13 May So Easy A Child Could Do It
“Well! he huffed and he puffed. He puffed and he huffed. And he huffed, huffed, and he puffed, puffed; but he could not blow the house down.”
– The Three Little Pigs, English Fairy Tale
High income Americans face financial hurdles that other people don’t understand. One of the largest is saving enough to maintain their standard of living in retirement.
Last month I recommended that in addition to maxing 401(k) contributions, they take advantage of “Backdoor Roth IRA’s” as a partial solution. I then recommended that they also save & invest outside of retirement accounts. One of the things I suggested they should do is invest in real estate.
The problem is, most people have no more idea about how to successfully invest in real estate than they do about how to perform open heart surgery. So let’s talk about successful real estate investing & how easy it is to get started.
To get started, let’s clarify that when I say “invest in real estate”, I mean income producing real estate. I do not mean raw land, vacant lots, and the like. Real estate that doesn’t produce income is a net loss until (if) you get lucky enough to sell it. Even then, research shows that average annual returns are in the low single digits. Why? Because of expenses. Property taxes, insurance, maintenance, etc … is a net cash outflow, which is a negative return aka loss.
Neither do I mean labor intensive real estate activities like flipping houses. High income Americans tend to be very, very busy. Spend your free time enjoying family & friends, not trying to make more money doing something at which you are not an expert.
Income producing real estate is just that; it produces a steady stream of income for the owner. It could be a rental house, a duplex, a four-plex, an apartment building, a strip-mall, an office building, etc … It doesn’t really matter what type of property it is so long as it produces income in excess of expenses (profit).
We all know what profit means, but what most people don’t know is how to value investment real estate. It’s very simple. In fact, my wife & I once had a 1-page worksheet we used to value potential real estate investments. We were looking at duplexes so often that we carried blank copies in our vehicles and completed them on the hood of our car as soon as we walked out the front door of potential opportunities. We quickly knew what the real estate was really worth & would make an offer on the spot!
Here’s how it works;
- Maximum Potential Income – Vacancy Rate = Real Potential Annual Income
- Real Potential Annual Income – Operating Expenses = Real Net Income
- Real Net Income / Capitalization Rate = Real Estate Value
That’s it. Three steps and you’re done. Let me explain a couple of these terms so you can begin taking a look at properties, placing a value on them, and making offers.
Maximum Potential Annual Income – this is the maximum rent a property could produce at 100% occupancy. EX: a 4-plex leasing at $1,000/unit/month. ($1,000 x 4 x 12 = $48,000).
Vacancy Rate – 100% occupancy is rare. There is always some vacancy, even if it’s just 2 weeks between tenants while a unit is cleaned & repaired. I always use 10% as a conservative vacancy rate. EX: $48,000 Maximum Potential Annual Income – 10% Vacancy Rate = Real Potential Net Income. ($48,000 – $4,800 = $43,200).
Operating Expense – these are the expenses associated with owning real estate; taxes, insurance, maintenance, and so forth. This is all reported on Schedule E of the owner’s income tax return. The listing agent should have the most recent 3 years Schedule E available to you. Remove depreciation and you have operating expense. EX: Real Potential Net Income – Operating Expense = Real Net Income. ($43,200 – $8,640 = $34,560).
Capitalization Rate – if you are going to have a disagreement with a real estate agent or with a seller, this is where it will happen. Many, if not most, will try to tell you what the “local cap rate” is. Hogwash! Capitalization Rate is the rate of return you desire to earn on your investment. That amount varies for everyone, which means there is no such thing as a “local cap rate”. This matters, because the lower the capitalization rate, the higher the value of the property; the higher the rate, the lower the value of the property. Just like any other type of investment, real estate has risks. Smart investors are compensated for the risk they take. An 8% return is a moderate return. The S&P 500 averages 11.76% per year. Those numbers don’t change much over time, so I personally split the difference and use 10% as my cap rate for real estate investing. And I stick to it. I could easily take the money I have earmarked for real estate and invest it in the S&P 500 instead, so why would I let an agent or seller convince me that I’d be happy with 8% or 6%? I won’t. EX: Real Net Income / Capitalization Rate = Value ($34,560 / 10% = $345,600). In this example, the most you would be willing to pay for this 4-plex is $345,600 and not one penny more. Of course, a savvy investor will try to get it for less than that if possible.
That is really all there is too it. You just need to find a real estate agent who specializes in incoming producing property, or even better yet; a young, new agent who wants to specialize in income producing property. Like anything else, real estate marketing & sales has its specialties. Among those specialties are income producing properties. A good specialist will educate you even farther on how to value potential investments. For example, can you raise rent & lower expenses? That can produce a huge immediate profit.
Since you’re so busy, you probably also want to hire a leasing agent. Leasing Agents will keep your property leased, manage tenant applications, collecting rent, making repairs, maintenance, etc …. They should have software to account for all monies and report to you regularly. Just make sure they are bonded & insured. This way your real estate investment becomes as hands-off as your market investments.
So now you have a solid, hands-off, income producing investment. Does it get any better? Yes! Your rental property produces depreciation which reduces your taxable income. Depreciation varies and the IRS is prone to changing depreciation schedules, so your CPA is in the best position to help you there. As a rule of thumb, look at Schedule E again. What is the current owner reporting as depreciation? Use that amount as your rule of thumb. EX: The current owner reports $10,000/year depreciation. You will get to reduce your taxable income by ≈ $10,000 +/-. If you are in the 32% marginal tax bracket, you’ll save $3,200 in income taxes! Every high income American could use that.
Income producing real estate is a great diversifier, a great source of retirement income, and a decent tax reduction tool. And it’s so easy a child could do it successfully. Why wouldn’t you use it to your advantage?
Sapiat Asset Management is a fee-only, independent registered investment advisor, specializing in goal oriented, financial planning & investment management for Gen X Individuals & Families, their Businesses, & the Trusts that benefit them.