Read an Excerpt
The Second Homeowner's HandbookA Complete Guide for Vacation, Income, Retirement, and Investment
By Jeff Haden
Atlantic Publishing Group, Inc.Copyright © 2006 Atlantic Publishing Group, Inc.
All right reserved.
Chapter OneBuild Your Foundation
Everyone wants to build wealth, and there are a number of great ways to do so. For many, real estate investments form a major portion of their investment portfolio. Steve Bange explains why investing in a second home was the right choice for both his investment and his personal goals.
"I've had money in stocks since I first got out of college, and like everyone I've had ups and downs. It never occurred to me to buy a second home - I thought that was something only wealthy people did. When I realized I could leverage my savings and my credit rating to buy another home, I jumped at the chance, and I'm glad I did. Not only has my property appreciated, but someone else, my tenant, is paying my mortgage, and I've gotten tax advantages I never would have. I like to think of my second home as a big part of my retirement plan with an added bonus. If I have an emergency, I can sell the home and get my hands on the capital. I cannot sell my pension plan."
* * *
Possibly, you have heard someone say, "Real estate investing is not right for everybody". The answer to that statement is, "Well, it should be." Real estate investing is a great way to build wealth. Before we look atexactly how to go about purchasing a second home, let us look at some of the benefits of real estate investing.
The Benefits of Real Estate Investing
The Risks Are Minimal
Real estate prices have risen dramatically in recent years, especially in major metropolitan areas like New York, Chicago, and Los Angeles. Here is an example: a couple bought a home in 2001 for $219,000 in Scotch Plains, New Jersey, a commuter town across the river from Manhattan. Two years later, they sold it for $344,000. They then moved to Harrisburg, Pennsylvania, where they bought a home for $319,000. Twelve months later, they sold that home for $358,000. While it is true that in some areas of the country home prices have stayed relatively flat, most areas of the country have seen double-digit increases over the past three to five years.
As a result, some experts predict that the real estate market "bubble" will burst soon, and prices will fall dramatically. Others predict that interest rates are bound to rise in the near future. If it sounds scary, it is not. You can make money in any real estate market: rising, falling, or flat. No matter what the current conditions are, you can profit from them. Here are some examples:
If prices are rising quickly, you can buy properties that need cosmetic repairs and flip them for easy profits. ("Flip" is a word used to describe the process of buying and then quickly selling a property, hopefully for a tidy profit.) If prices are rising quickly, you can take cash out by refinancing your loan. It is a simple process: if a $100,000 property has risen in value by 20 percent, you can refinance the loan on the property for 90 percent of its value, keeping the other 10 percent as cash that you can use to invest in other properties or investment vehicles. ("Cash out" is a term used to describe the process of refinancing and taking equity out of the property in the form of cash.) If interest rates fall, you can refinance your properties at a lower rate, reducing your monthly payments to improve cash flow and make money available for other investments. If interest rates rise, home prices typically fall. You can buy under-valued properties and assume lower-rate mortgages from owners eager to sell, or take advantage of seller financing options at lower than market rates. If interest rates rise, new construction rates typically fall. Builders are less likely to build "spec" homes when they have to pay higher interest rates on construction loans. Less new construction decreases the supply of homes, and when the market picks up again, supply is usually out-stripped by demand, and prices rise. Real estate, like many other investments, is cyclical in nature, but what is not cyclical is the fact that the population continues to increase, and as a result, the demand for housing will continue to increase.
Think about it: are real estate prices higher now than they were ten years ago? Absolutely! Think about what your parents paid for their house. If a retired couple paid $12,600 for their home in 1963, their home is worth $245,000 today.
Rent prices also continue to rise. Years from now, the price you will pay for the average home will be much higher than it is today. In 2003, the U. S. government published statistics regarding median home prices. Look at how rapidly the average home has appreciated over the past 35 years:
What is interesting to note is that while prices have certainly boomed in the past five years, prices have risen at double-digit levels in every five-year period. Very few investments can match that level of appreciation over the long-term.
Real estate prices are likely to continue rising. There are a number of reasons why; let us look at just a few. Over the next twenty years, the following is expected to happen:
The U.S. population is expected to grow by more than 40 million people. The U.S. median income is expected to increase by 50 percent.
Ten million people will choose to buy vacation homes in the U.S.
More than sixty million children and grandchildren of baby boomers will enter the housing market.
Environmental restrictions and land shortages will tighten property development in popular areas, causing a decrease in supply and an increase in housing prices.
More than 60 million baby boomers will seek retirement income, and many will sensibly turn to real estate investments. Minorities and immigrants will continue to buy homes in record numbers. Currently 75 percent of whites live in their own homes, while only 40 percent of Hispanics and Asians own their homes. As their rate of home ownership increases, demand for housing will increase.
So what is the end result? Real estate prices should continue to rise, making smart real estate investing and investing in a second home a great way to grow wealth.
There are two basic ways to get income or cash from real estate investing: buying and selling properties for a profit, commonly known as "flipping," or by collecting rent from tenants who occupy your properties. Most successful real estate investors do both. As the owner of a second home, you can choose either method of increasing your income.
If you "flip" properties, the profits can be either used as income for living expenses or to invest in more properties. The average real estate investor does not seek to earn an income from their properties, at least not at first. Most try to increase their net worth, but over time, you can do both.
For example, let us say you buy a house for $150,000 for use as a rental property. If your mortgage payments, taxes, insurance, etc. add up to $1,200 per month, but you are only collecting $1,300 per month in rent, you are generating very little monthly income. Nevertheless, you are building wealth.
Each year, more of your principal is paid off, and as the property appreciates, your equity grows. In effect, your tenants are paying your mortgage for you. If interest rates fall and you refinance your loan, you may be able to widen the gap between your expenses and your rental income. On the other hand, you may choose a "cash out" refinancing in order to free up capital for other investments. Whether you leave the equity in the property or take cash out, you are building wealth.
As years pass, you will grow significant equity in the property. If you hold the property long enough, you will eventually pay off your mortgage, and the money you were putting towards mortgage payments can now be seen as "income" or to fund other investments. If you are a "buy and hold" investor, then your short-term income potential is low, but your long-term wealth potential is high. Your income potential is high once your properties are paid off. If you "flip" properties, you can still build wealth by continually reinvesting profits, or you can use some of the profits as income. In either case, real estate investing is profitable and financially rewarding.
Unlike investing in stocks or other traditional investment vehicles, there are a number of tax advantages you can benefit from when you invest in real estate. Here are four of the most widely used and effective:
Investing in your own home. Not only is mortgage interest paid tax-deductible, but so is the profit you make when you sell your home. When you sell your personal residence, defined as a home where you have lived for at least two of the past five years, up to $250,000 in profits for an individual and $500,000 for a couple is tax free. You can buy and sell your personal residences every two years and continue to avoid taxes on your gains. By definition, if you are interested in buying a second home you already own your first, so you should already be taking advantage of the tax advantages from owning a home. Investing in rental properties. You can also avoid taxes on capital gains of rental properties you own as long as you follow the IRS Section 1031 Exchange regulations. You are not really exchanging your property with someone else. As long as you buy another investment property within a few months, your gains are tax-deferred. We will look at Section 1031 Exchanges in a later chapter. Depreciation. If the income you receive from a rental property exceeds your expenses, you have to pay taxes on that income, right? Not necessarily. Investment properties can be depreciated over a number of years, which means that each year you can offset your income by a percentage of the value of the property. If you depreciate a $100,000 property over twenty years, you can offset up to $5,000 in income each year by depreciating your property, meaning that $5,000 in income is tax-free. After twenty years, you will no longer be able to depreciate the property, but in the meantime, you have sheltered significant amounts of income. Retirement plans. If you think your IRA funds can only be invested in stocks or bonds, think again. You can also invest your IRA dollars in real estate. IRA funds invested in real estate enjoy the same tax advantages as funds invested in stocks, bonds, mutual funds, etc.
Investing in real estate offers unique opportunities to grow wealth and gain income tax-free. To understand the specific tax implications for your situation, make sure to consult with a qualified accountant or financial services professional.
Another unique feature of real estate investing is that you can buy properties using little or even none of your own money.
Leverage is a simple concept to understand: if you buy a $100,000 house and only put $5,000 down on a twenty-year mortgage, your $5,000 investment has allowed you to control and invest in a $100,000 property. That is leverage. Do you now own $100,000? Of course not, but you do control it, and you can take advantage of it. Let us say you rent the property to other people for twenty years and pay off your mortgage. While you will have had expenses such as upkeep, maintenance, occasional repairs, etc., along the way, hopefully your rental income has at the least matched your expenses. In effect, your tenants have paid your mortgage and expenses for you. We will stay conservative and say the property rose in value by twenty percent, a figure that historically is well below average appreciation rates. So now, you own a $120,000 property, and you have only spent $5,000 of your own money. Moreover, each month it continues to bring in income for you. If you do sell, your profit is $115,000. That is twenty-three times what you invested; try finding that rate of return anywhere else. That is the power of leverage.
Leverage can allow you to buy more and more properties. As your property values rise, you can borrow against those properties to make further investments. Here is the bottom line: most successful investors use the power of leverage to maximize their returns on their investments.
Keep in mind, though, that leverage can increase your level of risk. If you borrow too heavily and do not have sufficient cash reserves, you can find yourself forced into foreclosure or bankruptcy. Unexpected events will occur, so make sure you have sufficient cash on hand to weather small storms. If you have borrowed so heavily that having a tenant fall a month behind on rent will cause you to miss making your mortgage payment, you are too heavily leveraged. If you are living above your means already, borrowing more money to buy properties only increases your risk. There are a number of reasons to invest in real estate. Like all investments, though, there is an element of risk and unpredictability. You should always seek the help of competent legal and tax advisors.
Assess Your Skills and Interests
Before you start looking for a second home, you will want to look at your goals, your motivations, and your personal resources. Understanding your skills and your goals for the second home will help you make smart decisions and will save you time and money. Why? Real estate investing of any kind takes time and effort. You will need to do your homework. If you are investing in rental properties, you will also have to decide whether you have the time and skills to tackle major or minor maintenance and repairs or whether you will need to hire someone else to handle those items for you. You will also need to evaluate your financial situation to determine what types of real estate investments are right for you. If you are interested in buying a vacation home that you will also rent to others, the same considerations apply. Even if you are buying a second home and you will be the only tenant of the home, you will still need to take into account the fact that your home maintenance responsibilities will double.
If you like what you are doing, you will be more successful at it. It is that simple. If you do not, you will hate every minute of it, even if you are successful at it.
Look at your own personality first. Do you enjoy working with people? If you do not, then becoming a landlord probably is not right for you. You can still invest in a rental property, but you will just need to factor in the cost of using a property management firm to deal with your tenants.
Do you deal effectively with stress? If you do not, taking on too much risk might not be the best move for you. You should probably avoid owning a large vacation property or buying foreclosure properties, at least at first. After you become more experienced, you may find that taking on more risk is not stressful at all, because you have the capital and expertise to work through problems as they come up. (Continues...)
Excerpted from The Second Homeowner's Handbook by Jeff Haden Copyright © 2006 by Atlantic Publishing Group, Inc. . Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.