I have been asked many times, “Is now a good time to invest in real estate with the uncertainty of our current coronavirus environment?” There is always some risk in any sort of investment, anytime, anywhere. For purposes of this article, we will take a look at residential real estate and analyze the factors involved in an investor’s decision-making process.
Potential for appreciation
Residential real estate has proven to be a good investment over the years. Over the long term, through strong economic times and even rough economic times, home values have continued to rise in Boulder County. However, there certainly have been periods when market conditions have slowed sales and have caused a dip in prices. An old saying says, “Buy real estate and wait”. In Boulder County, if you bought in the 1980s, you would have had to wait patiently. In the 1990s, appreciation was much more robust, and a profit could be made after only a short time. Our current data shows that along the Front Range of Colorado, prices have not dropped due to coronavirus.
Nationwide, there has been a housing shortage since the end of the Great Recession ending in 2012. This is primarily because the demand for housing has exceeded the building industry’s production of homes every year since 2007 to present. This low inventory has added increased pressure on housing prices.
Another reason appreciation occurs is job growth. If job growth is boosted, demand eats up the available supply of homes. People move in and need a place to live. When job growth stops, the real estate market levels off. Job growth is even more important than interest rate levels on the overall market. If you don’t have a job, it is tough to afford the mortgage payment, regardless of interest rate. Lower interest rates, nevertheless, stimulate the local move-up and first-time home buyer market.
Speaking of interest rates, they are now at the lowest point of my 40-plus year career. Coronavirus has put downward pressure on interest rates to keep the economy stimulated. This makes it a great time to buy an investment property and lock in the mortgage rate on your real estate purchase. The lower the mortgage rate for financing, the higher the overall rate of return on your investment.
There are certain real estate investment concepts for which the coronavirus has no effect. The first is debt reduction. In most cases, real estate is purchased using a 30-year amortizing loan. Regardless of the economic environment, when a payment is made on the mortgage every month, a certain amount goes toward principal reduction. If one of your goals is to own property free and clear, you can create a payment schedule on a 30-year loan that will it pay off in any timeframe you prefer. In most cases for investment property, rent will cover the mortgage payment. With each month that goes by, your tenant is helping you pay off your loan and build equity.
Coronavirus has not stopped the ability of an investor to get a loan secured by real estate purchased. The concept of leverage is what is known as using “other people’s money” or OPM. When you invest in real estate it makes the most sense to get a loan for a good portion of the purchase price.
Let’s take a look at an example. (No, there aren’t any $100,000 condos in our market, but it makes the example below easy to understand.)
To illustrate an example of leverage, let’s say you had $100,000 to invest. You then used that money to purchase one $100,000 condominium. If the real estate market were appreciating at 5% a year and you held the property for five years, the condominium would be worth $122,347 or a gain of $22,347. Now let’s say that, instead, you took that same $100,000, put $20,000 down on each of five $100,000 condominiums. You now own $500,000 worth of real estate. If the market appreciates at the same 5% per year for five years, your real estate would be worth $638,140 or a gain of $138,140 on the same $100,000 investment.
As you trade up, it is important to keep your equity position at a level that allows you to survive downturns in the rental market.
Coronavirus has not changed any of the tax benefits you can claim from owning rental property. Nonetheless, you should consult your tax advisor on the ways ownership of real estate will affect you personally. However, the main reason you receive a tax break is for depreciation, that is, the loss in value of the property over time. Depreciation is a tax concept whereby you qualify for a write-off, but don’t have to spend the actual dollars to get it. For example, on a $100,000 purchase, your accountant may choose to declare 80% of the value as depreciable. You can’t declare the whole value as depreciable because some of the value is attributed to land and land doesn’t “depreciate”. Therefore, in this example, $80,000 would be depreciable. Under the current IRS rules, you can take the $80,000 and divide it by 27.5 years for an annual depreciation deduction of about $2,900. In addition to depreciation, real estate taxes and other expenses for the property can offset your rental income. The bottom line is that real estate, in the early years of ownership, will show a loss, which results in a tax deduction and tax savings for you. There are limits as to the amounts you can deduct due to real estate losses. Depreciation can also be “recaptured” at time of sale, which means that you have a higher taxable gain. You need to consult your accountant to determine how all the IRS rules will affect you.
In the early years of rental property ownership, it is difficult to achieve immediate positive cash flow. In other words, when you first buy a property, the rental income probably won’t cover the mortgage payment, capital improvements, maintenance, and all its expenses. If the cash flow is about break even on a month-to-month basis, after you consider taxes and appreciation factors, the overall cash flow is positive. After owning the property for several years, rents should go up, the mortgage payment stays the same (except for increases in taxes and insurance), and the monthly cash flow increases.
First-time real estate investors and seasoned investors can review all the factors to determine if now is the time to invest. Consult your Realtor® and your financial planner to see if investing in real estate is right for you.
By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail DuaneDuggan@boulderco.com, call 303.441.5611 or visit boulderco.com.