The allure of real estate investing is obvious. The fact that real estate is a tangible, physical asset holds sway in the minds of many. Real estate investing is also intuitive- the idea that you can buy a property and rent it for more than the cost of ownership just makes sense. However, just like any other type of investing, real estate investing is beset on all sides with risks and pitfalls that must be navigated strategically. Below are some of the most common issues these investors face.

Overhead

Overhead includes all the expenses associated with owning and operating real estate. For certain types of properties, such as raw land, overhead is very low. Other types of property have much higher operating expenses. Consider the costs of operating a short-term rental property near a ski resort. You’ll need to budget for more ongoing costs such as snow removal, but due to the harsh climate, you also face more frequent replacement of things like windows, doors, roofs, and siding.

Many of the costs that comprise overhead must be paid regardless of occupancy- even when the property is vacant, you’re still on the hook. Businesses typically need to keep cash reserves of a minimum of three months of operating expenses, but depending on the type of real estate you own, this number could be significantly higher. The savings required for this cash reserve significantly increases the amount needed to purchase a property safely.

Taxes

Taxes must be carefully considered before buying, selling, or generating income from investment properties. The tax laws that apply to real estate are specialized and require a full understanding by both the owner of the property and the owner’s CPA.

During conversations with clients who own or are interested in owning investment properties, the most commonly cited benefit is the income potential. While income is certainly a good thing for investors, it’s important to remember that income is taxed at higher rates than capital gains and qualified dividends. In most cases, net income from operating income real estate properties “passes through” and directly increases the owner’s income (and potentially their marginal tax bracket). By contrast, qualified dividends from stock are taxed at much lower capital gains rates. While extra income sounds attractive, you need to consider whether you wish to add income or not. Many investors would prefer to see investment gains in the form of unrealized capital gains rather than ordinary income.

While gains on a personal residence can often be avoided by utilizing the Home Sale Gain Exclusion, gains on investment properties are typically not eligible for this exclusion.  This means that if a capital gain is recognized, the investor is on the hook for capital gains taxes in the year the property is sold. The IRS allows real estate investors to delay recognition of capital gains on real estate through a complex process known as a 1031 delayed exchange. Executing a 1031 exchange correctly requires great care and the assistance of a talented CPA and Tax attorney. We have written about this topic more extensively here.

Finally, investors must be aware of all applicable state and local taxes. Certain jurisdictions charge a higher property tax rate for residences that are not the owner’s primary residence. Different localities have different occupancy taxes. Knowing the ins and outs of state and local taxes is crucial prior to making the decision to purchase a rental property.

The bottom line with taxes is the laws that apply to real estate and related businesses are complex and require research on behalf of the investor and deep understanding on behalf of their CPA.

Leverage

Many real estate investors finance the purchase of investment properties with loans. While this strategy requires a smaller cash outlay, it’s important to remember that this strategy also increases your risk. Often, this use of leverage increases returns but it has the potential to create disastrous outcomes as well. During the 2008 recession, commercial real estate prices fell nearly 40% nationally. This meant anyone who had less than 40% equity at the start of the recession was now underwater- they couldn’t get enough from the sale of the property to pay off the loan. During the same time, these properties were now more difficult to rent- leaving the owners on the hook for the loan. Debt isn’t necessarily bad, but you must understand the additional risk you’re taking on if you use debt to finance your investments.

Proximity Bias

Proximity bias is the tendency for people to invest in the industries or areas they know best. Most people assume they have a level of expertise in their local community. This makes investment in properties in the same geographical area as their home easier. While it may be true that people understand their local community better than any other, this strategy is rife with pitfalls.

For starters, just because you know your area well, doesn’t mean you have an edge over other investors in your area- it’s possible there are other people who know your area even better than you. Owning a home and an investment property in the same town also means you’re exposing yourself to a higher level of risk. Consider the impact of hurricanes in the Southeast or the impact of wildfires in the west- chances are, if one property gets hit, the other will get hit at the same time. Finally, certain areas are more susceptible to localized economic impacts. For example, during the great recession, Phoenix and Las Vegas experienced more pronounced real estate downturns than the rest of the country. Investors owning multiple properties in those cities were hit harder than investors with more geographically diverse holdings.

Conclusion

The allure of extra income from real estate investing is enticing, but there are many mistakes that must be avoided. This blog just scratches the surface of some of the most important issues, but there are many others that may apply to your specific situation. For a longer list of some of the pros and cons of real estate investing as well as other things to look out for, click here. If you are interested in investing in real estate and would like to discuss your financial situation with a CERTIFIED FINANCIAL PLANNER™, schedule a meeting with us today.