Is Too Much Cash A Real Estate Problem?

It’s difficult to imagine that mounds of cash might be a problem, but in some circles a surplus of coins is raising a concern: What to do with real estate dollars now that the housing market in some areas is slowing.

In a rising market the strategy is easy: Use leverage and get as much property as you can, either in the form of a more expensive house or by purchasing vacation homes and investment real estate.

A mortgage, of course, means leverage, a joy to much of the late-night infomercial crowd. But when the market turns less certain, the same strategy can be a loser. The leverage that maximizes investment results when values rise can also create huge losses and liabilities when values fall.

The marketplace in many communities is now in flux. Home values are no longer rising at rates seen in the past few years — and in some markets asking prices are in decline. In effect we may be on the verge of a new marketplace incentive: Instead of buying property primarily with the hope of appreciation, why not buy property because it produces income?

It’s sometimes forgotten that real estate is a serious source of recurring income. Own a good investment property and its associated monthly checks can be a very pleasant addition to income.

About 30 percent of all homes are now mortgage-free and you can bet that a growing number of investment properties are held with only a small mortgage or no mortgage at all.

But why do people buy with all cash?

Imagine that you buy an investment property for $450,000. You pay all cash, money obtained from the sale of other property or through a 1031 exchange. Now ask how much income you would have to earn on the factory floor or in front of a computer to equal the property’s return.

First there is rent, say $2,000 a month.

Second, there is depreciation, say $1,000 a month. Let’s agree that depreciation has a cash equivalence equal to about $350 a month for our purposes. It may be higher or lower depending on your tax bracket and the jurisdiction where you live.

Third, rental income is generally not subject to certain payroll taxes associated with wage income. For the employed, figure a savings of 7.65 percent or $153 a month in this example. (For the self-employed that’s a savings of 15.3 percent, the cash equivalent of $306 a month that investors do not pay.)

Thus our model $450,000 investment produces an equivalent income of at least $2,503 a month or $30,036 annually. That’s a gross return of 6.6 percent, a stream of income that can be used to support a mortgage if one is desired in the future.

In practice, of course, there are vacancies, property taxes, insurance and repairs. But at a time when the economy is uncertain — remember the stock market fell modestly last year — rental income is not to be ignored.

An attraction of real estate investing is that while prices are established at the time of purchase, rental rates can rise. In effect, a home purchase is a kind of hedge — the economics that make sense today may be better in the future. A $2,000 rental rate may grow over time, but a purchase price will never change.

There are pitfalls and hazards with all investments, including real estate. One concern is the large number of investor condos now available in certain markets. Another is that renting is less attractive than ownership for many people — and ownership has become easier in recent years with historically-liberal financing. Both factors can push down local rents and increase vacancies.

Also, of course, with no mortgage there is no mortgage interest to deduct, meaning the taxable income on the property will be larger.

While not for everyone or for every market, the ability to own a mortgage-free property brings with it certain joys. When option loans and interest-only financing evolve into self-amortizing loans with far-higher monthly payments, the owner of a debt-free property can still sleep at night. If it happens that a property has a vacancy, the situation is managed more easily when hefty mortgage payments do not loom ahead. As to rental payments, when there’s no mortgage cost to subtract it’s easy to appreciate the value of a free-and-clear property.

Published originally by Realty Times on February 7, 2006 and posted with permission.

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