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Real estate investing: The full breakdown

At a glance:

  • Real estate as home ownership

  • Real estate as investment property

  • Real estate as leverage

  • Summary of real estate investing

For most people, the first and only real estate investment they make is their own home. In fact, it is many people's largest investment of all. Yet investing in one's home is not much different from investing in other real estate ventures.

As one pundit put it, real estate is always a good investment because they are not making it any more. There's a lot of truth in this, but real estate investing isn't always a good deal. Real estate values rise and fall just as those of any other investment do.

Real estate generally requires a larger investment in one unit of property than other investments. It has ongoing expenses such as property tax and maintenance costs. However, real estate provides collateral, making it easy to leverage your investment with a small down payment and large mortgage. If you live in it, it also provides utility value.

When done right, real estate can be a very good investment indeed. When done wrong .…

Real estate as home ownership

Everyone needs a place to live. Anyone who lives anywhere is either a renter or owner. It has always been part of the "American dream" to own one's home.

However, it has not always been easy or wise to do that. By learning some of the basics of home ownership, you will be able to make wiser decisions about owning a home.

Should you buy a home?

For most homeowners, their residence is the largest single investment they will ever make. Before buying a home, determine whether it even makes sense to do it. In addition to the purchase price, property owners are responsible for annual property taxes, maintenance and repairs, as well as huge interest expenses on the unpaid part of their home loans.

You may also be liable for financial damages to persons who are injured on your property. If your property is damaged or destroyed by wind, water, fire, or malice, you are still liable for payment of your home loan. Before deciding to buy a home, evaluate the costs of ownership versus the cost of renting.

You can build equity

Of course, a big plus on the side of home ownership is that you build equity over time. Home ownership is an investment. This means that as you pay down your home loan—called a mortgage—you vest more and more of your value; so if you sell your home, you will get to keep more of the cash you put into the house through your mortgage payments.

The value of your home is also subject to market conditions, and it could rise or fall like any other investment. But even if the value declines, you do have the use value of your home, for which you did not have to pay someone else rent.

Is it too big or too little?

There is also the question of space. How much space do you need—now, in five years, or more? A home is usually a long-term investment, so you need to determine how much space you need and what you are going to do when you outgrow your house—or when it is too big for your needs.

Some houses are "expandable," meaning you can build additional rooms as you need them. However, taking them off is another story. Do you need land and the responsibilities that go with it, such as mowing the lawn, tending the garden, and attracting the neighbors' kids and pets?

"Location, location, location"

"Location, location, location"—the only three things you need to know about real estate (this is not always true, actually). Is the location suitable for your needs? For some families with children, location in the "right school district" is very important.

New homes under construction are seen in Phoenix, Arizona. (Photo: Justin Sullivan/Getty Images)
New homes under construction are seen in Phoenix, Arizona. (Photo: Justin Sullivan/Getty Images)

For others, location near work is important, while others value safety (low crime) away from toxic substances and in a place with weather they can tolerate. These factors contribute to the market price of a house when you buy, and again when you sell it.

Many families address these concerns by moving from one house to another when their needs change. They transfer the equity from one house to another one. However, one must exercise forethought, as real estate transfer costs and taxes can take a huge chunk from your accumulated equity.

What types of homes are there?

There are different types of home ownership, as well, to suit the different needs of homeowners. For some, ownership of a single-family home is best; others like a shared ownership arrangement such as a duplex, condominium, or co-op apartment.

  • Single-family home ownership has outright responsibility for the house and land.

  • A duplex involves part ownership of a two-family house and land, where the two families share expenses of the outside maintenance by mutual consent.

  • A condominium grants shared ownership between the buyer, who owns the inside appurtenances, and a homeowners' association that owns the outside structure and land. This works out well for those who do not want to mow the lawn or repair or replace the roof. But there are huge restrictions on what owners can and cannot do. There are also ongoing association fees to cover the common area expenses.

  • Akin to condominium ownership is participation in a cooperative, or co-op. This usually applies to an apartment building in which the residents own shares of the whole building rather than their own apartment. Owners bear expenses in proportion to their share of ownership.

Real estate as investment property

There are many ways to invest in real estate. You can invest in unimproved land, in land with buildings, or land with other income-producing attributes, such as minerals or leases for recreation use. You can be a direct investor or you can be part of an investment group such as a limited partnership (LP) or real estate investment trust (REIT).

You can be an active investor or a passive investor. Irrespective of how you invest, you should be aware of features of real estate used as housing and for commercial purposes.

Rent

Real estate investors let others use their property in consideration for payment. Rent is a payment made for the use of someone else's property. Rental terms are often set down in a written document called a lease.

A lease is a legal document that specifies all the terms, conditions, duration, and payments for use of property. A lease gives the owner (the landlord) and renter (the tenant) certain specific rights and specifies obligations of both parties. These rights and obligations are enforceable by law.

Expenses are deductible

Rent is considered income to the real estate investor and is subject to income tax. However, the investor may deduct all expenses for the upkeep, maintenance, management, and advertising of the property. Expenses also include interest payments and taxes. Capital invested in the property, including capital improvements, can be depreciated (deducted in proportion to the expected "useful life" of the property).

The useful life is deemed to be how long the property will last before it must be replaced. Buildings, appliances, and other appurtenances eventually wear out and need to be replaced. The expected life of most property to be depreciated can be found in Internal Revenue Service (IRS) depreciation tables.

Depreciating your assets

There are a variety of depreciation formulas one can use, depending on the type of asset and the date it was placed in service. The IRS prescribes which one you can use to take the appropriate deduction. Sometimes you may have an option as to the method used.

Semi-detached Edwardian period houses in warm evening sunshine. (Photo: Richard Baker / In Pictures via Getty Images Images)
Semi-detached Edwardian period houses in warm evening sunshine. (Photo: Richard Baker / In Pictures via Getty Images Images)

Deprecation for tax purposes is a very complex subject. It is wise to seek the advice of an attorney or accountant in handling this item, to prepare your taxes in the most advantageous manner permitted by law.

Land has an infinite useful life and cannot be depreciated; however, minerals and other natural resources that produce income can be depleted. An investor can take a depletion deduction prescribed by the IRS for income-producing resources on their land.

Common advantages of real estate investing

The advantage to real estate investing is that it produces income that is sheltered from taxes by expenses and depreciation (or depletion). Furthermore, the long-term value of real estate tends to increase over time if well managed. One also has flexibility in managing real estate to generate income, capital gains, or a combination of both.

Real estate investment "losses" may also be used to offset taxes on other income. Because depreciation and depletion deductions are not actually paid in cash, as would be a mortgage interest payment, they tend to offset actual cash income—sheltering it from taxes.

Residential real estate

Real estate designated as housing is called residential real estate. If the owner lives on the property, it is referred to as "owner occupied"; otherwise it is rental property or vacant. Investment real estate may include single-family homes, duplex homes, condominiums, and cooperatives. If the owner does not live in the home, he or she may rent or lease the property to others who pay the owner for use of the property.

Real estate used for trade or business, such as a shop, store, office, or factory, is called commercial real estate. Raw land, or undeveloped land, is real estate without any buildings or other useful structures. Undeveloped land is leased for recreation, camping, hunting, etc., or for its natural resources, such as minerals, oil, and natural gas.

Real estate as leverage

A key to successful real estate investing is leverage. Leverage allows an investor to use a small amount of cash to generate large returns.

How it works

Here is an example of how it works: A hypothetical investor purchases real estate worth $100,000. The investor puts down $20,000 cash and borrows the difference ($80,000). If the investor later sells the property for $120,000 (a 20% gain) and pays off the $80,000 loan, he or she is left with $40,000. This represents a 100% return on the original $20,000 investment.

A 20% gain on the sale of the property was leveraged into a 100% gain on the cash invested. Of course, this is an oversimplified example used to illustrate the meaning of leverage. We did not discuss income and expenses as well as other costs, such as real estate transaction fees, loan interest, commissions, or the holding period (one year, two, or more), but the concept is accurate.

Why leverage works with real estate

Leverage works better with real estate investments than other kinds of investments because it is easier to borrow money against real estate than other assets. Leverage also works for stock investments using a margin account, but the rules are very stringent because the stock is not a tangible asset. Land (real estate) will always be there, and they are not making any more. Creditors are eager to lend money to borrowers for real estate purchases because such loans are secure.

Success is not guaranteed

Not everyone who invests in real estate is successful. It has been known for real estate values to fall rather than rise. Like other investments, real estate values move up and down and in market cycles. When investing in real estate, it is important to have a long-term strategy because you may have to be in it longer than anticipated in order to realize your investment goals, if at all.

Leverage works both ways. If the investor above had sold the property for $90,000, they would have suffered a 50% loss on their $20,000 investment despite the fact that the decline in value was only 10%. Furthermore, the lender was paid in full for the loan—despite the real estate loss.

Summary of real estate investing

For most people, home ownership is the largest investment they will ever make. Making that investment requires substantial forethought and planning.

Once you start investing in real estate, there are many advantages and rewards if you do it wisely. Using leverage, you can multiply the return on your investment.

By carefully managing rental property, you can control income, capital gains, and taxes. Plus, there is a variety of investment real estate to choose from, including residential, commercial, and undeveloped real estate.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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