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WHY BUYING INCOME PROPERTY MAKES SENSE
April 7, 2017 by David Palma Leave a Comment
It’s All About R.O.I.
If you haven’t thought about buying income property, maybe you should. Investing in real estate makes good sense. Even though it’s a Seller’s market right now — with more buyers than sellers limiting choices and raising competition — with the right mindset and advice from Palma Properties as your professional REALTOR®, buying income property can yield great returns.
Buying Income Property Is All About R.O.I.
Investing in real estate allows you to use debt to leverage your cash. Income property investments hedge against inflation, earn excellent appreciation and provide tax benefits, too.
You’ve got a number of choices… a single family residence; a multi-unit property like apartments or condos; maybe even a mobile home — or one of the hottest markets these days, a vacation rental. Each of these options carries its own set of things to think about. First, here are some general considerations.
Buying Income Property Requires a Review of Your Finances
Carefully review your financial position
Before you invest, you need to pay down your debt. While savvy investors might carry debt as part of their investment portfolio, the average person probably shouldn’t. If you’re burdened with student loans, medical bills or kids who will soon be going to college, buying income property may not be the right move for you right now. If you’re in doubt or confused by this, consider contacting a CPA or Mortgage Broker.
Next, you need to make sure you have the down payment. Investment properties generally require a larger down payment than owner-occupied homes and have more stringent approval requirements. Plan on having at least 20% down on non-owner-occupied properties — but as low as 3.5%, if you live in part of a multi-unit property. More on this under “Financing,” so read on.
When you consider buying income property, it’s best to set proper expectations for your ROI. Big Wall Street firms who buy distressed properties aim for 5% to 7% returns. They have to pay for their staff. But as an Individual, you should set a goal between 7% and 10%. As your local REALTOR®, we’ll help you assess the market and come up with an appropriate rental price. We’ll compare rents for comparable units in the area. We’ll also factor in annual maintenance costs — about 1% of the property value — utilities if they’ll be included, and take other costs into account, like insurance, property taxes, pest control, landscaping, property management fees, and HOA fees, if they apply.
Location, Location, Location
The mantra of Location, Location, Location rules
We can help you find a community where an income property will fit in. Our solid, working-class neighborhoods in the Ukiah area — generally where middle to lower income tradesmen reside, and businesses might be intermingled — make the best choice. No matter which neighborhood you choose, we’ll help you make sure your property won’t be the street’s ugly duckling.
We think it’s best to stay close to home. We’ve found that absentee owners usually hear about issues less quickly, and that often makes problems bigger and more expensive to resolve. A location within a twenty minute drive from your home will make you more available to your tenants, and able to respond promptly.
Looking for bargains
Bargains don’t always pay off
A bargain now will help you tolerate fluctuations in value over time, so you can profit, if or when you sell. We can help you decide on what is a “good value”. Keep in mind that real bargains get snapped up, quickly, so you need to be ready to act when you find one — another way we can help.
While it may be tempting to look for a house you can get on the cheap and flip into a rental, if this is your first property, that’s generally not a good idea. But if you have a contractor or handyman who does quality work at well under market rates, or you’re skilled at major home improvement, a fixer-upper can be a great game plan.
Either way, we can help you find the best choice — an off-market property, a reasonable fixer, or a home that’s priced below the market and just needs a little TLC.
As the saying goes, “Size matters.” Here’s a case where bigger isn’t better. The size of a lot and square footage of a home will determine the tax rate. But beyond increasing overall property value, it won’t do much as far as income goes. Neither will room size. Generally, 4 small- to medium-sized bedrooms may actually earn you more than 3 large ones.
“A 1 and a 2 and a 3”… No, not Lawrence Welk. We’re talking about Multi-unit Properties
Multi-unit properties offer great advantages
I’ll bet that so far, you’ve been thinking about single family homes. Now, let’s broaden your horizons.
From an investment viewpoint, multi-unit properties are a great way to quickly grow an income property portfolio. Multi-unit properties are among the most powerful strategies you can use to create amazing and consistent cash flow. Plus, you can combine a roof over your head while building wealth, by living in one unit and renting the other units out for profit.
There are plenty of indicators that show multi-family properties will continue to create great investment opportunities:
- 75 million Baby Boomers are headed to retirement, and many apartment complexes will likely be converted to senior-living communities
- Many millennials are choosing to rent rather than buy
- Building new apartment units is getting more expensive
More Expensive, But Easier to Finance
Buying an apartment building will likely cost a lot more than a single-family home. A single-family residence here could cost you as little as $200,000, but a multi-unit building could run well up into the millions. So, how the heck do you finance all that?
If you think getting a loan for a single-family property would be a lot easier than getting financing for a million dollar building, think again. Banks are actually more likely to lend on a multi-unit property. Why? Because they generate strong cash flow every month.
Lenders love them
You can get into that multi-unit property for a lot less, too. If you live in one unit and rent the others, you can get it for just 3.5% down with an FHA loan. And with an FHA 203K remodel loan – you can even incorporate repair costs. Working with our local lenders, we can help make this happen.
Let’s talk some real numbers
Now let’s focus in on that all-important benefit — cash flow. Here is an illustration of what a $500,000 6-plex can do for you. We’ll use the 50% Rule, where we plan on total expenses to be 50% of total rental income, and a 3.5% interest rate.
Rent: $1,200 each x 6 = $7,200/month of income
50% expenses = $3,600
Mortgage at $482,500 (3.5% down): Payments of $2,100/month yield $1,500/month cash-flow
Mortgage at $250,000: Payments of $1,650/month generate $1,950/month
Mortgage at $100,000: Payments of $1,000/month get you $2,600/month
Make It Worry-Free
Income with fewer worries
Most single-family income property investors can’t afford an external manager to handle day-to-day operations — like finding and screening tenants, collecting rent, coping with evictions and maintenance. But multi-family properties produce enough money each month to make hiring a property manager feasible without significantly cutting into their margins.
Governments like multi-unit buyers, too
Not only do we see providing housing as a good thing; governments think so, too. Cities like it, because you’re providing residents with clean, safe, affordable housing. That means, you can gain all sorts of tax incentives. You’re running a business, so you are eligible for lots of deductions. You can depreciate things in a multi-unit property over more than twenty years… thirty if the property is classified commercial.
The Booming Vacation Rental Market
Personal enjoyment and positive cash flow
This cottage industry (no pun intended) has exploded. It’s worth about $100 billion globally today, with just over a quarter of that in the US, and there are projections it could reach $170 billion in the next 2 years.
Here’s what it means to you. According to the National Association of REALTORs, 920,000 vacation homes were purchased in 2015 in the U.S. HomeAway co-founder and CEO, Brian Sharples says,
“The clear benefits of vacation rental ownership start with the personal enjoyment a family can experience with their own vacation home. But the simple mathematics of renting that and making a significant dent in your mortgage, and even increasing your family’s annual income, is an excellent bargain in a world where vacation rentals are growing more and more popular.”
A Little-Known but Valuable Option
Did you know that buying income property is something you can do inside Your IRA? ‘Turns out people have been doing it for more than 30 years, and it’s an extremely powerful tool!
Your IRA is a powerful tool
Even if they’re aware of this, people tend to ignore this option because of what they see as the lack of tax benefits. But don’t let them discourage you. Read on to learn how we challenge conventional wisdom and see why it’s smart to buck the trend.
To begin with, rather than fretting over tax advantages, the right question to ask is, “What can I invest in through my IRA that will generate the highest net rate of return?” Stocks in your portfolio generally yield a 7.5% return while bonds might earn 4.5%. But what if you could get 6% in your first year on an income property and see your return rise over time?
A Detailed Process
You’ll need professional guidance
Buying income property through your IRA isn’t something you’ll want to do on your own or through LegalZoom. You’ll need a qualified law firm, to hold your money as a “Self-Directed Custodian.” If you were on Wall Street, you’d call them a stock broker. They’ll hold the money until you’re ready to invest.
Remember, of course, to maintain a comfortable cushion of liquid assets in your IRA.
Next, decide on the kind of income property you want… a single-family home, multi-unit structure — apartments or condos, etc. What you choose will dictate the structure of what comes next.
Your law firm will set up a specifically-crafted LLC (Limited Liability Company). It will have to be registered in the same state where you’ll be buying your property — not in Delaware or offshore — and contain appropriate IRS and ERISA (retirement plan) provisions. Here in California, the state will want its $800 minimum corporation tax, so you’ll have to register here as well. Your IRA will hold the LLC, the LLC will hold the income property and the checkbook used to buy it. But you’ll still be able to manage the LLC and sign the checks.
There Are Limitations
Understand the regulations
When buying income property, there are federal requirements and restrictions you need to be aware of, and while they’ll involve additional costs, as we said at the beginning, if you focus on property that will generate the highest return on your investment, you’re likely going to come out way ahead of other options.
- You have to have a REALTOR® represent you in the purchase of your property – you can’t do it yourself.
- You can’t co-sign on a regular (“recourse”) loan and you can’t use your credit to get a loan on the property. But you canleverage your cash by pooling your money with partners. Banks will also lend on a “non-recourse loan,” but you’ll have to put down at least 40%.
- You can’t work on the property yourself (add “sweat equity”), either. You have to have a third party do any maintenance or enhancements.
- You have to have a third party manage rentals.
You’ll have to file an annual tax return for what’s called “unrelated debt financed income.” And if you flip your property, there’s also an “Unrelated Business Income Tax” you’ll have to pay.
Uncle Sam wants his share
While all this might sound daunting and confusing, keep two things in mind: First, along with your professional lawyer, we are well versed in this process and will handle most of the details for you. And second, buying income property through your IRA will beat any returns your likely to earn from either the stocks, bonds or mutual funds in your portfolio.
For more information, check out The Self Directed IRA Handbook at www.SDIRAhandbook.com
The Bottom Line:
Whatever Path You Choose, You Win
No matter what direction you take in buying income property, with us here to help you make the right choice, you’re going to enjoy the return on your investment.