Real Estate and Other Investment Alternatives

LECTURE Real Estate and Other Investment Alternatives Because not everyone wants to own just mutual funds.

Real Estate Investments: Direct • Your home – a.k.a. Principal residence • As discussed in chapter 7, your home … • Is the major asset of most households • Has great tax advantages • Is a good hedge against inflation • A home produces an after-inflation return of about 2.5 percent a year (San Diego?) • But it is a home first, an investment second • In my humble opinion…

Examples of Direct Real Estate Investments • Vacation home • Tax advantages depend on if the IRS views it as rental property • Rental property • Whole course unto itself!(More later) • Undeveloped land • Can be tremendous gains but this type of investment poses enormous risks • All the money is riding on a single parcel of land • Plus there is no cash flow and you still have to pay the property taxes • And there is often no guarantee that you will be able to develop the land

Real Estate Investments: Indirect • Real estate syndicates or limited partnerships • Real Estate Investment Trusts • Similar to mutual funds but they hold real estate instead of stocks or bonds • Examples: Shopping centers, malls, apts, etc. • Equity Sharing • You put up the down payment for someone else and then share in the appreciation • Low-income housing • At first, it is primarily a tax credit or deduction • But eventually becomes a real estate investment

Investing in Commercial Property • Most common investment of this type is a duplex or small apartment building • Also includes hotels, office buildings, stores, and many other types of commercial establishments • Look for income to be greater than expenses • “Duh! Good advice, guys!” • But do not be surprised if you are looking at negative cash flow for several years • Rule of Thumb: Price = 7 to 10 times Rent • In San Diego? Ha! Ha! Ha! Ha! Ha! • Again, I think the South Bay is where the bargains are if you are so inclined

Investing in “Fixer-Uppers” • Concentrate on smaller properties first • Two to four units and live in one of them • Look for low down payments and seller financing of rundown properties • Banks usually do not want to loan to distressed properties, however… • Banks are all too happy to finance a rundown foreclosure on their books • Stay away from property managers • Nobody cares about your property as much as you do(but there are always exceptions)

Investing in “Fixer-Uppers” (continued) • Most Importantly, • Are you savvy dealing with repairs? …and… • Are you savvy dealing with renters? • Fixing a tenant is just as important as fixing a toilet • One bad tenant can set you back thousands • Make improvements that add perceived value • Example: Install a white picket fence • Investing in Fixer-Uppers,Jay P. DeCima

Advantages of Real Estate Investments • A hedge against inflation • Financial leverage • The use of borrowed funds for investment purposes allows you to acquire a more expensive property than you could own on your own (More later) • For Real Estate Partnerships • Easy entry as a limited partner • Limited financial liability as a limited partner • No management concerns • You can not check the price of your real estate investments every day on the Internet • One of the major problems with stocks • (Well, actually, you can … zillow.com & trulia.com)

Disadvantages of Real Estate Investments • Liquidity may be poor • It may be hard to sell the property (or your share of the property if a partnership) • Not a problem for REITs – buy/sell like a stock • Normally there is a lack of diversification • REITs & partnerships offer diversification • Passive tax shelter for real estate syndicates • Management or tenant problems • The PITA Factor! • Property values can decline • Oh, yes, they can!

The “Perfect Investment” • “C’mon, Paiano – Admit it! • Real estate is the ‘Perfect Investment’” • This is what people were telling me a few years ago • Beware the Permanent Trend(Andrew Tobias) • Real estate goes up and down in cycles • Ask those who bought in 1990 and sold in 1994 • And those who bought in 2006 and went through foreclosure… • Real estate seems to be finally back on its feet • If you plan to hold for the long-term, you should do well, in my humble opinion • By the way, there is no “Perfect Investment” • Folks were saying the same things back in 1999 about Internet stocks

The “Perfect Investment” (continued) • “But what about Leverage?! Huh? What about the ability to make money with other people’s money?” • I already told you about it, didn’t I? • “But isn’t that what makes real estate such a great investment?” • Well, yes. Let us look at the two problems in the older book that illustrate the power of leverage • Financial Planning Problems 1 & 2 • Page 563 (from an old BUS-121 text book)

Real Estate and Leverage 1. Calculating the Return on Investment. Dave bought a rental property for $200,000 cash. One year later, he sold it for $240,000. What was the return on his $200,000 investment? 2. Calculating the Return on Investment using Financial Leverage. Suppose Dave invested only $20,000 of his own money and borrowed $180,000 (90% financing). What was his return on investment? Page 563, Financial Planning Problems 1 & 2 from our previous book

Real Estate and Leverage (continued) 666. Calculating the Return on Investment using Financial Leverage and things do not go as planned. Suppose Dave invested only $20,000 of his own money and borrowed $180,000 (90% financing) … and the property value went down 20%. What is he going to tell his wife? Page ???, Financial Planning Problem that was conveniently left out of the previous text book…

Real Estate and IRAs • Yes, you can do it • Many people believe it is prohibited • But there are strict, complicated rules • Do not try to go it alone! • There are huge penalties if you break the rules (15% to 110%) • Few knowledgeable regulated trustees & advisors • Find a reputable, experienced trustee • Usually have high operating fees and expenses • Can not be your home or business • Nor your parent’s nor children’s • But it can be your brother’s or sister’s (?)

Real Estate and IRAs (continued) • Must have sufficient cash in the account to perform necessary transactions • If not, you must either sell the property, or • Deposit more cash into the IRA • But if you go over the annual maximum contribution level, then you will be penalized 6% per year on the amount over-deposited until there is sufficient cash in the IRA and you are able to withdraw the amount that you over-deposited (“Huh? What?”) • For this reason, often people “pool” their IRAs • Which is normally forbidden (?) • Again, seek a reputable, experienced trustee

Real Estate and IRAs (continued) • The advantages can be dubious • Investment real estate often has many of the same advantages as an IRA without any the constraints of an IRA • Capital gains taxes are deferred until you sell the property which may not be until retirement • Income is usually negative or minimal for years • Real estate offers many tax deductions which you will not get if it is inside an IRA • And capital gains on real estate can currently be eliminated if you simply live in the property for two years before you sell it – “principal residence” • $250,000 single / $500,000 married

Real Estate and IRAs (continued) • Or the advantages can be compelling • If the real estate investment is in a Roth IRA, then any capital gains and rental income will be tax free in retirement • Plus you can not check the price of your real estate investments every day on the Internet

Real Estate and Capital Gains • “Wait a minute. Did you say that there are no capital gains taxes on real estate?” • Currently, as the law stands now, as long as the real estate is your primary residence for 2 out of the last 5 years, you pay no capital gains on the first… • $250,000 if you are single • $500,000 if you are married • By the way, capital losses on your primary residence are not tax-deductible The property must be your principal residence. Be careful! If you own two or more properties and frequent each regularly, the IRS can rule that none of your properties is your principal residence!

Investing in Precious Metals • Gold • Bouillon – bars and wafers • Gold bouillon coins • Gold stocks • Exchange-Traded Mutual Funds (ETFs) • Silver • Platinum, palladium and rhodium If you believe that the world economy is going to fall apart anytime soon, put your money here! “…if your reason for owning gold has something to do with the end of the world as we know it, shotguns and canned food probably would be more practical investments.” – Tom Petruno, Los Angeles Times

Growth of $1 Investment 1801 – 2011

Investing in Precious Gems • Precious stones • Diamonds • Sapphires • Rubies • Emeralds Video. Sorry, Ladies… There ain’t nothin’ scarce or treasured about precious gems.

Investing in Collectibles • Includes rare coins, works of art, antiques, stamps, rare books, sports memorabilia, antique cars, rugs, Chinese ceramics, paintings and other items that appeal to collectors and investors • Can be both a good hobby and investment, or a financial disaster (Example: El Cajon Barbie Guy) • Be careful of investment scams • Know the dealer’s reputation • Comparison shop “Don’t buy art as an investment.” Christopher Burge, Christie’s Auctions

Metals, Collectibles & Taxes • The maximum capital gains taxes on most all financial and real estate investments is currently 15% • The capital gains taxes on precious metals, art, and collectibles is 28% • Plus precious metals, art, collectibles are not allowed into an IRA (or any other tax-qualified plans) Do ya’ think the Congress is trying to tell ya’ something?

Starting a Business • The most profitable investment anyone can make is starting a business • It is also one of the riskiest investments anyone can make – You’ve heard the statistics: • “50% businesses fail in the first year!” • “80% of businesses fail in the first 5 years!” • “100% of businesses fail in the first 10,000 years!” The truth is that no one knows the failure rate of small businesses because no one – not even the IRS – knows how many small businesses there are! Another truth is that many small business owners often will fail 2 or 3 or more times … until they succeed.

Starting a Business (continued) • SCORE – www.sandiego.score.org • Service Corps of Retired Executives • Kiva – www.kiva.org • Worldwide peer-to-peer lending organization • Accion San Diego – www.accionsandiego.org • Awesome local small business organization • South SD Small Business Development Center • Hosted by Southwestern at our National City campus – www.growmybiz.org There are tremendous resources available to small business owners. Don’t Go It Alone!

Investment Scams • Have you ever seen ads like these? • “Start your real estate empire with No Money Down!” • “You, too, can take advantage of the tremendous opportunities now in the wide-open Real Estate Foreclosure Market!” • “Just take our Guaranteed, Sure-Fire Three-day Real Estate Investment Seminar for only $2,995 that will pay for itself in just one month” • “You will be on your way toward Riches beyond your Wildest Dreams!” If it sounds too good to be true …

Bottom Lines • Buy a house and make it your home • It should reward you well over the long-term • Both personally and financially • Learn the ropes regarding being a landlord • Possibly working for a property manager • Do not overextend yourself with too many properties • Stay away from precious metals and gems, art, or collectibles as an investment • Unless you absolutely love it as a hobby first • Dream, think, plan about what kind of business you would offer to the world • Maybe some day, yes?

Real Estate and Other Investment Alternatives