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REAL ESTATE HISTORY IS OUR GREATEST TEACHER – Written by Jackie Lang

In the October 2002 Commonwealth Newsletter, Jack Miller wrote that American’s must either own or rent their dwellings.  Of a population that is approaching 300 million, almost 70% of all Americans choose to live in a house.  Houses serve as a refuge for owner’s net worth in ways that nothing else does.  A free and clear house yields about 7% net after tax income and a reasonably leveraged house will amortize its debt while providing a comfortable cash flow cushion for investors.

Houses are more tax-favored than other competing real estate investments.  Leveraged investors get to depreciate house assets that they haven’t paid for yet.  When full-time landlords lose money, they get to deduct losses against all types of income, and when they make money they only pay capital gains taxes.  Best of all, gains taxes are purely voluntary.  Owners of positive cash flow rental property need only sell when they think it to be in their best interests.  Even then, paying taxes on gain is optional!  Strong talk, but absolutely true.

Jack also wrote that the mother lode in the house business centers itself on houses in the middle 20% or so of the house market.  Here, income, financing, appreciation and management effort are more or less at a point of equilibrium.  Houses outside this range perform differently over different time periods.  Let’s dig deeper:

In the top 40% of the housing price spectrum are houses that make a lot of sense as personal residence investments, but, when financed conventionally, can be too expensive as rentals.  They require large down payments, and produce rents that are disproportionate to their value.

One such $300,000 house that I owned only produced $1500 in gross rents.  Two $150,000 houses would have produced about $1200 each.  And three $100,000 houses would have produced about $900 each.  Selling the $300,000 house and moving the money tax free into three other houses would have increased my gross rents by 80%.  As house prices are reduced, rents, as a percentage of price, rise.  This leads to putting too much weight on the other end of the seesaw.

When the above logic is pursued too far, an investor strays too far down the economic scale into low income and subsidized housing.  Where a house investment certainly can produce higher rents, it is at the cost of higher, more intensive management effort, higher cost financing, high liability, higher regulation, and lower appreciation.  Low income housing attracts low income tenants who have neither the skill nor the intention to keep rental property maintained, or the protect the owner’s property.

In the lower reaches of the house market, there are fewer buyers who can qualify for home loans, and fewer investors interested in bidding up the price, thus lower priced rentals don’t appreciate as much as to the others.  In the final analysis, a person who invests in these properties is sacrificing future security for current income.  Thus, low income rental ownership is more akin to operating a business than it is to increasing long term financial security.

One very successful entrepreneur I know of has accumulated hundreds of low income rentals that have made him wealthy.  Now, when he could be enjoying the good life, he is unable to sell them to this low income tenants.  The only way he will ever be able to get out of the income trap he has caught himself in is to sell his houses at a savage discount to other low-income landlords.  Not only would he lose a large portion of his net worth, but he’d also have to carry the financing.  In so many words, this would make his family’s financial security totally dependent upon the management skill and reliability of the person who is making the payments.

If he had directed his considerable talent less to buying high income-producing low-growth properties and more toward low-income, high growth houses, these would have been easier to sell for cash to tenants and been easier to finance.

The bottom line:  With so many great deals available today, it is a good idea to spend your time, energy and money acquiring houses in the median price range.

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