Chapter 11
IN THIS CHAPTER
Putting a roof over your head and containing your housing costs
Analyzing housing as an investment
Getting started in real estate investing beyond your home
Thinking of a home in which you live as an investment may seem like a poor idea to you. In many parts of the country, home prices suffered in the late 2000s and early 2010s.
But although homes may require plenty of financial feeding, over the course of your adult years, owning rather than renting a home can make and save you money. Although the pile of mortgage debt seems daunting in the years just after your purchase, someday your home may be among your biggest assets.
Like stocks, real estate does well over the long term but doesn’t go continuously higher. Astute investors take advantage of down periods; they consider these periods to be times to buy at lower prices, just as they do when their favorite retail stores are having a sale.
As financial decisions go, deciding whether and when to buy a home is pretty challenging. You have plenty of financial considerations to contend with, as well as personal issues. Psychologically, many folks equate buying a home with settling down. After all, you’ll be coming home to your home day after day, year after year. You can always move, of course, but doing so can be costly and time-consuming, and as a homeowner, you’ll have a financial obligation to deal with.
In this section, I cover the important issues to consider when comparing buying to renting.
You’ve probably already heard some arguments regarding the supposed financial benefits of owning a home. These benefits include the notion of buying and owning a home for the tax breaks, as well as the thought that paying rent is analogous to throwing your money away.
Renting isn’t necessarily like throwing your money away. In fact, renting can have several benefits, including the following:
You face significant costs when buying and selling a home. My analysis suggests that you probably need at least five years of low appreciation to recoup your transaction costs. Some of the expenses you face when buying and selling a home include the following:
On top of all these transaction costs of buying and then selling a home, you face maintenance expenses — repairs, cosmetic work, and so on — during your years of home ownership. To cover the typical transaction and maintenance costs of homeownership, the value of your home needs to appreciate about 15 percent over the years that you own it for you to be as well off financially as if you’d continued renting. Counting on that kind of appreciation in case you need or want to move elsewhere in a few years is risky.
Some people invest in real estate even when they don’t expect to live in the home long, and they may consider turning their home into a rental if they move within a few years. Doing so can work well financially in the long haul, but don’t underestimate the responsibilities that come with rental property. See the section “Investing in Investment Real Estate,” later in this chapter.
If you’re considering buying a home, you may be concerned about whether home prices are poised to rise or fall. No one wants to purchase a home that then plummets in value. And who wouldn’t like to buy just before prices zoom higher?
It’s not easy to predict what’s going to happen with real estate prices in a particular town or neighborhood over the next few years. Ultimately, the economic health and vitality of an area drive the demand and prices for homes in that area. An increase in jobs, particularly ones that pay well, increases the demand for housing, and when demand goes up, so do prices.
If you buy your first home when you’re in your 20s or 30s, you will likely be a homeowner for many decades. Over such a long time, you will surely experience numerous ups and downs. But you’ll probably see more ups than downs, so don’t be too concerned about trying to predict what’s going to happen to the real estate market in the near term and whether prices may fall a little. You should do a basic rent-versus-buy comparison, of course, to see whether the properties you’re considering offer decent value or not. A silver lining of the late-2000s decline in home prices is that homes are now more affordable than they have been in a long time and offer good value versus renting in many areas.
That said, at particular times in your life, you may be ambivalent about buying a home. Perhaps you’re not sure whether you’ll stay put for five years. Therefore, part of your home-buying decision may hinge on whether current home prices versus the costs of renting in your local area offer you a good value. The state of the job market, the number of home listings for sale, and the level of real estate prices compared with rent are useful indicators of the housing market’s health.
Buying a home is a long-term financial commitment. You’ll probably take out a 15- or 30-year mortgage to finance your purchase, and the home you buy will need maintenance over time. So before you decide to buy, take stock of your overall financial health, determine how large a down payment you’ll need, and understand how much lenders will be willing to lend you.
To qualify for a mortgage, you need good credit and a stable, reliable source of employment income. Mortgage lenders will tell you the maximum amount that you’re qualified to borrow. Just because they offer you that maximum amount, however, doesn’t mean that you should borrow that much.
Buying a home without considering your other monthly expenditures and long-term goals may cause you to end up with a home that dictates much of your future spending. Have you considered, for example, how much you need to save monthly to reach your goals? How about the amount you want to spend on your current lifestyle?
If you want to continue your current lifestyle, you have to be honest with yourself about how much you can really afford to spend as a homeowner. First-time home buyers in particular run into financial trouble when they don’t understand their current spending.
Buying a home can be a wise decision, but it can also be a huge burden. Also, you can buy all sorts of nifty things for a home. Some people prop up their spending habits with credit cards — a dangerous practice. So before you buy a property or agree to a particular mortgage, be sure that you can afford to do so and that it fits with your overall plans and desires.
When deciding how much to borrow for a home purchase, keep in mind that most lenders require you to purchase private mortgage insurance (PMI) if your down payment is less than 20 percent of your home’s purchase price. PMI protects the lender from getting stuck with a property that may be worth less than the mortgage you owe, in the event that you default on your loan. On a moderate-size loan, PMI can add hundreds of dollars per year to your payments.
If you have to purchase PMI to buy a home with less than 20 percent down, keep an eye on your home’s value and your loan balance. Over time, your property should appreciate, and your loan balance should decrease as you make monthly payments. After your mortgage represents 80 percent or less of the market value of the home, you can get rid of the PMI. Doing so usually entails contacting your lender and paying for an appraisal.
What if you can afford to make more than a 20 percent down payment? How much should you put down then? (This problem is rare; most buyers, especially first-time buyers, struggle to get a 20 percent down payment together.) The answer depends on what else you can or want to do with the money. If you’re considering other investment opportunities, determine whether you can expect to earn a higher rate of return on those other investments versus the interest rate that you’d pay on the mortgage. (Forget about the tax deduction for your mortgage interest. The interest is deductible, but remember that the earnings from your investments are ultimately taxable.)
Mortgage lenders calculate the maximum amount that you can borrow to buy a home. All lenders want to gauge your ability to repay the money that you borrow, so you have to pass a few tests.
For a home in which you will live, lenders total your monthly housing expenses. They define your housing costs as
Mortgage payment + Property taxes + Insurance
Note: Lenders don’t consider maintenance and upkeep expenses (including utilities) in owning a home, but of course, you will incur these expenses as a homeowner.
Although lenders may not care where you spend money outside your home, they do care about your other debt. A lot of other debt, such as consumer debt on credit cards or auto loans, diminishes the funds that are available to pay your housing expenses. Lenders know that having other debt increases the possibility that you may fall behind or actually default on your mortgage payments.
If you have consumer debt that requires monthly payments, lenders calculate another ratio to determine the maximum that you can borrow for a home. Lenders add the amount that you need to pay on your other consumer debt to your monthly housing expense.
Get rid of your consumer debt as soon as possible. Curtail your spending, and adjust to living within your means. If you can’t live within your means as a renter, you won’t be able to do it as a homeowner either.
Your mortgage interest and property taxes are generally tax-deductible on Form 1040, Schedule A of your personal tax return. When you calculate the costs of owning a home, subtract the tax savings to get a more complete and accurate sense of what homeownership will cost you.
When you finally buy a home, refigure how much you need to pay in income tax, because your mortgage interest and property tax deductions can help lower your income tax bill. If you work for an employer, ask your payroll/benefits department for Form W-4. If you’re self-employed, you can complete a worksheet that comes with Form 1040-ES. (Call 800-829-3676 for a copy.) Many new home buyers don’t bother with this step, and they receive a big tax refund on their next filed income tax return. Although getting money back from the Internal Revenue Service may feel good, it means that at minimum, you gave the IRS an interest-free loan. In the worst-case scenario, the reduced cash flow during the year may cause you to accumulate other debt or miss out on contributing to tax-deductible retirement accounts.
If you want a more precise estimate of how home ownership may affect your tax situation, get out your tax return, and plug in some reasonable numbers to guesstimate how your taxes may change. You can also speak with a tax advisor.
Down the road, also know that eligible homeowners can exclude a large portion of their gain on the sale of a principal residence from taxable income: up to $250,000 for single taxpayers and up to $500,000 for married couples filing jointly.
Be realistic about how long it may take you to get up to speed about different areas and to find a home that meets your various desires. If you’re like most people, with a full-time job that allows only occasional evenings and weekends free to look for a house, three to six months is a short period to settle on an area and actually find and successfully negotiate for a property. Six months to a year isn’t unusual or slow.
Remember that you’re talking about an enormous purchase that you’ll come home to daily. Buying a home can also involve a lot of compromise when you buy with other family members, particularly spouses.
In this section, I discuss your housing choices, how to research communities, and finally how to check out homes and value them.
If you’re ready to buy a home, to help focus your search, you should make some decisions about what and where to buy. Here are the most common types of housing you will encounter:
Cooperatives: Cooperatives (or co-ops) resemble apartment and condominium buildings. When you buy a share in a cooperative, you own a share of the entire building, including some living space. Unlike in a condo, you generally need to get approval from the cooperative association if you want to remodel or rent your unit to a tenant. In some co-ops, you must even gain approval from the association to sell your unit to a proposed buyer.
Co-ops generally are much harder to obtain loans for and to sell, so I don’t recommend that you buy one unless you get a good deal and can obtain a loan easily.
With the exception of single-family homes in the preceding list, the other types of housing are shared housing. This type of housing generally gives you more living space for your dollars. This value makes sense, because a good chunk of the cost of a single-family home is the land on which the home sits. Land is good for decks, recreation, and children’s playgrounds, but you don’t live “in” land the way you do in your home. Shared housing maximizes living space for the housing dollars that you spend.
Another possible benefit of shared housing is that in many situations, you’re not personally responsible for general maintenance. Instead, the homeowners’ association (which you pay into) takes care of it. If you don’t have the time, energy, or desire to keep up a property, shared housing can make sense. Shared housing units may also give you access to recreation facilities, such as a pool, tennis courts, and exercise equipment.
From an investment perspective, shared housing isn’t best. Single-family homes generally appreciate more than shared housing does. Part of the reason for that is that shared housing is easier to build and to overbuild, and the greater supply tends to keep prices from rising as much. On the demand side, single-family homes tend to attract more potential buyers. Most folks, when they can afford it, prefer a stand-alone home, especially for the increased privacy.
You may have an idea about the type of property and location that interests you or that you think you can afford. Even if you’ve lived in an area for a while and think that you know it well, be sure to explore different types of properties in a variety of locations before you start to narrow your search.
Thinking that you can know what an area is like from anecdotes or from a small number of personal experiences is a mistake. Anecdotes and people’s perceptions often aren’t accurate reflections of the facts. Check out the following key items in an area you’re considering:
www.usgs.gov
) has maps that show earthquake risks, and the Federal Emergency Management Agency (www.fema.gov
) has flood-risk maps. Insurance companies and agencies can also tell you what they know about risks in particular areas.www.neighborhoodscout.com
.Schools: If you have kids, you care about this issue a lot. Unfortunately, many people make snap judgments about school quality without getting the facts. Visit schools, talk to parents and teachers, and discover what goes on at the schools.
Consider school quality even if schools aren’t important to you, because they can affect the resale value of your property.
Over many months, you may see dozens of homes for sale. Use these viewings as an opportunity to find out what specific homes are worth. Odds are that the listing price isn’t what a house is actually worth. Property that’s priced to sell usually does sell. Properties left on the market are often overpriced. The listing prices of such properties may reflect what an otherwise greedy or uninformed seller and his or her agent hope that some fool will pay.
Of the properties that you see, keep track of the prices that they end up selling for. (Good agents can provide this information.) Properties usually sell for less than the listed price. Keeping track of selling prices gives you a good handle on what properties are really worth and a better sense of what you can afford.
After you decide where and what to buy, you’re ready to try to put a deal together. To do so, you need to understand mortgages, negotiations, and inspections. I cover these issues and many more in Home Buying Kit For Dummies, 5th Edition (Wiley), which I cowrote with Ray Brown.
If you’ve already bought your own home (and even if you haven’t), using real estate as an investment may interest you. Real estate investing, like the stock market and small-business investments, has long generated tremendous wealth for many investors.
Real estate is like other types of ownership investments, such as stocks, in that you have an ownership stake in an asset. Although you have the potential for significant profits, don’t forget that you also accept greater risk. Like stocks, real estate goes through good and bad performance periods. Most people who make money investing in real estate do so because they invest in and hold property over many years.
In this section, I discuss how to make wise real estate investments.
Many people build their wealth by investing in real estate. Some people focus exclusively on property investments, but many others build their wealth through the companies that they started or through other avenues and then diversify into real estate investments.
Real estate, like all investments, has its pros and cons. Investing in real estate is time-intensive and carries risks. Do it because you enjoy the challenge and because you want to diversify your portfolio. Don’t take this route because you seek a get-rich-quick outlet. Here are some of the reasons why people pursue real estate investments:
If you think you’re cut out to be a landlord and are ready for the responsibility of buying, owning, and managing rental real estate, you have numerous real estate investment options to choose among.
Some investors prefer to buy properties, improve them, and then move on. Ideally, however, you should plan to make real estate investments that you hold for many years, perhaps into your retirement years. But what should you buy? Following is my take on various real estate investments.
Real estate investment trusts (REITs) are entities that generally invest in different types of property, such as shopping centers, apartments, and other rental buildings. For a fee, REIT managers identify and negotiate the purchase of properties that they believe are good investments; then they manage these properties, including handling all tenant relations.
REITs are a good way to invest in real estate if you don’t want the hassles and headaches that come with directly owning and managing rental property. You can research and purchase shares in individual REITs, which trade as securities on the major stock exchanges. An even better approach is to buy a mutual fund or exchange-traded fund that invests in a diversified mixture of REITs.
If you’re willing to be a landlord, your best bet for real estate investing is to purchase residential property. People always need places to live. Residential housing is easier to understand, purchase, and manage than most other types of property, such as office and retail property. If you’re a homeowner, you already have experience locating, purchasing, and maintaining residential property.
The most common residential housing options are single-family homes, condominiums, and townhouses. You can also purchase multiunit buildings. Consider the following issues when you decide what type of property to buy:
If having tenants and maintaining a building is a lot of work, you can consider investing in land. Over time, in areas experiencing economic and building growth and using up available land, land values appreciate well.
Although land doesn’t require upkeep and tenants, it does require financial feeding. Investing in land can be problematic for the following reasons:
If you decide to invest in land, be sure that you meet the following criteria:
You know its zoning status. The value of land depends greatly on what you can develop on it, so thoroughly understand the land’s zoning status and what you can — and can’t — build on it before you buy. Also research the disposition of the planning department and nearby communities. Areas that are antigrowth and antidevelopment are less likely to be good places for you to invest in land, especially if you need permission to do the type of project that you have in mind.
Be aware that zoning can change for the worse. Sometimes, a zoning alteration can reduce what you can develop on a property and, consequently, the property’s value.
If you’re really motivated and willing to roll up your sleeves, you may want to consider commercial real estate investments (such as small office buildings or strip malls). Generally, however, you’re better off not investing in such real estate, because it’s much more complicated than investing in residential real estate. It’s also riskier from an investment and tenant-turnover perspective. When tenants move out, new tenants sometimes require extensive and costly improvements.
In addition to considering investing in commercial real estate when your analysis of the local market suggests that it’s a good time to buy, consider it when you can use some of the space to run your own small business. Just as owning your home can be more cost-effective than renting over the years, so is owning commercial real estate if you buy at a reasonably good time and hold the property for many years.
In the following sections, I explain what to look for in a community and area where you seek to invest in real estate. Investing in real estate closer to home is best because you’re probably more familiar with the local area, allowing you to have an easier time researching and managing the properties.
Invest in real estate in communities that maintain diverse job bases. If the local economy relies heavily on jobs in a small number of industries, that dependence increases the risk of your real estate investments. The Bureau of Labor Statistics (www.bls.gov
) compiles this type of data for metropolitan areas and counties.
Also determine which industries are most heavily represented in the local economy. Areas that have a greater concentration of high-growth industries stand a greater chance of faster price appreciation.
Finally, check out the unemployment situation, and examine how the jobless rate has changed in recent years. Good signs to look for are declining unemployment and increasing job growth. The Bureau of Labor Statistics also tracks this data.
The price of real estate, like the price of anything else, is driven by supply and demand. The smaller the supply and the greater the demand, the higher prices climb. An abundance of land and available credit, however, inevitably leads to overbuilding. When the supply of anything expands at a much faster rate than demand, prices usually fall.
Upward pressure on real estate prices tends to be greatest in areas with little buildable land. In addition to buildable land, consider these important real estate market indicators to gauge the health of a particular market:
For more details on investing in real estate, see Real Estate Investing For Dummies, 2nd Edition (Wiley), which I cowrote with Robert S. Griswold.