Second Base

Realizing that improved real estate is a depreciable asset (have you ever filled out Form 1040, Schedule E?), an honest investor who truly wishes to get a return on an investment in rental real estate should first get a handle on the meaning of capitalization. In case you were wondering, that has a good deal to do with the term capitalism, which is a dirty word to some people who think that failing to properly capitalize a venture is a virtue.

Capitalization refers to the ability to reasonably compare the costs of an asset to the benefits that derive from owning it. Accountants are familiar with the concept, but most amateur real estate investors, sad to say, are not. Even Jesus warned about the dangers of failing to capitalize ventures. I won't tell you where He said that; you have to look it up for yourself, but it is there and He was very clear about it.

An investor who has no start-up capital is on shaky ground. I know, having started several businesses on shoestrings and losing my shirt because I was undercapitalized. Therefore, we will give our hypothetical investor the tidy sum of $10,000, and see what he could (maybe should) do with it.

There is a basic formula for calculating the income produced by an investment : Income = Rate * Value. If we consider putting the $10,000 in the bank at 0.2% interest (which is about what some banks are paying right now on savings accounts and CDs), then the annual income (simple interest) on $10,000 would be R * V = 0.002 * 10,000 = $20. That is not much of an incentive for saving. It is one of the reasons why intervention by the Federal Reserve, lowering interest rates to stimulate the economy, will ultimately have disastrous effects. The only people who will win that one are the bankers, who get to use every one else's capital virtually for free.

Our investor could put the money into the stock market. There are many solid mutual funds that have been paying 8%-12% per year. What is important to look at, though, is the mix of the annual return from those funds. How much is due to dividends paid by the companies that the fund invested in, and how much is due to capital gains that the fund earned through stock speculation? If the latter has been a very high percentage of the annual gain, the new market economics may soon make that fund much less appealing than one which derives a higher percentage of its gains through dividends paid on annual production.

In the end, all solid gains come from the production of goods and services. Rental real estate is a service which produces places in which people can live. The rates of gain from those things are regularly published. For real estate investors, the Appraisal Institute publishes the Korpacz Real Estate Investor Survey© National Market Indicators, which is a gold mine of data on current capitalization rates for various types of real estate.

An example would be the Overall Cap Rate for Apartments for the 4th quarter of 2007 (3.5%-8%, with a mean rate of 5.75%), or the Residual Cap Rate for Apartments for the 4th quarter of 2007 (4.5%-8.5%, with a mean rate of 6.58%). These are rates obtained by surveys of market participants; they are the rates that are being reported by serious investors in this field. They are also bellweathers for the economy in general, since any inflation rate (driven by artificially low interest rates) that exceeds the mean cap rates for a class of investment makes it economically foolish to hold that investment class.

Our investor also must study the care and feeding of his investment. We will assume he wants to buy a house and rent it out to generate income. He would like to have the largest gains possible, but he is a young sprout of 35 years, and would like to make an investment that he can still be drawing income from 30 years from now, when he retires. For this reason he prudently seeks a rate of return that appears supported by professional investors in his investment class.

Our investor will buy a house. Out of the gross rent, he will pay a mortgage, taxes, insurance, and anything that is needed in the way of maintenance. When he is ready to pass on, he will have not only earned an income over a lifetime, but will also have built an equity position. That equity position, however, should be considered a windfall bonus if it turns out to be a gain that beats the inflation rate, because in order to maintain the property, he will have to make further capital improvements over the life of the investment lest it depreciate through negligence to the point where it would be worth less than the original purchase price and also possibly lose its income generation potential.

Our investor will start with $10,000, and hope to match the Overall Cap Rate for Apartments (about 6%, or $600 in annual net gain). For the sake of simplicity, we will stick with the short term implications, fully realizing that as his equity position increases, the theoretical yield should also rise. The fact that the monthly payments on the loan will remain constant (we will assume he goes the full 30 years without refinancing) make a short-term analysis more realistic.

Next time we will help our investor choose his investment property.