A common question from our lawyer clients is, “Should I invest in real estate?” This is a great question, especially considering some of the wealthiest people in the United States have a core investment in real estate. Besides, real estate has numerous tax advantages and enables investors to generate “passive” cash flow. (What is the word passive in quotes? Read on to find out!)
In this post, we discuss individual buy-and-hold rental real estate. We explain some advantages and disadvantages of real estate investing to help you determine if investing in real estate is right for you as a law professional.
How Can Attorneys Invest in Real Estate?
Just as there are numerous career paths for attorneys (private or public service, patent or family law, etc.), there are also numerous paths for real estate investors. Some common ways to invest in real estate include:
- Real Estate Investment Trusts (REITs)
- Crowd-funding, Syndication and Real Estate Funds
- Individual Real Estate
On a scale of passivity, buying and holding a low-cost REIT index fund is one of the best ways to get exposure to real estate with little effort. While direct real estate is the most labor-intensive, syndication is somewhere in the middle – where you’ll need to do a lot of work upfront to vet your new partners.
Real Estate Investment Trusts (REITs)
A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties. REITs can be publicly traded on an exchange, such as the New York Stock Exchange (NYSE). Publicly-traded REITs are bought and sold just like stocks.
And just like stocks, one of the best ways to invest in REITs is with a low-cost index fund. That’s why a low-cost REIT index fund can be a great addition to your investment portfolio. For busy attorneys, getting truly passive exposure to real estate can make sense with a low-cost fund.
Run from non-traded REITs
REITs can also be non-traded. Non-traded REITs are sold privately with an accompanying sales commission. As with most financial products sold with a commission, private REITs should be avoided. This goes not just for busy attorneys, but attorneys with lots of time on their hands – as well as every other human. Non-traded REITs are terrible not just because of just the double-digit upfront sales commission, but also because of high ongoing fees.
Direct Real Estate
There are many advantages of real estate investing that you can’t access with a REIT. To benefit from some of the other advantages of real estate investing, you must invest directly. There are different ways to invest directly in real estate, some of which are explained below.
Crowd-funding, Syndication and Real Estate Funds
Investors pool their money to purchase ownership in a property, portfolio of properties, or property fund. Unlike a REIT, syndicate members have more direct ownership of the real estate properties. From direct ownership, members get certain pass-through tax benefits, such as depreciation.
One challenge of crowd-sourced real estate investments is high-ongoing fees. These high fees may be reason enough to avoid crowd-funded real estate investments.
Large Upfront Time Commitment with Syndication
When it comes to investing, the size of your investment return is usually proportional to your effort. (The exception to this is buying and holding low-cost index funds.)
One benefit of real estate syndication is that it is more passive than acquiring individual holdings yourself. Yet, the challenge with syndication is similar to the challenge with mutual fund investing: you’ve got to pick a winning manager. And, at least with stock market vesting, your odds of doing so aren’t great. So, if you can’t adequately vet a syndication sponsor, a low-cost REIT index fund may be the best option for you.
Individual Real Estate
With individual real estate investing, you own the real estate. All else being equal, outright ownership allows for a higher investment return by avoiding fees charged by syndicate sponsors or other intermediaries. However, this assumes that, as an amateur real estate investor, you’ll be able to acquire investment opportunities on par with professionals.
Individual real estate ownership also gives you greater control over your investment plan, such as whether or not to rehab or upgrade a property in order to raise rents or attract higher-quality tenants.
Four Advantages of Direct Real Estate
If you’re considering investing in direct real estate, it may be because of the many advantages available with the strategy. Direct real estate allows you to:
- leverage your investment return by using mortgage debt,
- receive regular cash income,
- offset taxes on real estate income by deducting real estate depreciation,
- increase your investment returns by injecting extra capital in the property (AKA forced appreciation).
Leveraging Real Estate
Using a mortgage to stretch your investment dollars is one of the benefits of investing in real estate.
For example, if you have $100,000 to invest, you can invest that money in the stock market – or even a low-cost REIT index fund. Alternatively, you can use that money as a down payment on a rental property. And, if you invest only 20% down, you have $80,000 left over to invest in other properties.
However, leverage is a double-edged sword. On the one hand, it is helpful to increase the return of your initial investment. On the other hand, if you have major unforeseen issues and the property cannot cash flow, a forced sale can result in a significant loss.
Worst-Case Scenario Planning
Be mindful of risk when leveraging your real estate investments; understand what the ‘worst-case situation’ may be.
Risks vary with distinct investing strategies. For example, are you a buy-and-hold investor, or a flipper?
Worst Case Scenario for Buy-and-Hold Investors
Buy-and-hold investors hold their investments for relatively longer. These investors usually hope to earn an investment return by collecting rent. However, they may be able to increase their return by capitalizing on property appreciation.
The worst-case scenario for a buy-and-hold rental investor can be an extended vacancy coupled with extensive rehab costs. Imagine a tenant trashing your unit on their way out the door. Now, you have an empty unit that needs fixing before you can rent it again.
Therefore, if you’re a buy-and-hold investor, consider: Do you have enough cash on the sidelines to fund ongoing expenses (property taxes, mortgage payment, insurance, etc.) and the needed repairs? If you’re a high-earning attorney, your answer may be “yes.” The income from your day job can float your real estate investment until it gets back on its feet.
Worst Case Scenario for Flippers
If you’re in the business of flipping properties – buying real estate at a depressed price, fixing it up, and then selling it – a worst-case scenario could be a lack of buyer interest. (Imagine trying to sell a property in 2008.) For flippers, the consequence could be either selling the property at a loss, or holding the property until you sell it for your desired price.
In the first case of selling at a loss, you’ll need a cash buffer to make up the difference. In the second case of holding the property until an attractive bid comes along, you’ll need to float the expenses of maintaining the property until it’s sold. As with the previous scenario, it’s likely that your income as an attorney will float your real estate investment.
Don’t count on being able to profitably rent out a failed flip as a stop-gap. To make up the difference, you will need that attorney’s paycheck. That’s because, in high cost of living areas, you could end up with a negative cash-flowing property.
Cash Flow in Direct Real Estate
Certain real estate investments offer higher passive income cash flows than dividend stocks or REITs. This is especially the case for properties in lower cost-of-living areas. While these properties may appreciate slower than equities—or not at all—the cash flow generated could be higher than the same amount invested in a stock and bond portfolio. (This is especially true once the mortgage is paid off.)
Let’s return to our $100,000 investment capital example above. By putting only 20% down, that $20,000 can be used to buy a $100,000 property. That single property could generate four-figure cash flows annually, net of expenses, and mortgage payments. Now, multiply that by five. That $100,000 could generate a nice monthly bit of cash. Again, that amount of cash flow could be orders of magnitude greater than a stock and bond portfolio.
Taxes on Direct Real Estate
Two common tax strategies of real estate investing include 1031 exchanges and offsetting income against depreciation.
With a 1031 exchange, real estate investors avoid taxes when swapping properties. Capital gains taxes are deferred. Of course, the IRS imposes several requirements to qualify for this special tax treatment.
Offsetting Income with Depreciation
Depreciation is one tax advantage of real estate investing loved by real estate investors. Even though a property may generate cash after expenses, the tax write-off of depreciation allows investors to pay little or no tax on that income.
In certain circumstances, individuals may be able to deduct up to $25,000 of passive rental losses against ordinary income. However, this requires relatively low income. Almost always, our attorney clients make more than $150,000 ceiling to take advantage of this deduction.
If you are willing to invest the capital (or even the energy and time), real estate investments offer higher returns when making improvements to the property. For example, you can install high-quality flooring and cabinets to increase a unit’s value. With a better property, you can charge higher rent.
In real estate investing, the process of improving a property is called forced appreciation. If you’re an attorney with a lot of time on your hands—and do the upgrades yourself—your forced appreciation is your sweat equity.
Challenges of Individual Real Estate Investing
Yet, investing in individual real estate is not without its challenges. Busy law professionals need to consider the following when choosing to manage a real estate portfolio.
Labor-Intensive “Passive Income”
When it comes to individual holdings, to say that real estate investing offer passive income is generous. Compared to the simplest of stock market investments—set-it-and-forget-it target-date funds—real estate investing has significantly more complexities.
If purchasing individual properties yourself, you are charged with finding deals, purchasing properties, finding and placing insurance, ensuring that the properties are maintained in good condition, find tenants, and so on – not to mention vetting and managing a property manager!
For many, the investment return available with individual real estate is worth the time and work. However, if you are busy with your law career or do not want to dedicate a lot of time, we do not suggest investing in individual real estate.
Vacancy & Economic Issues of Real Estate Investing
As with all investments, there are risks. With real estate investing, you may encounter prolonged vacancies. This is especially the case if one or two corporations primarily fuel the area you invest in. For example, Detroit was fueled by manufacturing. As more companies left the city, real estate investments in Detroit turned into a loss for many.
Investing in just a single area can similarly subject you to the risks of natural disasters such as hurricanes, earthquakes, wildfires, and so on. Insurance may compensate you for some of this expense, but you are rarely paid in full.
This is why—just as with your stock portfolio—you need to diversify. Don’t invest exclusively in a single area or even a single region. As the old saying goes, “don’t put all your eggs in one basket.”
Dealing with Tenants
As a property owner, you might come across some irresponsible or dangerous tenants. Because of the potential for property damage, nonpayment, and additional headaches, it is prudent to thoroughly screen tenants before renting to them. You can do this yourself or use a property manager. (Anyone who is serious about real estate investing does just the latter.)
Hiring a property manager impacts your cash flow. Yet, it allows you more freedom – not needing to deal with “people” issues regularly. This allows you to stay focused on the numbers, and acquire your next property.
Hiring property managers doesn’t solve all your problems, however. Keep in mind that you will have to ‘manage’ the manager.
Real estate is not a liquid investment. Unlike investment accounts whose values are updated daily and can be sold promptly, selling individual real estate takes time. If you need your investments to provide instant cash at a moment’s notice, direct real estate investing is not for you.
Real Estate Investing for Law Professionals
Individual real estate is a great investment strategy to diversify and generate higher cash flow yields through the use of leverage and even ‘sweat equity.’ Yet, if you are busy, without the time to dedicate to the real estate market, we do not recommend individual real estate investing. Instead, you can access real estate investment returns via a low-cost REIT index fund.
This post is for law professionals looking at buy-and-hold single-family residences (single-family homes, duplex, triplex). If you would like a deeper discussion, schedule a Meet and Confer call with us.