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Investing ... in Real Estate

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Of the various forms of investments available that involve possible tax incentives, the most widely used is real estate. Historically, real estate has been sold as an investment for income and long-term gain, as well as a hedge against inflation. Real estate investors actually profit from inflation because with a 30% equity, just a 3% inflationary increase in property values results in a 10% return on investment. Without even considering normal operating profits and tax benefits!

Real estate can be purchased in many forms, including: shopping centers, industrial buildings, warehouse net leases, apartments, single family residential housing, and even raw land. The investment can be direct, or through various kinds of partnerships and investment trusts.

Real Estate investments were badly injured by the Tax Reform Act of 1986. We here at RHOL calculated it took about 18% off the value of most large investment properties. Fortney H. (Pete) Stark, (D-Calif.) of the House Ways and Means Committee, said of the decisions regarding the taxation of real estate in the1986 Act: "It'd take a genius to invest in real estate and pay taxes," (after the act becomes law.)

The industry was hurt in 86 but certainly not killed. What appeared to be down for the count has gotten up off the ground and is again turning handsprings!

As Business Week recently reported on the real estate recovery: "It started as a few isolated cases, then slowly, almost imperceptibly, it spread across the country. It spread into apartments, single family housing, stores, warehouses, hotels and offices. After many fits and starts, the battered industry is finally on the rebound and picking up momentum. The economic expansion gets a lot of the credit for helping to shrink the industry's huge inventory of unused office space. Vacancy rates, though still high, are dropping in most office markets across the country. In some areas rents are even rising, and hefty concession packages are no longer necessary to hook tenants."

  There are many reasons for the rebound in real estate....

Prices of large investment grade real estate properties are still low, perhaps because of the perception that tax reform removed many of the benefits of ownership. That perception is still allowing investors to pick up, (particularly large) properties at bargain-basement prices. As long as there are more sellers than buyers, investors with cash will continue to cash in on the buyer's market. 

Plus, interest rates are back to near a 20-year low, making it easier for new financing to reduce ownership costs and push profits up. Combined with fewer and fewer vacancies (a trend that's locked-in. thanks to an eight-year lull in construction of new buildings), profits look robust for years to come.

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Tax Ramifications

In the decade before reform, one of the major reasons for the high degree of tax shelter investment in real estate was that the "at risk" rules introduced by the Tax Reform Act of 1976 did not apply to any partnership in which the principal activity was investing in real estate. The "at risk" rules limited your tax deductions to the amount you invested plus the amount of borrowed funds for which you were personally liable. Real estate tax shelters were exempt from this requirement until January 1, 1987 (Tax Reform Act of 1986).

The Tax Reform Act of 1986 applies the at-risk rules to the activity of holding real property, with an exception for qualified non recourse financing. In general, taxpayers will be considered at risk with respect to their share of any qualified non recourse financing that is secured by real property used in the activity. The term qualified non recourse financing means any financing that is borrowed by the taxpayer (1) with respect to the activity of holding real property; (2) from a qualified person, or represents a loan from a federal, state, or local government, or is guaranteed by any federal, state, or local government; (3) except to the extent provided in regulations, with respect to which no person is personally liable for repayment; and (4) which is not convertible debt.

The combination of first-year accelerated deprecation and heavy start-up costs may produce tax deductions exceeding the size of an initial cash investment when 80 percent of the cost of that investment is financed with borrowed funds. What that means is that if investors are in the 31 percent bracket, their net initial cash outlay may be reduced to zero! However, with any tax shelter, as with any investment, never invest just on the basis of tax deductions alone. You must always consider the total expected cash flow from the property. The advantages of a real estate tax shelter are that the risks are normally minimal and the total cash flow is normally augmented in the early years by substantial tax savings. Furthermore, a good shelter should be structured to give you substantial cash rental income that is either minimally taxed or not taxed at all due to offsetting depreciation expense deductions even in the middle years. These depreciation deductions are pencil transactions that do not involve any real cash outflow, and they arise out of basis created by borrowed money. In effect, with a properly structured transaction you get to eat your cake and keep it too.

Active Vs Passive Real Estate Investments

Many investors are turned off by real estate because they do not have the time or inclination to become landlords and property managers. Both of which are in fact, a career in themselves. Fortunately, there are other ways for passive investors to enjoy many of the secure and inflation proof benefits of real estate investing without the hassle.  

Limited Partnerships: Throughout the 1970s and 80s the most popular investment vehicle used by passive investors to participate in the benefits of real estate ownership was through the use of Limited Partnerships. LPs are still used today but their popularity suffered dramatically after the 1986 Tax Reform Act drastically reduced the deprecation deduction available to investors. LPs leveraged the tax benefits of deprecation much like traditional real estate investments leverage equity. We discuss the subject in much more detail on our Limited Partnerships page.

LLCs and LLPs: Limited liability Companies and Partnerships are a fairly recent creation in most states. They are particularly advantageous to real estate investors because they allow tax benefits, including deductions for deprecation and operational losses, to be taken against ordinary income on a personal return, while limiting your personal liability in much the same manner as a corporation.  

PARTNERS: There are many ambitious hard working young people who have everything necessary to get ahead in life, except rich relatives or seed capital. Advertise that you have venture capital available in places likely to be seen by your ideal partners. Then utilize the tenant screening techniques available to you on RHOL pages to help you determine which of the many candidates likely to respond is the best one for your first venture. The partnership can be constructed in a myriad of ways, some of which give you most of the tax benefits and appreciation, while providing your young partner with badly needed income. 

REITs: Real Estate Investment Trusts may well be an answer for you, and perhaps the single best investment you can put in your IRA, pension or retirement plan. A typical REIT has the advantages of real estate but protects you with all the built-in safety, diversification and professional management of a well-run, conservative mutual fund.

There are several ways to Profit

History indicates that inflation is sure to pick up again soon, because governments who can print money ... eventually do. That historical fact also indicates that you now have a once-in-a-generation opportunity to buy real estate at bargain basement prices and ride what many are convinced will be the most powerful comeback of the next ten years. And there is no better or more convenient way to do it for most working families than with REITs.

REITs are really just like the stocks that trade on the major exchanges. They are, in effect. mutual funds of investment grade properties. They pay out 95% of their income as dividends, reinvesting the rest. Because they trade just like other stocks, that allows you to invest as much, or as little, as you want. And instead of hassling with the multitude of ways local government interferes in rental housing, late paying tenants and broken toilets, you can get in on the real estate rebound as easily as picking up the phone and calling your broker. You'll be letting professional managers handle all the fuss and muss. And when you're ready to sell, no need to place classified ads and show the place to prospective tenants. Just call your broker and say, "sell."

REITs have performed better than stocks, despite a recent lackluster real estate market. Since 1975, during the biggest bull market in stock market history, REITs have quietly outperformed stocks by 17% a year vs. 15% a year. That doubles your money every 4.2 years.

Less Volatile Than Stocks. REITs have a "beta" of only .65, meaning they're 35% less volatile than the stock market. They give you wonderful diversification from the storms of the S&P 500.

Best Real Estate Performer. Between 1975 and 1994, all forms of property (including houses, land, buildings and other structures) in the U.S. appreciated by a modest 8% per year. Owner occupied single-family homes gained only about 6% a year, just barely outdistancing inflation. By averaging 17% a year, REITs actually blew the socks off other typical other real estate investments, as well.

Better Than Bonds. REITs now yield about as much as bonds (6%-7% or so). Yet, while bonds get killed by inflation, REITs profit from it. And with REITs, your dividends can grow by 6% a year, something your bonds or CDs will never do.

Better Than Utilities. REITs yield more than many utilities, yet are superior in many ways. Example: when utilities make too much money, government regulators seek a rate rollback. But when REITs rake in big extra profits, they give them all to you, the owner. No government regulators scream that you're making" obscene" profits. Moreover, utilities must usually receive approval from regulators to raise prices to cover higher expenses. REITs require no such approval. Shopping center leases and subsidized rental housing, for example, typically provide for rent increases tied to the Consumer Price Index. This allows REITs to capture rent increases brought about by inflation. 

REITs' earnings as measured by FFO increased by 12.3 percent in the last quarter of 1999 compared to the same period a year ago, according to latest data compiled by the National Association of Real Estate Investment Trusts (NAREIT).

NAREIT reported that both mortgage REITs and publicly traded real estate operating companies reported particularly strong earnings growth in last year's final quarter. Office, retail and apartment REITs all reported higher FFO per share growth in the fourth quarter.

For all reporting companies tracked by market analysts, 84 percent of the earnings reports met or exceeded consensus analyst expectations.

Find information and links to helpful REIT sites at : National Association of Real Estate Investment Trusts|

Financial history lessons should help all of us to conclude that - one way or another - families should have investments in real estate to help compensate for the expected capitol depreciation likely to occur from government caused inflation.

We at RHOL highly recommend direct involvement in the rental housing business, and we are here to help you with every aspect of your endeavor. However, if you are not able or inclined to be a landlord, and fear the potential personal entanglements of partnerships with landlords, then LPs and REITs are certainly worth your consideration. But remember, both require fees and compensation to brokers and investment managers.

Also see: Financial Analysis of your Investment | 1031 Tax Free Exchange

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