Four principal factors drive the opportunity for income property investing. In most investments, such as stocks and bonds, there are only one or two factors like appreciation or dividends that drive the value of the investment. Income property is unique, because it is a multi-dimensional asset that generates value by the interplay of four primary factors. These factors are Price Stability, Cash Flow, Tax Advantages, and Leverage.
Real estate prices tend to be much less volatile than stocks. The relative lack of liquidity with real estate creates this phenomenon. Many financial advisors view this as a disadvantage, but since real estate markets operate with a smaller number of relatively large transactions, this results in less price volatility and a longer window of opportunity for investors to act. Typically, large price movements only occur from massive increases or decreases in the number of available buyers.
When real estate is rented to tenants, it generates regular cash flows that can be used to pay for the mortgage interest, taxes, insurance, and management fees of the property. The big advantage of this cash flow is that it allows the investor to develop a “passive” income portfolio, since direct work is not required to generate the cash flows . . . the tenants simply continue to pay their rent month in and month out. Because of this, one of the key things to look for when evaluating real estate investments is the ratio of cash flow to the value of the property.
It is important to note that not all real estate investments involve regular cash flows. Many “speculative” real estate strategies involve purchasing property that the investor will repair, improve, and then “flip” for a profit. This type of investment can result in very large gains, but also carries quite a bit of risk because there is a possibility the investor will be stuck with very large payments and no cash flow if the improved property cannot be quickly sold at the desired price.
The most powerful “arbitrage” opportunity in real estate is finding properties in markets that will produce superior cash flow relative to the price of the property. The reason that cash flow has so much power is because it provides coverage against downside contingencies for the investor, while maintaining the upside growth opportunity. In most “bubble” markets, the price of real estate is driven up so high that the cash flow produced by the asset is very low relative to the purchase price. Because of this, it is generally best to target “arbitrage” properties with superior income prospects.
The impact of taxes on the performance of an investment can be quite profound. The reason for this is because when taxes are assessed as an investment grows, it reduces the capital base that is “in the game” to compound and grow. Conversely, if taxes can be deferred until a later date, it allows for the returns to compound more aggressively. In the case of real estate, the government has instituted a transaction called a “like kind” exchange that is articulated in section 1031 of the Internal Revenue Code. The benefit of this transaction is that it allows an investor to defer the taxes that are due upon the sale of a real estate asset if another real estate asset of equal or greater value is purchased within a specified period of time. (I should mention that I am not a qualified tax advisor, and that anybody looking to conduct a section 1031 exchange should consult with a CPA and 1031 specialist) The power of this transaction is that it allows investors to compound real estate investments into larger deals while deferring taxes.
In addition to the long-term tax advantages of deferring gains, there are short-term tax advantages for real estate investors as well. These advantages stem from the fact that businesses pay taxes different than individuals. (If you are investing in real estate, that means you are in business as an investor.) As an individual, the government takes the taxes out of your salary before you can spend any of it. As a business, you pay taxes on the revenue that is left over after your legitimate expenses have been subtracted. The compounded impact of moving legitimate expenses above vs. below the taxable income line can also be very profound over time. (Once again, you should consult with a tax professional when conducting your business operations to as-sure compliance with the tax code.)
In the context of investments, leverage refers to using “other people’s money” to finance your investment. Thus, leverage becomes a “magnifying glass” for the returns of the underlying asset. When the asset produces gains, those gains will be increased by the amount of leverage you have used to purchase the asset. Similarly, if that same asset produces losses, they will also be magnified by the leverage. The “key” is to use leverage for assets that are less volatile so that you minimize the probability of producing a crippling financial loss. As the volatility of a leveraged investment increases, the probability of a “total loss” goes up exponentially.
Because of this magnifying effect, an investor can gain control of a relatively large capital asset for a relatively small amount of cash. (Even in the current “20% down” environment, investors can control an asset that is five times as large as their initial investment.) When a property value increases by 10% and the investor has 20% down, the investor doesn’t just see their equity go up by 10% . . . their equity increases by 50%. (10% appreciation multiplied by 5X leverage)
Furthermore, real estate can often be financed with fixed-rate loans. (In the case of residential real estate, the loan duration can be up to 30 years at a fixed rate.) This allows an investor to lock-in their cost of capital at current rates so that any future monetary inflation increases their value and rental income while the interest payments stay flat.