Real estate offers investors many ways to make money. Investors seek real estate investments as an alternative to stocks and bonds as a way to diversify the assets in their portfolios, thereby reducing overall risk. And that’s the key for choosing any investment — risk and return.
Two ways to earn long-term income in real estate is to purchase rental properties and to buy mortgage notes. These investments have very different characteristics that help determine the risk and return of each.
Investing in Rental Property
If you are a “hands-on” type, an active investment in rental property might suit you. You purchase one or more rental units and collect rent from tenants. You can buy residential or commercial properties, and your duties as landlord depend on how the lease is structured. That’s important, because the greater your responsibilities, the more it can cost you to own the property. For example, you might purchase a small office building and rent out units with leases specifying that the tenants pay for taxes, insurance, and maintenance. On a residential rental, you normally are responsible for all three.
Your return on rental property is the net amount (after expenses) you earn on rent plus any capital gain or loss if you sell the property. This investment is tax-efficient because you deduct your expenses, including mortgage interest, tax, insurance, repairs, and depreciation. When you depreciate rental property, you receive a lucrative tax break during the cost recovery period (typically, 27.5 years). Thus, your after-tax return on rental property is:
After-tax ROI on Rental Property = (Annual after-tax cash flow + depreciation) / Cost basis of property
The after-tax ROI depends on your tax bracket, your occupancy rate, your rental income, and your expenses. For example, suppose you are in the 25% tax bracket. You purchase a house for $500,000 (including net closing costs), putting up $150,000 and borrowing the rest. You the put the house up for rent at $4,000 per month, or $48,000 per year (assuming no vacancy periods). Your costs are $1,000 a month ($12,000 per year), giving you a net income of ($48,000 – $12,000), or $36,000.
You borrowed $350,000 and assuming, a 4% interest rate and 30-year term, the monthly payments would be $1,773 a month. Thus, the after-debt payment return ($36,000- $21,276) would be $14,724. Assuming that the land is 60% of the house’s value you can write off and thus increase your return by $7,272 ($500,000 * 40%) divided by 27.5 years for a total of $21,996. After taxes, that income is reduced by 25%, giving $16,497. Therefore, your after-tax return is $16,497/$150,000, or 11.00%.
If you eventually sell the property, your total after-tax ROI will be the total after-tax revenues minus the total cost divided by the total cost.
This example looks like a good deal, but we haven’t discussed risks that can decimate your return. These include:
- Vacancy periods
- Tenant default
- Weakened rental market
- Unexpected repairs
- Increases in property tax
- Neighborhood deterioration
Suddenly, your 11.00% return may look a little sketchy. If you happen to be risk-averse, you might look askance at this type of real estate investment.
Return on Mortgage Notes
The return you earn on mortgage note investments is a function of how much you pay for a note versus how much you collect. The main risks to this type of investment are:
- Default risk: This risk is mitigated to a large extent by the mortgage deed which secures the property. The property is the collateral you can seize and sell if the homeowner defaults on the mortgage. If the amount of your investment is low compared to what the home can be sold for your risk is further minimized.
- Prepayment risk: If the homeowner prepays the mortgage, you will collect less interest. Most residential mortgages carry no prepayment penalties. However, you will not lose any of the remaining portion of your investment. The term of your investment will simply be shorter.
- Reinvestment risk: If prevailing interest rates decline, your return on the reinvestment of your rental cash inflows will be smaller.
If you are risk averse and/or prefer passive investments to active ones, you can invest in high-quality mortgage notes that are the most likely to provide the return you expect. A high-quality note is one that is:
- A first-lien mortgage with a low loan-to-value ratio
If the note is of sufficiently high quality, you will likely collect all the mortgage principal and interest (P&I). The total return, or yield to maturity, on the note is:
ROI on Mortgage Note = (Cash inflows from note – Cost of note) / Cost of note
The critical factor is the cost of the note. Notes always sell at a discount to their present value, which is the sum of the cash flows reduced by the appropriate discount factor. The discount factor represents the time value of money and is tied to inflation and interest rates. Naturally, the greater the discount, the higher the ROI.
The way to achieve a desired return is to figure the note price you would pay to obtain the required yield. For example, suppose you are evaluating a seasoned, performing, first-lien mortgage note with an unpaid balance of $100,000 and an amortized interest rate of 5% on the balance. That is, you would collect an average interest rate of 5% on the remaining balance after accounting for amortization of the loan.
If you were to pay $100,000 for the note, you would earn a 5% yield. However, suppose you desire a 7% yield. You would reduce your bid to $80,688, which is the present value of the note discounted at 7%. If you wanted a 10% yield, you’d use a larger discount.
The note’s interest is taxable as passive income. Thus, the maximum tax percentage you will pay is 20% regardless of your tax bracket. This is much lower than the ordinary rate you pay on shorter term investments.
The typical yield range of high-quality mortgage notes is 6% to 8%. This is passive income that avoids almost all the risks associated with owning rental property. Plus, there are no daily management responsibilities. Before you invest you should determine how active you want to be in the investment and the degree of risk you want to take. In other words, depending on your needs, mortgage note investing may provide a better risk-adjusted return compared to owning rental property.