As Donald Trump and Warren Buffett will both tell you, buying Real Estate has been one of the keys to their financial success. But how can an ordinary person use Real Estate to build wealth? The answer: Residential Income Property.
Many people do not realize that if a property has 2, 3 or 4 units, an ordinary residential loan can be obtained on the property rather than a higher interest rate commercial loan. With sufficient down payment (these days, about 25 to 30 percent for non-owner occupied), the rents on the property may be enough to cover the mortgage and property taxes or even provide a positive cash flow once the tax advantages are considered.
What tax advantages? Well, for one thing, there is “passive loss”, also known as depreciation. On paper, these homes can be considered to have a “loss” in value based on a formula that allows roughly one thirtieth of the building’s purchase price (not including the land) to be taken as a “loss” for tax purposes. This paper “loss” will have to be accounted for as an adjustment to the tax basis for Capital Gains at the time of sale; however, a 1031 exchange can avoid this tax payment for many years until such a time (say, retirement) when it is more advantageous to take the gain.
Other tax advantages are that many costs of the property, such as the purchase of tools, maintenance, property management, etc, are tax deductible as well.
When buying income property, it is important to work with a Realtor who can help you figure out market rents and also help you project expected appreciation on the property. Calculating a “Gross Rent Multiplier” (GRM), which is the cost of the property divided by the annual income, is a good rule of thumb for screening down to which properties you are interested in.
Properties in an area that typically have lower appreciation, such as Lawndale, Inglewood, or Hawthorne, these days can have GRM’s of 9 to12, meaning that they should fully pay for themselves in 9 to 12 years just on the rental income. Properties in the three Beach Cities, where appreciation has been historically higher, will have higher GRM’s — from 16 to 22 — meaning that because of their higher prices, it will take longer for the rents to pay back the cost of the property. However, these areas will traditionally have gone up more in value, so they can be an equivalent or better investment if you have a higher downpayment or can handle a few years of negative cash flow and treat these properties as a long term savings project.
Neither approach (lower value properties with faster payback vs. higher value properties with better appreciation) is right or wrong — this is an individual investment decision. Both can help you build wealth in Real Estate!
Finally, income property is GREAT for the first time home buyer. Because the FHA allows owner occupied loans on multi-family properties, you can live in one and rent out the others for as little as 5 percent down! The FHA loan limits are higher than the single family $729,750 limit as well.
You may wish to consult with your accountant to understand if the tax advantages of income property could help you. And when you are ready to invest, choose a knowledgeable Realtor who frequently works with investors to help you understand the cash flows and investment options you have.