Are Rentals Good Investments?
QUESTION: I recall you used to often write about investing in single-family rental houses. But lately, you haven’t said much about rental houses. Do you still think they are good investments?
ANSWER: Yes, I still believe rental houses are the best real estate investment for most individuals. However, I hasten to qualify that statement. I’ve been buying and selling rental houses for over 20 years and I see no reason to change.
But in recent years I have recommended buying only fixer-upper houses, where the investor can force the value of the home up by adding profitable improvements. Gone are the days where an investor can buy a house and sit back to let inflation drive up the market value of the house. Although that happens in a few “hot markets” such as Seattle, Sacramento, and Laughlin, Nev., in most cities the real estate market is currently stagnant.
But the home buyers who purchase fixer-upper houses, as I do, and then upgrade them force their value up if the right improvements are made.
For example, I am remodeling a two-bedroom, one-bathroom home into a deluxe three-bedroom, two-bathroom home. My goal is to raise the market value by $2 for each $1 spent on improvements. Although I don’t always meet that target, I come close enough. Then I usually lease-option the house, so I can get top price and top rent for the house.
Rental Depreciation Formula Explained
Q: A few weeks ago you suggested that a home buyer keep his old home as a rental property. You said he can deduct the mortgage interest, property taxes, insurance, repairs and depreciation. Please explain what depreciation is.
A: Depreciation is an accounting concept. It is an income tax deduction for estimated wear, tear and obsolescence of real and personal property. This non-cash deduction is allowed even though a property might be appreciating in market value. The net result is that depreciation shelters part of the rental income from taxation.
Under current federal tax law, owners of residential rental property can depreciate their property over 27.5 years straight line. But investors in commercial properties must use 31.5 years straight line depreciation.
To illustrate, suppose you buy a $125,000 investment property and allocate $25,000 to the non-depreciable land value and $100,000 to the depreciable building. If it is a residential rental, you can depreciate $3,636 for each of the next 27.5 years. But you can depreciate only $3,174 each year if it is a commercial building. Please consult your tax adviser for more details.
Sometimes Renting Is Better Than Buying
Q: You often encourage people to buy real estate. But I question if that advice always makes sense. For example, I own six small neighborhood convenience grocery stores. All are located in rented buildings. Five of the stores do very well, but the sixth store had a high vandalism problem and big losses so I abandoned the lease.
It cost me $10,000 to get the landlord to cancel the lease. Now I have an opportunity to buy a building where I can open a new store in a good location. But the owner only wants to sell and he will not rent. Since I have done so well with long-term leases I am wondering if it would be a mistake for me to buy a building for one of my stores?
A: When I recommend buying real estate, I am referring to home ownership. I do not necessarily recommend buying commercial property.
Business owners often find they do better paying rent rather than owning buildings. Your situation is a classic example of how business assets can best be used to expand your business by renting locations without tying up cash in real estate ownership. I presume you have good long-term leases of at least 10 years, so you need not worry about unreasonable rent raises.
But after you know a location is good for your business, then you might want to gradually buy the buildings where your stores are located if you plan to remain in business there. By owning the buildings you won’t be subject to greedy landlords who often raise rents astronomically when a lease expires for a business which is doing well.
Teach Yourself All Real Estate Basics
Q: I work for a manufacturing corporation where some of my duties involve real estate management in addition to being the corporate treasurer. The company owns about 30 properties and we buy or sell several properties each year.
I love the real estate work even though I don’t know what I am doing. I tried taking community college real estate classes, but my travel schedule required me to drop out. Can you suggest any basic real estate book where I can quickly learn the real estate fundamentals?
A: I highly recommend the new book,” Supercourse for Real Estate Licensing” by Julie Garton-Good, published by ARCO Books, New York, available for $24.95 in stock or by special order at local bookstores.
Although it is designed for license preparation, it also is an extremely well-written, 606-page basic real estate textbook. You will really impress your boss after you quickly learn the real estate fundamentals from this excellent book.
