Real Estate as an Income-Generating Asset

With more and more people today planning for retirement without pensions, and with mounting concerns over the financial viability of Social Security, alternative income generating assets are being considered by many current and would-be investors.

In addition to direct real estate investment, an investor today can choose a publicly traded Real Estate Investment Trust (REIT) whereby managers of the REIT will invest your money in various types of properties.  The REIT managers will choose the properties that they feel are appropriate, manage the properties and expenses, and pay-out 90% of the profits in the form of dividends.  A range in dividends currently of 3.5% to 6.0% is considered reasonable.

While this article will focus on “direct” real estate investment, it should be noted that publicly traded REIT’s offer one distinct advantage over direct real estate investment, and that is “liquidity”.  For some investors, the ability to go to the market and sell an asset is important which would make REIT”S worthy of consideration.  Seeking advice from a certified financial planner is highly recommended when considering the vast options in REIT investments.

For those brave souls, like myself and thousands of others, that prefer direct investments in income producing properties, there are numerous options to consider.  Depending on the amount of capital you have for investment, your options can include single family residences (SFR’s), condos, townhomes, small apartments (1 to 4 units), mid-size apartments (5 to 20 units), larger apartment properties, and commercial properties such as office, industrial, retail, mobile home parks, self-storage, seniors care and hospitality properties.  Your degree of experience with these property types will help in your selection of future investments, and there are property management companies that specialize in the management of each property type.

At the lower end of the scale price-wise, many investors buying rental houses and rental condos are paying with all cash, or are putting large down payments into investments.  This not only increases their monthly positive cash flow from the rental property, it also helps them win the bid at purchase.  Some investors today are paying cash to close the deals then fix-up and lease the property and follow-up with low-to-mid-leveraged financing on the property later.

Whether you’re buying a house to rent-out or buying a 10 unit apartment building, or for that matter a 50,000 sq. ft. office building, your most important consideration after deciding “what” and “where” should be the “cash-on-cash return”.  Open-up a CD at your local bank today and you will be lucky to get 1.0%, with no appreciation possibilities and no depreciation.  You will, however, have FDIC insurance on your deposits at the bank.  If your portfolio includes excess funds for investment over and above what you feel you should have in liquid assets, and you would like to have an investment that sends checks to your mailbox (or direct deposit), consider investing in income producing real estate.

The following is an example of an income property investment that happens to be available in the market today (in order to be relevant), and what the cash-on-cash return would look like.  We will also discuss returns on other property types later in this article.  Note that what an investor is willing to live with on a cash-on-cash return is an individual thing, and those returns can increase or decrease over time based on a number of market and property factors.

Cash-on-Cash Return Example

Purchase of a one-bedroom, one-bath condo (670 Sq. Ft.) in Dana Point, CA, within walking distance to the beach.  Purchase price= $160,000, closing costs estimated at $2,500, planned improvements (paint, carpet, appliances, window coverings, repairs, etc) = $8,000.  Total costs = $170,500 (assumes an all cash transaction).

Monthly rent………………………… $1,350

Association dues……………….    –   320

Property taxes……………………   –  160

Estimated repairs………………     –  50

Insurance (L/L policy)……….    –   30

Net Income                           $790/month

$790 x 12 months = $9,480/Year net income

$9,480 divided by $170,500 (total cash) = 5.56% cash-on-cash return

With corrections in residential real estate values being 40% to 50%+ in numerous markets over the past 5 years, many real estate investors currently believe that residential values are at or close to a bottom.  Some markets have even seen increases in values during the summer of 2012 (over the previous year).  The illustration above shows an actual investment opportunity today offering an approximate 5.50% cash-on-cash return, with potential upside value, plus depreciation of the improvements.  (note that you can only depreciate the improvement portion of rental real estate, not the land portion).

The above example assumes that you will be managing this asset yourself.  You may choose to have a property management company manage the property for you due to the “hassle or liability factor” or because you are out of the area.  A good rule of thumb for self-managing a property is to be located within a 30 minute drive from your rental properties.  Some investors are willing to drive further.  I personally try to stay within the 30 minute rule on investments self-managed.

If you were to hire a property management firm for the condo in the example above, a new cash-on-cash return would need to be calculated.  The adjusted net income would be $690/month assuming a property management fee of $100/month.  This would equate to a net income of $8,280/year, producing an adjusted cash-on-cash return of 4.86%, still substantially higher than rates at the bank today.  Higher returns go hand-in-hand with higher risks, it should be noted. Some investors of residential rental properties today are receiving higher cash-on-cash returns, generally by purchasing foreclosures that require significant improvement before leasing.

Real estate investments, like stocks, can be highly volatile.  To give you an example, the condo investment in Dana Point illustrated above could have been purchased in 1997 for $70,000.  The price of this condo increased to approximately $400,000 10 years later at the top of the market in 2007.  If you can purchase this condo today for $160,000, that’s a 60% drop in value over the past 5 years.  But consider this, since 1997 the rent for this property went from $800/month to $1,350/month currently.  That’s nearly a 70% increase in rent.  The rent on this property increased by $550/month while the expenses increased by only $175 /month over the same period (assuming that you held onto this property since 1997 and enjoyed the lower tax rate).  If you had owned this property over this time period (1997 to 2012) you would have been on a “very wild ride” on values, and a steady ride on net income.  Keep in mind that one-bedroom condos within walking distance of the beach are fairly easy to rent, especially at this rent level.

What would the cash-on-cash return look like if you had purchased this Dana Point condo in 1997 and held it as a rental since then? Assuming a purchase price of $70,000, closing costs of $2,500, and improvements of say $12,000 during this hold period, your total cash investment would be $84,500. The net income today would be approximately $850/month due to your lower tax rate. This equals $10,200/year in net income. Annual net income of $10,200 divided by total cash investment of $84,500 = 12% cash-on-cash return. Not bad! (Numbers are based on an actual investment scenario during that time period, based on an all cash purchase).

If you should finance the purchase of investment properties, or refinance to pull cash out later, a new cash-on-cash return will need to be calculated based on a lower net income (when considering the monthly mortgage payment) and having less cash invested in the deal (due to a portion of the investment being financed).

Apartment properties in the Orange County, CA market are in high demand and can push cash-on-cash returns lower, especially in highly sought after coastal areas.  Otherwise, cash-on-cash returns on apartments locally can be found in the 4.50% to 6.00% range.  Commercial properties generally offer higher returns (6.00% to 8.00%+), but can include higher risks such as risks associated with leasing (occupancies) and leasing rates, both of which can decrease during recessionary times.  Apartment occupancies in Orange County, CA have held-up very well during this last recession, enforcing the idea that people “need a place to live”, especially if they have been forced out of an over-leveraged home, have recently moved to our area, or they are moving out of their parents’ homes.  The degree of risk and return that you are willing to accept should be based on your overall investment portfolio and on your experience with a particular asset type.

Picking the right property management company, should you choose not to self-manage, will be a very important part of your investment decision.  Adding income producing properties to your portfolio could enhance your income today and during retirement, and may offer upside potential in values down the road.

William Fischer is Principal of Lighthouse Realty Capital, a licensed California Real Estate Brokerage Firm located in Orange County, California.  With over $800 Million in income property loans originated and funded, Bill has 25+ years of experience working for Banks handling commercial real estate finance, and is experienced in the management of residential income properties since 1985.  Lighthouse Realty Capital handles the financing and management of income producing properties.  California DRE License #00865007.

The opinions shared in this article are for general information only and are not intended to provide specific advice or recommendations.  Any performance references are historical and are not a guarantee of future results.


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