How to invest in Real Estate

It's strange how rental real estate is thought of as an investment. Like Rodney Dangerfield, it gets no respect. While bonds and equities get the Wall Street Journal and Financial Post, Google "how to invest in real estate" and you'll run across all kinds of no-money down methods that seem planned to sell books and tapes instead of rental real estate. On television there is Report on Business TV, but for real estate love it or list it. It strikes me as sad that such a solid investment opportunity gets such bad reviews.
Of course it is possible to acquire property with no money down, but it involves arranging a 100% mortgage, and for rental property you only do that if you have equity in other properties. For example, if you have one property bought and paid for its not difficult to arrange a line of credit at prime. A $100,000 condo would cost about $400 per month, plus taxes and maintenance of about $200. In short, it would carry and give you cash flow to feed the mortgage costs.
A more regular method to buy real estate is with a down payment of some kind. Generally is you can make a property carry itself with less than 40% down its worth purchasing. These properties are easier to find in balanced markets.
There are several reasons to own income property.
Reason #1 to own income property is because the renters buy it for you. Even if the other benefits didn't kick in, that alone justifies it. But the fact is, there are other advantages to investing in rental property
Reason #2 is leverage. The best description of leverage is in the book Buy, Rent, Sell, by Lionel Needleman (Needleman is not a huckster; on the contrary, he's a very accomplished author and professor with many books and articles published on housing in Canada and the UK. His assumptions and math is a bit simplistic, and should be adjusted for your particular market, but the book is worth it).
He explains leverage this way: John and Mary each purchase a house $100,000. One year later both places have gone up 10% in value. Both purchasers sell the properties and compare the results.
John started with $100,000, and now he has $110,000, so he has earned a 10% return on his money. Mary, meanwhile, put $10,000 down on her investment, and mortgaged the rest for$90,000. After selling and paying off the mortgage she counts her money. She also got a $10,000 profit, but since she only placed $10,000 in the property, she's got a 100% return on her investment. And, as you guessed, the real trick is that while John bought one rental, kept it a year and then sold it with a $10,000 profit, Mary got 10 houses, held them one year, and then got rid of them for a $100,000 profit. Both started out with $100,000, but after 12 months John has only $110,000 while Mary $90,000 more. The numbers are simplified in the example, but they decisively indicate the wonder of leverage.
Reason #3 is taxes. In most tax jurisdictions expenses incurred on income property is a deduction. And, you can usually incur depreciation costs on the structure that in effect are paper losses and that actually reduce the tax. Depreciation functions like this: we know that the value of a durable item, like a house, decreases with time. Even if the property is well maintained, an old house is not worth the same amount as a new house. This loss in value is called depreciation, and you can use that loss to reduce the tax burden.
Of course, when we invest in income property we usually expect that it will go up in price, and over the long term it often does. What happens with the depreciation in a case like that? The taxman was told the property decreased in price through depreciation, but at the end of the process we sold for a profit. The tax agency will generally say that you’ve “re-captured” the depreciation and will tax you.
Re-capture is terrible. Its like finding that you’ve already spent the savings that you were planning on spending in the future.
There is a good solution. When you buy the investment you divide the original investment between the structure value and the land value. Without cheating you try to value the land as low as is reasonable and the building as high as you can (do the math and you’ll see its worthwhile to be reasonable on your estimates). When the property goes up in price and you sell the property, you tell the taxman that you didn’t recapture any depreciation since the structure did depreciate, while the land increased in value. This profit is capital gain, and capital gain is usually taxed at lower rates than income like…rent. You depreciate the money you make when it comes in as rent, and pay tax on it when it comes as capital gain.
Owning rental real estate also enables you to write off the costs of things that you may have bought anyway, from office supplies to a trip to see the property.

Reason #4 is capital gain. Capital gain doesn’t always happen, but it often does. As we’ve seen with leverage, the capital gain can be leveraged. Even better, the capital gain can, in some years, be greater than what some people earn from a year's work.

Reason #5 pulls everything together by combining free cash flow, leverage, and tax planning. Rental real estate earn cash flow. To start the cash flow may be neutral or even negative, but given enough time it will usually becomes positive. When it changes you have to pay income tax on the additional rent. The solution is to re-mortgage and incur some more interest costs, reducing your taxes. You also re-leverage your first property. The next step is to take the funds and acquire another income property. You don't pay income tax, get depreciation, and receive a capital gain. Better, with two properties you spread your risk, and when it's time to sell you can stretch out the timeline and sell the properties in different years to minimize tax.

It can't be emphasized enough that you have to buy the property wisely. You need to be familiar with the location and the potential tenant. Properties that are desirable and are in a desirable area stay rented. “Desirable” doesn’t have to mean “mansion”, but clean and well priced are key. Whether you buy a small apartment or a three bedroom house with a suite isn’t critical.
Metrics are critical. The first is price-to-rent ratio. This means that you take the purchase price, for example, $100k, and divide the monthly rent of $1000 into that. In this case the result would be 100. Numbers between 75 and 175 are good, but never forget that projected capital gains and interest rates impact what numbers you use. Low interest rates lead to higher numbers, and good capital gain projections will command higher numbers. Over 200 is scary in almost every location unless all you are looking for is dependable income, aren't concerned about capital gain or don’t plan on ever selling.
Another excellent metric is the break even point. This is the percentage of the price need for a down payment to allow the realistic rent to carry the property. The rent has to be a) market rent, not “optimistic” rent, and b) net rent, not gross rent. If the house will carry itself at less than 45% down its worth taking a good look at. Obviously, if interest rates are low the net rent will carry more, meaning the break even rate can be high. Remember that low rates don’t last forever, so unless you can lock in very long term you have to assume that the break even rate should be low in low interest rate environments, and can be higher in higher interest rate environments.
If you come across an investment property that has a desirable price to rent ratio and a good break even rate (and is in a good location and isn’t a inferior proeprty), its worth the effort to put the numbers onto a spreadsheet and calculating the internal rate of return (a real estate investment metric that combines various income streams) and projected cash on sale. There are spreadsheets and programs that can do this for you, but the key is “GIGO” – garbage in, garbage out. Get the correct taxes, the realistic interest rates, your projected income tax rate, and realistic estimates of capital gain and maintenance. Investment properties in urban generally appreciate in price more than properties in depressed or remote locales. They also often have what seem to be worse metrics – a downtown city condo may have a much worse price to rent and break even point than little house in a small town. However, capital gain in the rural area is likely much more spotty. Plotting mortgage pay down and tax benefits on a detailed spreadsheet let's you fairly evaluate precisely how competing purchases match up.
It would be wrong to ignore the issue of a property bubble, or crash. Buying on metrics both helps and hinders. It helps because if you are hard-nosed with break even rates and rent multipliers you won’t buy overpriced property (underpriced investment property doesn’t really exist in a bubble, and it doesn’t crash in value). It hinders because you can’t buy on metrics in a bubble, no matter how much you want to, because metric compliant properties aren't around.
The flip side of this is that when a market crashes there are plenty of metric compliant properties, but generally little mortgage financing and plenty of reluctant buyers and distressed sellers.
At the end of the day, a stable market is the optimum for buyers, although buyers who invest on metrics and exit the market near the top of a bubble often feel like they’ve hit the jackpot.