June 15, 2024
Jon Strauss, CFP®
Last month I attended a real estate conference, hoping to learn more about the current investment landscape. Instead of a deep dive into the market dynamics and trends, it was more of a sales pitch for a real estate course promising boatloads of “mailbox money” if you just follow their “3 easy steps to real estate investment.” In addition to the bad taste it left in my mouth about that organization, I was troubled by how easy they made real estate investment sound. We here at WEIL, along with many of our investors with experience in real estate, know that the reality is often more complicated requiring research, calibration, and disciplined procedures.
I want to be clear – this is not a newsletter that seeks to dissuade you from investing in real estate. For many investors, direct ownership of real estate can play an integral part of a diversified portfolio. However, we've seen people, enchanted by the siren song of passive income, dive into the residential and/or commercial landlord business headfirst, only to realize that successful direct real estate investment requires more active involvement than they bargained for. It requires strategic thinking prior to the purchase, ongoing management, and a deep understanding of municipal and legal regulations, not to mention potentially dealing with the inevitable bad tenants, leaking toilets, insurance claims, and bad neighbors or HOA overreach (to name a few).
In this newsletter, we'll explore key considerations for those looking to invest in directly-owned real estate. We'll discuss how to determine if real estate fits into your portfolio, calculate potential returns, and choose the best ownership structure. We'll also cover the importance of property management, share strategies for maintaining your investment properties, and highlight the need for adequate insurance coverage. Whether you're a seasoned investor or just starting, we aim to provide valuable insights into the world of real estate investing.
Determining How Direct Real Estate Fits into Your Portfolio
Directly-owned real estate can play an important role in your investment portfolio, however it should not be the only asset class represented there. You’ll need to determine your goals in the context of your overall portfolio before you decide to move forward with any real estate investment.
Consider the following rules of thumb:
· We generally recommend investors maintain a roughly 70 - 80% allocation to liquid assets in both before and after tax accounts (think stocks and bonds), and 20 - 30% in illiquid investments like real estate. (An exception should be made for significant ownership of a private business which could constitute a material concentration of your assets. But this is a subject for another day.) Maintaining sufficient overall liquidity is important because it allows you to seize attractive investment opportunities as well as navigate unforeseen expenses or market downturns without being forced to sell assets at an inopportune time.
· Define your primary investment goals. Are you looking for regular income, capital appreciation, or a combination of both? Understanding your motivation will guide your property selection and overall strategy.
· Assess your risk tolerance and be aware of the potential downsides. Direct real estate investment carries significant risks, such as vacancy periods, unexpected repairs, and market downturns. Be realistic about your ability to weather financial challenges and ensure that a potential loss would not unduly derail your overall financial well-being.
How to Determine Investment Return on Property
When evaluating the potential returns of a real estate investment, investors often focus on metrics such as cash-on-cash return (the annual return made on the property in relation to the amount of mortgage paid during the same year), Net Operating Income (NOI), and capitalization rate (cap rate). While these measures provide valuable insights into a property's financial performance, they are not the only considerations for investment decisions.
To gain a comprehensive understanding of a property's profitability, investors must analyze the NOI, which represents the annual income generated after accounting for operating expenses but before debt service and capital expenditures. A positive NOI may indicate that the property is generating income, while a negative NOI suggests that the property is losing money. NOI does not however account for potential appreciation or depreciation, nor potential changes in the level of occupancy and interest rates as and when debt is refinanced.
Cap rates, calculated by dividing NOI by the property's value, provide an indication of the overall rate of return on the investment. By comparing cap rates of similar properties through comparative yield analysis, investors can determine if a specific property offers a competitive return within its market and property type. However, cap rates alone do not paint a complete picture of an investment's potential. For example, comparable properties in different markets could well have significant variations in cap rates.
The question remains: is the return from direct real estate investment attractive enough? Compared to other forms of investments like stocks and bonds, real estate can require more active management and carries inherent risks like vacancy and maintenance. An investor must weigh the potential for higher yields with the greater effort and potential for illiquidity involved in direct real estate ownership.
How to Hold the Asset
One of the key decisions you need to make before venturing into the investment real estate space is how you’d like to hold title to the asset. Choosing the right ownership structure can significantly impact your risk exposure, tax benefits, and long-term financial planning.
Ownership Structures:
· Sole Proprietorship - Holding the property in your name may seem simple, but it can come with significant risk to your personal assets, due to the fact that as a sole proprietor you have unlimited personal liability.
· Family Trust - A trust allows assets to be managed seamlessly and bypass probate, but it may not offer the same level of liability protection as an LLC.
· LLC – A single member LLC can shield your personal assets from legal claims, compartmentalize your properties, and offer potential tax benefits. LLCs provide superior liability protection compared to trusts.
· Partnership - Joining forces with family or friends through joint ownership, a Tenancy in Common (TIC), or a multi-member LLC (which, like the single member LLC, provides the most protection for your other assets) can investing more financially accessible. It’s important to recognize though that shared ownership can lead to disagreements.
The Winning Combination:
LLC Owned by a Trust - For the best of both worlds, consider setting up an LLC to own your real estate property and have the LLC owned by a trust. This combination allows you to maintain the superior liability protection of an LLC, avoid the time-consuming and costly probate process, and gain more control over the distribution of the LLC ownership through the trust document.
Note that we always recommend that the question of ownership be confirmed with an estate planning attorney.
The Importance of a Good Property Manager
If you don't plan on making real estate your full-time job, finding a reliable property manager is important for your success. Hiring a property manager to manage a single property can be more expensive. To keep costs aligned, larger, more experienced firms often require a portfolio of real estate. The fee is typically 5% to 10% of monthly rental income, depending on the type of property and tenant. Tenant placement/leasing fees can cost between 50% and 100% of one month’s rent. Missing details such as these can lead to an inaccurate picture of your investment's profitability.
Before selecting a property manager, we suggest:
· Asking for referrals from other investors and conducting thorough interviews.
· Ensuring the prospective property manager has experience with properties similar to yours, is familiar with local laws, and has a robust tenant screening process.
· Considering the impact of property management fees on your overall investment strategy and ensuring you have accounted for these costs in your expected cash flow and return on investment.
Exit Strategies for Rental Properties
Planning your exit strategy before making your purchase is a key component of a successful real estate investment. Your long-term goals and objectives will shape your investment decisions and overall approach.
Here are some strategies to consider:
· Buy and Hold - Focus on growing rents and long-term appreciation, and weather short-term market fluctuations. (We believe that, generally, by most measurements, if properly maintained and managed, real estate tends to get better over time.)
· 1031 Exchange - Benefit from deferred capital gains taxes when selling a rental property and reinvesting the proceeds into another property. This allows you to grow your portfolio without immediate tax implications. But it does require adhering to strict timelines and guidelines.
· Delaware Statutory Trust (DST) - If you have an appreciated rental property and wish to transition to a more passive role, consider utilizing a 1031 exchange to transfer your investment into a DST. This strategy allows you to defer capital gains taxes on your appreciated property while gaining fractional ownership in a diversified portfolio of investment properties managed by the trust. Reducing your active role comes at a cost, though. Generally, returns in DSTs are lower than direct ownership, and they come with predetermined holding periods, so they may not be suitable if you need flexibility in accessing the proceeds of a sale.
· Charitable Remainder Trust (CRT) - Donate the property to avoid capital gains taxes and receive a potential lifetime income stream, while ultimately supporting a charitable cause. This strategy involves irreversibly giving up ownership of the property and adhering to complex tax rules. Additionally, contributed property needs to be free and clear of debt.
Maintenance and Upkeep for Investment Properties
Maintaining your investment property is necessary to protect your asset, attract quality tenants, and maximize your returns. Neglecting maintenance can lead to costly repairs, lower property values, and potential legal issues.
Here are key strategies that can help avoid common pitfalls:
· Regular Maintenance and Inspections - Develop a detailed maintenance schedule that includes tasks like HVAC tune-ups, gutter cleaning, exterior painting, and roof inspections. Schedule quarterly inspections for all property components and monthly checks for critical systems.
· Set Reserve for Maintenance and Capital Expenditures - Set aside 1 - 2% of the property value annually for maintenance and repairs. Set aside 5 - 10% of rental income monthly to cover periodic capital expenditure expenses.
· Build a Network of Contractors - Establish relationships with reliable, affordable contractors and service providers.
· Tenant Responsibilities - Clearly outline tenant responsibilities in the lease agreement, such as replacing air filters and reporting maintenance issues promptly.
Ensuring Adequate Insurance and Liability Coverage for Rental Properties
Protecting your investment property with the right insurance coverage is important to mitigate potential risks and financial losses. Proper insurance coverage can protect you from significant out-of-pocket expenses in the event of property damage, liability claims, or loss of rental income.
Here are key considerations to avoid common pitfalls:
· Landlord Insurance - Ensure your rental property is adequately insured, covering property damage, liability protection, and loss of rental income. Consider property value, location risks, and tenant profile when selecting a policy.
· Review - Review your policy annually to ensure it aligns with your property's value and the risks associated with renting it, and to mitigate for any change of circumstances.
· Umbrella Insurance - Add umbrella insurance for additional liability coverage to protect you in case of significant claims or lawsuits beyond the limits of your standard policy.
· Factors to Consider When Determining Coverage Amount - Ensure coverage matches the value of your property and other assets, rental income, and tenant risk level.
· Tips for Lowering Insurance Premiums - Opt for higher but affordable deductibles, install safety features, and require tenants to have renter’s insurance.
Keep in Mind
· California Prop 19 – An inherited property not used as a primary residence is reassessed at current market value, potentially increasing property taxes significantly.
· Local Laws - Local laws and regulations may have zoning restrictions, permitting requirements, occupancy limits, and safety standards that impact rental operations and profitability.
· Interest Rates – Interest rates on loans for rental properties are almost always higher than mortgage rates for owner-occupied properties.
· Brokerage Rules – Brokerage sales rules are evolving. As an example, the costs associated with a purchase have traditionally been borne by the seller, but that appears to be changing.
· Evaluate Health of HOA – Not all HOA’s are created equal. Budgets, reserves, special assessments, and their property manager’s competencies can vary wildly.
Investing in rental real estate is not for the faint of heart. It requires research, strategic planning, and a willingness to navigate complex challenges. However, for those prepared to put in the effort, real estate can be a powerful tool for building wealth and diversifying your investment portfolio, and one which we can advise you on should you choose to add real estate to your overall investment portfolio. As with all of your major financial decision, if you are considering a real estate investment, contact us to discuss your unique situation and explore how it may fit into your overall financial strategy.
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