.
The real estate investment sector presents a wide spectrum of risks and rewards. Plan your exit strategy and a path that allows for contingencies and pivots before putting your pieces on the board. Successfully navigating the current (and future) landscape requires understanding potential risks, making informed decisions, and implementing effective strategies to maximize rewards.
Share this guide to assist others in their journey to becoming savvy real estate investors, further spreading knowledge and fostering informed conversations in the real estate community.
Disclaimer: This article is intended for informational purposes only and should not be considered financial or legal advice. Consult a financial professional before making any major financial decisions.