Monday, August 5, 2013

33 Guidelines for investing in real estate............

Guideline #20:  Leverage is a two-edged sword.

It is through the miracle of leverage that real estate becomes such a fabulous investment vehicle.  Leverage is borrowed money, a mortgage.

The following example is a fairly typical, if simplified, example of how all this works:

Imagine buying a $250,000 single tenant investment property, with $25,000 of your own cash and $225,000 of borrowed money.  For arguments' sake, we will assume that the rental income from the tenant is sufficient to pay the mortgage, property taxes, insurance, maintenance, with all remaining cash flow going to the reserve for replacement account and to pay the income tax generated by the investment- in other words, you receive -0- cash flow.  After the passage of ten years, you decide to sell the investment.  With the combination of minimal (2.5%) inflation and correspondingly modest rent increases, along with the fact that the asset has been well maintained, the property is now worth $320,000.  The original loan of $225,000 has, after ten years, been paid down (by the tenant's rental payments) to $98,000.  After selling expenses (have to pay the broker their justly earned commissions) are deducted, your net from a sales price of $320,000 is $295,000, and then after paying off the $98,000 mortgage, you receive a net proceeds check of $197,000 at closing.

So, after ten years of prudent stewardship, you receive your original $25,000 back, plus an additional $172,000!   Leverage indeed.

(Remember, this was labeled "if simplified" because our neat little example ignores the tax man, which one should not do.  But we get ahead of ourselves.  Wait for Guidelines #28 and #33, where and when more will be revealed).

Leverage, if not properly respected (See Guideline #21 and Guideline #22), may have a dark side.  Trust me when I tell you that it is possible to buy an investment property with zero down payment.  In previous times (and perhaps again in future times) it was possible to borrow more than the purchase price.  In other words, one could buy a single tenant investment property for $250,000, and if the stars were properly aligned, borrow $275,000 or more.  Situations like this may turn out very well, but they leave very little margin for error.  If you lose your tenant, or if the market falters, such a loan may turn out to be problematic.

When one borrows money on real estate, one also signs a note promising to re-pay the money.  Just make sure you can.

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