Chapter 19: Investing in Real Estate

Real Estate Investment Trust (REIT)

A Real estate Investment Trust consists of at least one hundred or more investors, and is managed by trustees who conduct the business of the venture. Since it is unincorporated, the trust pays no tax, provided it distributes 95% of its income to the investors. 75% of the trust's income must come from real estate. REITs are government regulated and thus offer less risk than limited partnerships. Investors receive certificates of interest, not stock, since the trust must avoid being treated as a corporation.

Corporation

A corporation is not generally used for syndication because of the double taxation on income and the lack of depreciation "pass-through."

Syndication

A syndicate consists of a group, an association or a combination of individuals who join together to pool funds and to conduct a common venture to acquire real estate investments. Syndications allow many small investors to share in the purchasing power of a large investment organization. Syndications usually take the form of corporations, limited partnerships or investment trusts.

Annual Net Income

Annual net income is the profit remaining after deducting operating costs and debt service (payment of principal and interest). Rents should be sufficient, not only to cover operating costs and debt service, but also to provide a sufficient cash flow to show a reasonable return on the cash invested.

Appreciation

Appreciation is the future gain from the increased value of the investmentoveraperiodoftime. Thekeyfactorsaffectingappreciationareinflation, location, and timing.

Captial Gains Tax

Before l987, a capital gain realized from the sale of real estate was given preferential treatment. If the asset had been held for more than six months, only 40% of it was subject to tax. As a result of the Tax Reform Act of l986, all capital gains are fully taxable, regardless of how long the assets are held.

Boot

Boot might also come into play in a 1031 exchange. Because it is difficult to find two like-kind properties of identical value to exchange, one party will commonly contribute cash and/orphysicalpropertytoevenouttheexchange. Thebaseamountoftheexchangeremains tax deferred, but the boot is considered a taxable gain. Even with the boot, however, the recipient will pay less in capital gains taxes for the current tax year than if he had sold the appreciated property and then purchased a different property.

Combinations of RETS and REMTS

By combining real estate assets and mortgage loans, combination trusts can offer a greater degree of protection to investors during economic slumps.

Cash Flow

Cash flow is the annual spendable income that remains after deducting operating costs, taxes and mortgage payments. Ideally, the investment should produce a positive cash flow sufficient to justify the cash invested. Cash flow depends upon the amount of rent received, expenses and mortgage payments. Rents should be examined frequently and kept in line with competing properties. Reduced operating expenses and low monthly mortgage payments will increase cash flow. An example of an annual income statement is shown in Figure 19:1. Prior to the l986 Tax Reform Act, many investors in high tax brackets were content to "break even" or end the year with a negative cash flow, which would offset taxes on other income. Because of the reduced tax advantages, it is now more important for the investment to produce a positive cash flow or at least cover the expenses.

Pyramiding through Equity Buildup

Equity is the value of an asset in excess of its total debt. Equity may be built up through principal payments on a mortgage and may gain in value due to appreciation. Equity buildup is like money in the bank since it may not be realized until the property is sold. However, by using the equity for refinancing, an investor can generate cash for the down payment on other properties without having to invest any additional capital. Refinancing the property to generate cash for the purchase of additional investment property is called "pyramiding."

Preservation of Capital

Except in recent years, the value of real estate has appreciated at a rate equal to or greater than the rate of inflation. It is for this reason that ownership of real estate is often referred to as a hedge against inflation. Even during difficult economic times, real estate investments have produced a rate of return that is higher than the prevailing interest rates charged by mortgage lenders. Thus, over time, through the use of leveraging (borrowed money); an investment should produce more than it costs to finance its purchase. Leveragingisdiscussedlaterinthischapter.

Earning a Profit (2 forms of gains)

Investment property produces two forms of gains: (1) Annual Net Income and (2) Appreciation. Inflation will occur when the value of money decreases and wholesale and retail prices increase. As rents increase, property values should rise proportionately to preserve the capital investment and to act as a hedge against inflation. Location in a prime rental area of well-kept buildings near business and shopping areas creates desirabilityresultinginmoredemandforapartmentsandhigherrentlevels. Therightlocation with the proper features and amenities will increase the property's intrinsic value resulting in a higher price when the property is sold. Timing the purchase of investment property is usually best determined in retrospect. Investors who anticipated the huge demand for housing in the 70's and 80's as a result of the post-World War II baby boom benefited enormously. As demand outraced supply, it was not uncommon to see property values growing at an annual rate exceeding ten percent. Even when mortgage interest rates were at an all-time high in the early l980's, the rate of appreciation was sufficient to justify investing in real estate.

Tax Credits

Investors who renovate older buildings for low-income housing projects are allowed to take a direct reduction in tax due, rather than a deduction from income before the tax is computed. Investors who renovate historic buildings for reuse as a place of business or rentalsarealsoallowedadirectreductionintaxdue. Thetaxcreditisbasedupona percentage of the cost of renovating. For a detailed discussion of the effect of federal taxes on real estate investments, including tax credits, installment sales, passive losses and exchanges, see Chapter 16.

Real Estate Investments

Knowledge of real estate investment is important for real estate licensees so that they may better serve their clients in the purchase and management of income property. Brokers and salespersons, in the course of their activities, are exposed to opportunities in the market and should have sufficient knowledge to make investment decisions for them. This chapter examines real estate as an investment, its advantages and disadvantages and the various benefits of owning income property. Because of its fixed location, real estate derives its value from political and economic forces in its immediate area. Unlike stocks and bonds, there is no nationally organized market, making it a high-risk venture and, often times, unpredictable. However, its natural durability and relative permanency make it ideal as collateral for long-term mortgage debt. As such, it offers opportunities for large and small investors to purchase property with borrowed money and with minimum risk to their own capital.

Leveraging

Leverage is the use of borrowed money to finance the major portion of the purchase priceofinvestmentproperty. Toproducethemaximumreturn,theinvestorshouldtrytomake a small down payment and obtain a low interest rate mortgage with the lowest possible monthly payments. Theeffectsofleveragingcansubstantiallyraisetheactualreturnontheinvestment. Through leveraging, other benefits are possible. Since mortgage interest is a deductible expense from annual gross income, the investor should strive to maintain the highest possible mortgagethatisfeasible. Theinterestdeductionplusthedepreciationallowanceandgrowthof value of the property can also increase the rate of return by reducing annual taxable income. Leveraging increases the return on cash invested. If a property is bought for $500,000 with a $50,000 down payment, and then five years later it is sold for $550,000, which represents a 10%, profitsontheinvestmenti.e.purchaseprice. The$50,000profitalsorepresentsa100%return on the cash invested. A highly leveraged investment can be risky when values drop or the vacancy rate increases. Reduced income could affect the owner's ability to make mortgage payments resulting in possible bank foreclosure. Lower leverage reduces the risk.

Limited Partnership

Prior to l987 the most popular form of syndications were limited partnerships because of the limited risk and "pass through" of losses to investors in high tax brackets. Popularity of limited partnerships has waned since l987, since losses from passive business or trade activities may not be used to offset taxes on other income.

Real Estate Mortgage trust (REMT)

Real Estate Mortgage Trusts buy and sell real estatemortgagesratherthanrealestate. Theirmajorincomeisderivedfrominterestand discountsresultingfrombuyingandsellingshort-termjuniormortgages. Theyofferthesame tax benefits as REITS.

Tax Shelter

Tax shelter refers to the tax advantages available to real estate owners and investors. These advantages include deductions for expenses, real estate taxes, interest and depreciation. Other advantages include postponement of taxes, preferential tax treatment of capital gains and theabilitytooffsetrealestatelossesagainstthetaxpayer'sordinaryincome. TheTaxReform Act of l986, which became effective in l987, significantly reduced many of these tax-sheltering advantages. TaxshelterismorefullydiscussedinChapter16.

Tax Deferrals

Taxation of capital gains from investment property may be deferred by an installment sale and an exchange of properties of like kind, i.e. an apartment building for an apartment building. Installment sales and tax-free exchanges are more fully discussed in Chapter 16.

Investing in Unimproved Land

The intrinsic value of land depends upon its location and future growth possibilities of the surrounding area. As such, land investment is highly speculative and best left to experts as a source of investment. Obtaining financing for the purchase of unimproved land is very difficult because of the risk factor. Profitability depends upon whether the land will appreciate in value sufficiently to produce a profit after covering the acquisition costs, real estate taxes, lost interest on the cash invested and broker's fees. Also, since land does not depreciate, the investor does not benefit from a tax write-off.

Advantages of Owning Investment Property

The major purposes of investing in real estate are to: (1) preserve capital, (2) earn a profit and (3) obtain tax shelter. Another advantage is that the investor has a high degree of personal control over the capital invested as opposed to ownership of stock and bonds, in which case management and control are in someone else's hands.

Disadvantages of Real Estate Investments

Unlike other investments, real estate is relatively difficult to sell over a short period of time. This low liquidity means that a quick sale would most likely result in a loss. An owner of listed stock can convert assets to cash when funds are needed simply by telephoning his or her securities broker. Although cash can be generated in real estate by financing a portion of the equity rather than selling, it could take weeks or months before the transaction could be completed. Investing in real estate requires a personal commitment to management decisions, such as setting rents, selecting tenants, handling maintenance and making capital improvements. Although many of the burdens of the day-to-day operations may be taken over by professional management, small investors may be expected to personally perform physical tasks in order to reduce overhead and increase cash flow. Realestateinvestmentinvolvesahighdegreeofrisk. Valueissubjecttosocial, economic and political forces over which the investor has no control. Higher interest rates, declining rents, increased maintenance and vacancy losses can reduce the income to a point wheretheinvestmentisnolongerprofitable. Thesefactorsemphasizetheneedforexpert advice in making real estate buying decisions. Unfortunately, most small investors buy property intuitively without the benefit of a feasibility study.

Taxes on Profits from Real Estate

Until the Tax Reform Act of l986, the major incentives for investing in real estate were the preferential tax treatment of capital gains, and tax shelter through depreciation write-offs. Although these tax advantages have decreased, they are still worth considering when investing in real estate.