Why Invest in Real Estate?
Real estate is a limited-risk investment
Real estate is historically one of the most consistent and least volatile investments. Although there are minor regional differences the average rate of appreciation over the past 20 years in the United States is about 4% annually. Although there was a decline in residential real estate values in 2008 and 2009 this was merely an adjustment for four years of appreciation between 2003 and 2007 that averaged more than 10% per year. There was also a decline in home values in 2023, but this again was merely an adjustment of the overvaluation during 2021 and 2022, when prices increased approximately 15% in both years. The 3-year average from 2021 through 2023, that includes the 2023 decline, was well above 8%, double the 4% appreciation rate we use in our investment scenarios. Thus, despite brief periods of nominal volatility, real estate has been a reliably consistent long-term investment.
Stocks, on the other hand, are more volatile. During the 20-year period from 2004 through 2023, the S&P 500 index was either flat or down year over year in five separate calendar years and the spikes and dips were far more pronounced than those of residential real estate value. For example, the 2008 decline in residential real estate was only a 6.3% decline, which paled in comparison to the 38.5% decline in the S&P 500 index during the same year.
This lower volatility makes real estate a less risky investment than stocks.
Real estate typically has higher rates of return
As we stated previously, real estate appreciates at about 4% per year. You may have heard that the annualized rate of return on the S&P 500 is about 10%. So how can we claim that real estate yields higher returns?
The return on an investment includes two components. The income and appreciation in value. For stocks, the income is the dividends paid. For the S&P 500 the annualized appreciation in the value component is about 7.67%. The inclusion of reinvested dividends (the income component for the stocks) is what yields that higher 10% annualized return.
With real estate, the income component is the net rental income. As we demonstrated in our recent comparison of an investment in stocks versus an investment in residential real estate, when the income potential and appreciation in value are both taken into account, the return on residential real estate typically exceeds the stock market investment. That’s because rental income on real estate as a percentage of value far exceeds that of stocks.
Real estate can be leveraged
Although some other investments can be leveraged (e.g. stocks purchased on margin), only residential real estate is such a sound investment that it is possible for an investor to borrow between 85% and 100% of the funds required to purchase the investment. The ability to borrow the funds necessary to acquire an asset greatly increases the yield on that investment if the rate of return is greater than the interest rate on the leveraged portion of the investment.
Consider the following comparison.
Scenario A
$100,000 residential property
$100,000 cash investment
Gross annual rents: $12,000
Expenses: $6,000
Net rental Income: $6,000
Appreciation: $4,000 (4% of value)
Total return: $10,000 on $100,000 invested (10% of the original investment)
Scenario B
Same $100,000 property
25% down ($25,000)
Loan: $75,000 at 7% per annum.
(for simplicity lets assume that the interest is paid annually at the end of the year)
Gross annual rents: $12,000
Expenses excluding interest: $6,000
Annual mortgage interest: $5,250
Net rental income: $750
Appreciation: $4,000 (4% of value)
Total return $4,750 on $25,000 invested (19% of the original investment)
In this example, by using the power of leverage, we have converted the return on a real estate investment from 10% to 19%. These two examples demonstrate the magic of leverage to increase returns on investment.
Ownership of real estate has favorable tax consequences
Tax laws favor real estate investment. As with most types of capital investment, gain on the appreciation of real estate is taxed at tax rates as low as 0% and typically no greater than 15%. But these favorable tax rates apply to the appreciation on most capital investments, not just real estate.
But real estate has the additional advantage of being an asset for which substantial depreciation deductions can be taken, enabling an investor to avoid income tax on the investment, even during periods of positive cash-flow. And although the depreciation will typically be recaptured when the property is sold, the recaptured depreciation will usually be taxed at a rate below the tax rate for ordinary income that was avoided throughout the duration of the investment.
The ownership of real estate has the added benefit of being the perfect investment for an estate plan, since the valuable appreciated asset, including the depreciation that offsets ordinary income during the duration of the investment, can usually be passed on to heirs and devisees of the investor at a “stepped-up” basis, virtually eliminating the tax on the property.
Retiro Financial can help
The professionals at Retiro Financial possess the knowledge and experience to assist an investor with every element of the investment process. We’ve developed strategies for locating the properties that can be acquired below market value and have the greatest potential for both appreciation and the production of income.
Retiro Financial is also the industry’s favored source for financing programs designed especially for investors seeking to minimize their capital investment outlay without sacrificing a low rate of interest that will insure future profitability.
Questions? Give us a ring!
(Click a number to dial on your device)