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Investing in Residential Real Estate

Over the last three (3) months we've reviewed what is happening with home prices, including specific examples, in the following towns: Belmont, Watertown, Waltham, Cambridge, Lexington, Arlington and Winchester. Despite the negativity that appears in the media, I thought it might be constructive to show how investing in residential real estate can increase your wealth and why now is an opportune time to begin.

The following is meant to be a basic primer of the considerations you should make when anticipating to invest in residential real estate.

What is your investment need?

Is it to minimize your annual tax burden, is it for long term appreciation, is it for income in the short term or is it for growth now and income in retirement? Answering these questions helps you work out whether you need a cash positive, cash neutral or cash negative investment.

If you're looking for income now then you need a cash positive investment. A cash positive investment is one where more cash is received as rental income than is paid out on expenses and mortgage.

If you're looking for a cash neutral investment then you want most of the expenses on the investment to be covered by the rental income on the property, and there is no appreciable difference between 'cash in' and 'cash out' with regard to the investment.

If you're looking for a cash negative investment then you want your expenses on the investment to be larger than the income the investment property is generating.

Each of these is valid investment types depending on your primary sources of income. It depends on the mix of investments currently in your portfolio and whether they are active or passive sources of income. Real estate investment income generally falls into the realm of passive income unless you are a real estate investor/developer/professional and your primary source of income is from real estate investments. The maximum passive investment loss you can use against your active income is $25,000, but any additional passive loss can be carried forward from year to year. In other words, you do not 'lose' the losses but are able to use them against your active income (limited to $25,000 per year).

Even if you have a positive cash flow you may still have a passive loss that can be taken against your taxable income. This is through 'depreciation'. With assets used for investment purposes you are able to depreciate the value of the physical asset over a period of its useful life. For a house, the IRS has deemed this to be 27.5 years. So, the value attributed to the house (excluding the land value) can be depreciated and expensed over the 27.5 years in a method called straight line depreciation. There are other methods of depreciation that can be used but the most common is 'straight line'. Once you factor in the expenses you then have 'paper losses' which are attributable to your investment property.

A common investment purpose is for appreciable growth and income for retirement; Income may not be needed or wanted now, especially for those in the higher income bracket who may prefer losses rather than gains, but these same investors don't want the investments to 'cost' them much money either.

The primary determining factor over whether a home is cash positive, cash neutral or cash negative is the amount of equity you put into the home and the amount of mortgage required to fund the investment. The size of the mortgage and the resultant monthly mortgage expense and how this compares to the rental income determines the cash flow outcome. Mortgage debt and expenses to be considered and contribute toward the 'loss' are property taxes, general maintenance, rental fees or other costs that you pay to attain, operate, and to liquidate your investment property.

There are many types of residential properties that can be used as investments. One strategy is to invest in single family homes in fundamentally sound, desirable areas that can command premium rents. Tenants that can pay premium rents tend to be more stable and stay for longer thus decreasing your vacancy rates.

For example, let's consider you purchased an investment property for $600,000 and it is rented for $3000 a month. Assuming that you are looking for a cash neutral investment then you would do the analysis using a 20% down payment:

Purchase price:$600,000
Minus 20% down$120,000
Mortgage amount$480,000

The conventional loan limit has remained at its current values since 2006 and ranges from $417,000 to the low $700,000 (depending on specific areas) we will use conventional loan interest rates for this exercise. Based on an interest rate of 5.5% for a 7/1 Adjustable Rate Mortgage (ARM) (rates fluctuate daily). $480,000 at 5.5% is approximately $2,720 plus taxes and insurance. The current tenants pay $3,000 a month.

To summarize:
Rental income$3,000
Expenses of:
Mortgage$2,700
Property tax$560 per month ($6,800 for the year)
Reserve for incidentals$100
Results negative cash flow-$360 per month ($4,320 per year)

Assuming this property's building value was $450,000, depreciation per year is $16,350. Depending on your specific financial situation or tax bracket the total loss that may be deducted from your gross income, and thus reducing your total taxable income, is just over $21,000 ($4,320 + $16,356). This loss may result in a tax refund that is attributable to owning an investment property.

I offer the above information purely as a 'primer' if you are considering investing in real estate. This is a very simplified explanation of buying investment real estate. There are many factors to consider - for example vacancy rates, headaches associated with dealing with an investment, risk factors and risk tolerance etc. It needs to be highlighted during this discussion that I am NOT a financial adviser and all of the information contained within needs to be verified and discussed in the context of your specific financial situation with your tax accountant and financial adviser.

If you would like an estimate of what your home would sell for in today's market I would be more than happy to come by, have a look at your home, and then provide a CMA (comparative market analysis) which will provide you with an estimate of what your home should sell for, along with a marketing plan to get maximum exposure for your home.

If you'd like to chat more about the topic presented here, or the Real Estate market in general, then please call me on (617) 997 9145, or email me at Dani.Fleming@MAPropertiesOnline.com.

Lexington Statistics







MLS data is provided by MLSPIN. While MLS data is believed to be accurate, it cannot be guaranteed. MLS data is constantly being updated, making any analysis a snapshot at a particular time. All raw data remains the intellectual property of MLSPIN.
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