What to Really Consider When Investing in Real Estate

Over the last 5 years the excitement of investing in Real Estate has returned to the levels of the early 2000s. Property values have been soaring and people are getting Real Estate Rich once again. Now, with interest rates rising and property prices staying high, what should you consider if you want to get in? Is it too late? What do you even look at to determine if a real estate investment opportunity is a good opportunity? Also, why is inventory staying so low in a market that seems to be expensive?

In breaking down the specifics, we will also explore risks and tax implications. Finally, we’ll finish by helping you understand the differences between real estate investing and stock market investing. Not to say that one is better than another, but to help you understand the differences.

As we begin, I would like to start with an important definition that tends to get lost when we talk about these things. That is, the definition of the word INVESTMENT

INVESTMENT: The act of committing resources to something in an effort to earn a profit. The goal of an investment is to generate income or appreciation, ideally both.

What are some of the Benefits of Real Estate Investing:

1. Tangible Asset: Real estate provides investors with a tangible asset in the form of physical property. This can offer a sense of security and control.
2. Income: Rental properties can generate a steady stream of rental income, providing investors with a consistent cash flow.
3. Potential for Appreciation: Over time, real estate properties often appreciate in value. This is a good thing, however it can lead to significant capital gains when you decide to sell if not rolled into a new property.
4. Tax Advantages: Real estate offers several tax benefits, including deductions for mortgage interest, property taxes, and depreciation. Additionally, if you materially participate, are an active investor or a real estate professional you may even be able to deduct other income.
5. Leverage: Real estate can be financed with mortgages, allowing you to control a larger asset with a relatively small upfront investment. This means that if your property appreciates, the appreciation is on a larger asset than you could purchase with just your own money. Therefore the percentage gains could be quite larger.

Challenges of Real Estate Investing:

1. Tangible Asset: Because it’s a real asset, it really can have problems that need to be dealt with. This could be repairs, it could be maintenance such as grass cutting or even just collecting rent. Ultimately, someone needs to deal with the challenges. This could be you or you could hire someone to do it. Either way, real assets = real attention.
2. Down Payment: In the current real estate environment most banks are requiring at least 20% down. This money needs to come from somewhere or the bank won’t offer you a mortgage. Quick math, if you purchase a $300,000 investment property your down payment is $60,000. You will need to plan to make sure you have that available.
3. Additional costs: In addition to the down payment, you will also need to pay a number of other closing costs when you purchase the property. This includes Transfer Tax (between 2-4%, Title search and title insurance fees (~$2500-$5,000), Appraisal for the property, Home Inspection, Repairs or upgrades when you take possession to name a few. Also, the seller typically pays Realtor Commission which is ~6%.

Here are some of the Tax Impacts of Real Estate:

1. Property Taxes: Owners of real estate properties are responsible for property taxes, which can vary widely based on location and property value. In Delaware this tends to be lower than the national average
2. Rental Income Tax: Rental income is generally taxable, but you can deduct expenses such as mortgage interest, property management fees, and maintenance costs. One good thing to consider is that this income is typically considered passive and therefore isn’t subject to Medicare and Social Security taxes. W2 wages that you earn from your job are subject to these two taxes and are 7.65% up to $160,200 and 1.45% beyond $160,200. Early on, most of your expenses typically offset a portion, if not all of this income.
3. Capital Gains Tax: Profits from the sale of an investment property are typically subject to capital gains tax when you sell. Certain exemptions and deductions may apply.
4. Depreciation Recapture: Again, upon sale, you may need to recapture the depreciation you were able to write off when you owned the property. This is a 25% tax on the dollars you deprecated during the time you owned it.

Return on Investment Considerations:

Real estate investments typically require a longer timeline to realize substantial returns. Factors affecting the timeline include property location, market conditions, and property management. Generally, real estate investments are considered long-term, and investors can expect to see significant Return on Investment (ROI) over several years to decades. In addition, the one way that you can increase your ROI is by doing most if not all of the work yourself. Sweat Equity is a big way to make more money in real estate. If you don’t have to hire someone to do repairs, renovations or even build the property, your time factors into the overall contribution of the growth in equity.

Why are Home Prices so High?

People own more houses than they used to. Since 2012, when this stat first became a stat that was tracked there are an estimated 10 million second homes in the US. Add on the Pandemic of 2020 where the world was shut down and people wanted to enjoy their surroundings, many people who purchased second homes have become accustomed to spending time where they like and have no desire to sell them. 30 years ago, only a handful of people owned second homes. Now more than ever, retirees own 2 and sometimes 3 or 4 homes and hop around depending on the season.
In addition, many people can’t come to terms of selling a home that carries a 3% mortgage rate, in exchange for a new home with a 7 or 8% mortgage rate. Couple this with high prices and many people are choosing to just stay put, hence adding to the problem of low inventory.

When thinking about the differences between Real Estate and Stock/Bond Market investments, here are a few Benefits of Investing in Stocks and Bonds:

1. Liquidity: Stocks and bonds are highly liquid investments, meaning you can buy and sell them quickly. This liquidity provides flexibility in managing your portfolio. This excludes your 401k or employer sponsored retirement plan. However, if you are retired, this could include those assets.
2. Diversification: Stocks and bonds offer a wide range of investment options, allowing you to diversify your portfolio and spread risks in the Stock Market or Bond Market. Not all stocks or bonds are created equally. Remember, stocks are fractional shares of ownership in a company, this means you participate in that company’s performance. Bonds are debt issued by companies to finance their growth objectives. You receive an interest payment while you hold that debt.
3. Historical Returns: Historically, the stock market has delivered solid returns over the long term, making it an attractive option for investors seeking capital appreciation.
4. Income Potential: Some stocks pay dividends, providing a source of regular income. Bonds also offer periodic interest payments.
5. Truly Passive: A stock or bond market investment won’t ever need the grass cut or an air conditioner replaced. You can invest your money and not worry about a necessary repair like you do in real estate.

Taxation Impact on Stocks and Bonds:

Taxation of stocks and bonds depends on factors such as the type of account (e.g., taxable brokerage account, tax-advantaged retirement account), investment duration, and the investor’s income. Common tax considerations include:

1. Capital Gains Tax: Profits from the sale of stocks and bonds may be subject to capital gains tax. Long-term investments often benefit from lower capital gains tax rates. In addition, the Capital Gain isn’t realized or required to be paid until the investment is sold. Currently, Capital Gain rates are tied to your overall income tax rate. Therefore, you can strategically determine when you sell an asset which can lower the overall tax impact of this sale.
2. Dividend Tax: Dividend income is generally taxable, though some dividends may qualify for preferential tax rates. Determining what type of investment to purchase to minimize your taxation should be done before the investment is purchased.
3. Interest Income: Interest income from bonds is usually taxable at your ordinary income tax rate. This could also be completely tax free depending on what you purchase. Zero tax would be a very helpful for those who have very high incomes aside from their investment holdings.

Timeline and ROI in Stocks and Bonds:

Stocks and bonds tend to offer more immediate returns compared to real estate. However, the timeline for achieving significant ROI can still vary widely based on market conditions, investment strategy, and individual goals. While you may see gains in a matter of months or years, it’s essential to remain invested for the long term to capture the full potential of compounding returns.

Conclusion

Investing in real estate, stocks, or bonds each offers unique advantages and disadvantages. Your investment mix should align with your financial goals, risk tolerance, tax circumstances and investment timeline. There is a theory that we follow at Blue Rock Financial Group. Invest with the idea of when you plan to spend the asset you are investing. That helps to frame the timeline and risk profile for the dollars as opposed to just looking at an investment with too much emotion. The goal is for that investment to provide you with as much as possible, net of tax, when you plan to actually spend those dollars. It’s all about what you keep, not just what you make.
Real estate provides a tangible asset and tax advantages but often requires a longer investment horizon. Stocks and bonds offer liquidity, diversification, and historical returns, making them suitable for shorter timelines. Ultimately, a well-diversified investment portfolio may include a combination of these asset classes, providing a balanced approach to wealth accumulation and preservation. Be sure to consult with your Blue Rock Financial Planner to create and determine what suits your needs and objectives.