Chris Pummer, AOL Real Estate Columnist
-Sigombak-
The recent collapse of U.S. home sales ripped a magnificent bloom off the rose of real-estate investing -- yet buying rental properties remains one of the best ways for middle-income Americans to build wealth.
While the rich have a phalanx of investment advisors to help enrich them further every day, middle-class Americans struggle to just set aside enough money in their 401(k)s to secure their retirement. Real estate offers people of modest means an opportunity to build wealth in an investment they understand as homeowners and renters themselves.
Studies show residential real-estate investing returns an average 10 percent a year ? equal to the historic return for stocks. While it requires active management of the asset on the investor?s part vs. more passive stock investing, it can be a rewarding part-time endeavor for those with a long-term horizon.
Leveraged investing
The beauty of real-estate investing is the ability to leverage other people?s money ? namely, a mortgage lender and renters ? to make money for yourself.
Take, for example, a $200,000 home bought with 10 percent down and $8,000 in closing costs. If that property appreciates just 4 percent a year over 20 years, its owner turned a $28,000 investment into a $238,000 gain.
That scenario assumes the rental income covers annual mortgage, insurance, property-tax and maintenance costs, which it may not fully in the early years. But it also doesn?t factor in the likely surplus annual income in future years when rising rents more than cover fixed-mortgage costs.
Tangible asset
Unlike stocks, whose value is a matter of perception and psychology, real estate is a tangible asset and not just a paper stock certificate (which shareholders don?t even get in hand anymore!).
The steadily rising cost of constructing new homes protects and ultimately enhances the value of existing properties. That underlying strength is even greater in metro areas with a limited supply of developable land within easy commuting distance to the center city, or well-located properties in desirable coastal and resort communities.
Direct control
Unlike the crapshoot inherent in the stock market, real-estate investors have direct control over their investments. They set the rents, choose tenants and decide what improvements to make and when.
Rather than staking their fortunes with corporate executives who can fail to grow their companies for any number of competitive reasons, real-estate investors manage their own assets based on local market conditions.
Limited risk
Real estate values can and do fall as homeowners discovered in Texas in the 1980s, southern California in the early 1990s and various regional markets throughout the U.S. more recently.
Still, long-term investors seeking to build wealth for their retirement years face little downside risk with real estate. America?s rising population, shrinking household sizes and unfortunately high divorce rate are expected to fuel increasing demand for places to live for decades to come.
Diversification
Real-estate values generally don?t rise and fall in tandem with stocks and sometimes are countercyclical, moving in the opposite direction. It is what?s called in the investment world a ?non-correlated? asset.
Diversifying investment holdings into rental properties provides a solid counterbalance to stock-laden 401(k) and IRA accounts. A modestly priced, three-bedroom rental home won?t ever produce the explosive returns of a sensational stock like Google, but its owner can sleep easier knowing his or her future wealth isn?t wholly dependent on the whims of the stock market.
Immediate returns
Self-anointed real estate gurus trumpet the fortunes to be made in buying and flipping distressed and foreclosed properties, a fast-buck strategy that?s especially difficult to pull off in weak housing markets where properties languish for sale for months on end.
Still, smart shoppers can reap immediate paper gains on many properties. At any given time ? and especially in today?s markets with mounting supplies of unsold homes ? individual home sellers forced to sell quickly due to job relocation, divorce or unemployment may accept below-market prices to facilitate a sale.
Improvement potential
Just as with the purchase of a first home, it?s wise when shopping for rental properties to buy the least expensive home in the nicest possible neighborhood.
The benefit for the owner is threefold: The better the neighborhood, the less likely the number of rental properties available within it. Improvements made to modest homes in nicer areas will yield higher rents. And an owner could simply maintain the property during the rental period and improve it just prior to sale to bring it up to the neighborhood standard and command a much higher asking price.
The benefit of inflation
As Americans have seen in the last year, rising mortgage rates hurt home sales and property values. Yet rising rates can have a positive impact on owners of investment properties.
The fewer the number of people buying homes, the greater the number of renters, which heightens demand for rental properties. Since real-estate investment tends to slow as mortgage rates rise, that also means a tighter supply of rental homes in the near term.
Interest rate hikes are the Federal Reserve Bank?s means to curtail inflation by making borrowing money more expensive. Inflation benefits real-estate investors who can raise rents accordingly. So while long-term appreciation suffers from mortgage-rate spikes, the immediate rental income picture improves.
Tax-deferred gains
Real-estate investing provides the same type of tax-deferred advantage of 401(k)s and IRAs. Owners aren?t taxed on the appreciation in a home?s value until the time of sale ? and even then, they can forestall paying taxes by rolling their gain into another property.
Add to that another major tax advantage: The ability under present tax law for owners of rental properties to move into the home for a total of two years in any five-year period and pay no tax on up to $500,000 in capital gains. That opportunity argues for buying rental properties you could comfortably inhabit yourself for a spell.
Of course, real-estate investing is not without its downsides, which should all be heavily weighed:
Illiquid investment
Unlike stocks, which can be sold with the push of a computer keystroke, selling a home can takes months and entails considerable costs. If you?re not prepared to tie up your money for years to come, best that you don?t.
The difficulty in quickly selling a property, however, can work in investors? favor by discouraging them from running scared in a market downturn and dumping properties. The relative liquidity of stock investing is actually one of its greatest drawbacks, since countless investors sell in a panic, often at a loss, when an individual stock or the overall market drops.
Cash-flow constraints
The ideal situation is to buy properties whose rental income covers the monthly ?carrying costs? ? i.e. mortgage and insurance payments, property taxes and maintenance costs. The run-up in U.S. home values in recent years has made that scenario difficult to attain in many regional markets.
New investors today may find themselves in a negative cash-flow situation, meaning the rent doesn?t cover their costs. Investors must be prepared financially to cover any such shortfall or risk losing the property if they can?t foot the bill ? a crushing problem now facing many recent investors saddled with properties they expected to flip for a fast profit.
Sporadic income and unforeseen costs
However good the cash-flow numbers may look going in, rental-property owners risk being squeezed on several unforeseeable fronts.
The first is tenants who fail to pay their rent in timely manner ? or not at all ? leaving it to the owner to cover their mortgage payments out-of-pocket until they collect the back rent or evict a deadbeat. Next is tenant turnover, which can leave a property unrented for several months a year, during which time the owner must also cover the nut. Lastly, there are major repairs that must be done -- such as a new roof, furnace or septic system ? that can cost well into the thousands of dollars that must be ponied up on the spot.
Landlording
Finally, there?s the angst of trying to do right by tenants who don?t reciprocate in kind. Some may destroy the home you?re improving for them without any intention of raising the rent. And all catch on fast to when you?re playing them.
Tenant selection is a skill rental-property owners need to master fast since it has an immeasurable influence on success. If you?re suspicious by nature and have a short fuse, this is no business for you. If you can learn to recognize great tenants who?ll carry your mortgage for years and care for your property as if it were their own, you may be wise to never raise their rent and reap tremendous long-term benefit.