by Neil Jesani
Like with a home, a person can make real estate purchases of these types only needing a percentage of the sale price, borrowing the rest. This leverage is a major draw for investing in real estate. Let’s look at a quick example to illustrate this point.
Here we have an investor using $150,000 from their savings to buy a house outright. If the house increases in value by $8,000 in one year, then the investor made a return of 5% (assuming no other costs for this example). However, if the investor obtained 70% financing, he would only need $45,000 in cash when closing on the property. The mortgage would provide the additional $105,000 needed to acquire the property.
If we assume the same $8000 in increased value, the investor’s original $45,000 would yield an increase in equity of $53,000 in one year, a 15% return on investment. If he is using the house as a rental property, and you add in that income, the return is substantially higher. Even if the property value stayed stable with no appreciation, you would still see a positive return on the investment. Similarly, if property value were to go down by $8000 then you are losing 15% on your investment.
The above is a textbook example of how real estate investing can work. Please keep in mind that in the real world, you are going to have expenses on your property. An owner has to factor all those things in that we talked about with home ownership: interest, insurance, maintenance, improvements, etc. You have to take these into consideration when calculating the true cash flow from the property.
There are certain tax advantages when investing in a property. You’ll have depreciation on the property. Even if the value appreciates, the government allows owners a tax deduction of their property over its lifespan. Besides the depreciation, an investor can usually claim the interest portion of his monthly mortgage payment as a tax deduction.
When embarking on real estate investments, there are some definite do’s and don’ts that can keep an investor on a successful path. One of the first is not to do everything yourself. A successful real estate investor builds a team of professionals. You need to develop a good alliance with at least one real estate agent. In addition, it is a good idea to have an established relationship with an appraiser, home or building inspector, a closing attorney, and a lender or two depending on the volume of deals you conduct.
Once you have your property, you also need a team in the remodeling or maintenance side of the business: a plumber, an electrician, a roofer, a painter, heating and air conditioning professional, contractor, a flooring installer, a lawn maintenance service, a cleaning service, and an all-around handyman.
One of the biggest detriments to success in real estate investment is paying too much for the properties you acquire. Be very careful in analyzing the properties you are thinking about buying. Whether you are looking to turn it around quickly to sell or plan on receiving long-term rents, thoroughly investigate location, local real estate trends, and any other factors that could be the difference between success and failure.
Along those lines, it is important to educate yourself on real estate investments. Watching a couple shows on HGTV on how to flip houses doesn’t prepare you for all the intricacies involved. Before you invest your hard-earned money, read articles, scour the Internet, check out books from the library, and look for a local chapter of the National Real Estate Investors Association. Find someone successful in real estate, who will act as a consultant or tutor to bring you up to speed on what you need to know.
You also need to do your due diligence on the actual property you want to purchase. Successful real estate investors usually have to close deals quickly. However, that doesn’t mean you shouldn’t look at all of the costs, potential costs, and the market conditions surrounding any one transaction. An investor can deplete his savings by purchasing a property that needs a great deal of money poured into it. This is a particularly important point for new investors, who may be tempted to overlook additional out of pocket expenses assuming they’ll make up the difference if and when the property appreciates.
Another issue is if an investor does not calculate a property’s cash flow properly. If the investment strategy is to buy and then rent out properties, then you need to generate a sufficient amount of money to cover maintenance and other costs, as well as have some left over for income.
Something else that might block cash flow is if an investor buys a rental property with the intention of hiring a property manager to run it. The cost of such a manager will eat away at the monthly cash income from the property. Again, do your homework before moving forward on a purchase.
The amount of deals you are working on is going to have an impact on your success or failure. It is a good idea to have a sufficient number of transactions going at any one time so that your good deals will support any marginal ones. This gives you some flexibility as you try to either improve the properties that are a problem or get rid of them.
Another way to keep a positive balance is to make sure you have multiple exit strategies for any single property you invest in. If you buy something with the intent of flipping it and that doesn’t work, Plan B might be to rent it. If rents are stalling in your area, maybe offer it as a lease-purchase opportunity to a buyer. Since one of the downsides of real estate is the lack of liquidity of your investment, make sure to have several ways to generate income from it.
While we have had short discussions on knowing the hidden costs of owning property, there is one more factor many investors miscalculate: time, which is often underestimated. Things just tend to take longer than anticipated in real estate. This is everything from how long a successful rehab of a building will take to when the income from a rental property will reach a certain level. Time is money, as they say. Some experts say to double whatever your original estimate is when reaching a certain goal. If you can still live with the investment with that in mind, then it’s probably a good deal for you.
In addition to outright ownership of property, there are other categories of investing in real estate. For instance, you can lease a space or property and sub-lease it to others at a higher rate than you are paying, assuming your lease allows for subletting. As an example, you lease out an office space, divide it into smaller units, and rent them out to businesses. You can achieve quite a high return on your investment if your location is conducive to something like this.
Real Estate Investment Trusts (REIT)
For an individual, who would still like to invest in real estate while avoiding the responsibilities of actually being a landlord, he or she can buy into a real estate investment trust. REITs have a unique tax structure and became an alternative real estate investment in the 1960’s. They came about to encourage smaller investors to invest in real estate projects they otherwise wouldn’t be able to afford, such as building shopping centers or hotels.
A REIT is similar to a mutual fund in the way it works. You are investing in a portfolio of properties rather than a single building. You buy shares of a REIT, and your gain or loss depends on the performance of those properties as a whole. If one or two of the properties underperform, the hope is the remainder of the portfolio more than makes up for them. It spreads out the risk to the investor’s dollar. In addition to the diversity, another important advantage of REITs is their liquidity. Unlike actual real estate, REIT shares allow you to quickly and easily sell your shares.
Summary
This is only a general outline on real estate investing. It takes years of practice, experience, patience and exposure to truly appreciate, understand, and master. Remember that real estate is only one component of your diversified portfolio. How much money you put into it is going to depend on how much you are investing overall. You may find it is sufficient to invest in one or two additional properties besides your home. You might also decide that being a landlord doesn’t suit you at all, and that owning shares in one or more REITs works best for you.
As with any investment, buying and selling properties come with risk. The value of your investment will go up and down. Even though the t
rack record of real estate is one of steady appreciation, the market over the past 10 years illustrates there are no guarantees. Many times combining the real estate investment with cash value life insurance (we’ll discuss shortly) will provide the multiple tax advantages and ability to put your money to multiple uses.
CHAPTER 10
The Dull Investment of Life Insurance
“Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
Warren Buffett
A
s with many things we’ve discussed so far, life insurance has its origins in ancient Rome. Back then, they had “burial clubs” that provided funds for a member’s funeral, as well as some assistance to the deceased’s survivors. A London company, the Amicable Society for a Perpetual Assurance Office, began in 1706 with 2,000 members and was the forerunner to today’s life insurance companies. Life insurance became available in the United States while it was still a British colony. The Presbyterian Synods in Philadelphia and New York City created the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers in 1759. Two dozen life insurance companies sprang up between 1787 and 1837. Other companies formed after that leading to the many companies we have in existence today offering various types of life insurance products.
When you are establishing a plan to invest and protect your income, life insurance should be an important consideration. Life insurance is a replacement of income that can continue to support the dependents of an insured individual after that person has passed away. In addition to this primary purpose, life insurance is a powerful investment and tax-planning vehicle. We’ll explore the investment side of a life insurance policy.
Types of Life Insurance
There are two basic types of life insurance policies for you to consider. One is temporary, such as a term life policy. Then there is permanent life insurance represented by whole life, universal, and variable life policies.
Term insurance is similar to renting an apartment for a certain period of time. Once that “term” expires, you either find a new place to live or pay more in rent. A term policy works the same way – when you reach the end of the term, your insurance protection ends, and there is no cash value.
As the name implies, if you die because of any reason within the defined term – maybe in 10 years, 20 years or maximum 30 years – the insurance company will pay the death benefit to your beneficiary. If you do not die during the defined term period, then your life insurance premium is gone forever – very much like your car insurance premium. Term insurance suits someone who needs substantial life insurance, but does not have a lot of money to spend. Another way to look at term insurance is that it is a temporary solution similar to renting an apartment until you are ready to move into a house.
A cash value life insurance policy by comparison is similar to owning your own home. In this policy, premiums are larger than term policy premiums, just as mortgage payments are higher than rent, but you end up owning a life insurance policy with a cash value to utilize for any living needs. A permanent life policy covers you for the rest of your life. It builds cash value similar to increased equity in your home. It also enjoys income and estate tax advantages that give greater flexibility with your total investment plan. It can be used as a college savings plan, a retirement plan, or any other purpose you choose.
There is an ongoing debate about whether term or cash value life insurance is the better option. There is no easy answer to that, as no one size fits all. The best type of life insurance policy for you depends on your unique circumstances. You have to take into consideration many factors when making this decision. Age, health, financial responsibility, other financial assets and your personal opinion influence the decision.
Always remember that the purpose of life insurance is to provide cash for your family, your business or yourself. It can help create wealth when you have not had time to do so, and it can help protect your estate from taxes when you have accumulated a lot of money. Even though cash value life insurance has many advantages, it may not be appropriate for everyone’s personal financial situation. Let’s look a little more in-depth at two kinds of investment-grade cash value life insurance – whole life insurance and indexed universal life.
Whole Life Insurance
Whole life insurance provides three guarantees: premium, death benefit and cash value inside the policy. A whole life policy provides a decent internal rate of return (net to all the costs and expenses) of approximately 4% to 5% NET over the long-term period, usually 20 years or more. Whole life insurance also gives you the peace of mind that life insurance will always be there as long as the guaranteed premiums are paid.
As you pay premiums into your policy, it accumulates a cash value or equity in your policy (or in an account). Fueling this growth inside your policy are the dividends paid by the life insurance companies to your policy. Your premium will remain the same for life, and you will have a choice of paying premiums for that duration, whether it be for 7 years, 10 years, 15 years, or until you retire.
The cash value that builds up in a whole life policy (the equity) allows you some flexibility with how to use your policy. As long as there is at least some cash value in your whole life insurance policy, you can withdraw it anytime, very much like a savings account in a bank. Part of each premium payment accumulates in this account and continues to grow tax-deferred as long as the policy exists. You can withdraw your entire cash value tax-free via a loan strategy.
The cash value that builds up inside your policy is creditor-proof in most states. This makes whole life insurance a sort of double-indemnity policy by not only protecting your family should you die suddenly, but also, by protecting your family if someone sues you, or you have to declare bankruptcy.
There is no stock market link or a volatility associated with this kind of a policy, but the insurance company provides a fixed return for your premium dollars. There are only a few whole life insurance companies left. They have paid dividends for their whole life policies since their existence and most of them are a century and half old. Their typical dividend rate is around 6 to 7% and the net return comes to around 4.5 to 5% after all expenses are accounted for. Following is the last three decades of dividend history from some of whole life insurance companies:
One negative of whole life insurance is there is no upside potential such as in the stock market, as its return is guaranteed like a CD.
Indexed Universal Life Insurance
Indexed Universal Life is the latest innovation in the cash value life insurance world. It’s a hybrid product where you are able to link your return with various stock market indices such the S & P 500, Nasdaq 100, DJIA, EURO STIXX 50, Bloomberg Barclay U.S. Aggregate Bond etc., but with the security of general accounts of whole life insurance.
As per the graphic below, almost 95% of premiums invested in insurance companies’ general accounts yields around 5% annually. That means 95% becomes your original premium amount at the end of the year. Of the remaining 5%, first, insurance mortality and other administrative expenses are taken out, and the remaining money is left for what are called option hedge strategies. If corresponding stock or bond indices close in the negative, then the option expires worthless. If it closes positively, then the option is “in the money,” and that return is shared with the policyholder as a dividend. This eliminates any losses, while allowing the owner to participate in the upside of the stock market, with a cap on the return, such as 12%.
By limiting loss to zero indexed Universal Life insurance enhances return even with the growth participation cap at 12%. Please see below comparison of actual S&P 500 index return with zero floor and 12% cap since the inception in 1957. The actual return is 6.86%, while cap and floor strategy produce 7.02% return.
Please see on the next page a comparison of actual S&P 500 index returns with zero floor and 12% cap from 1960 to 1980, when the return was not so attractive. The actual return is 3.
97%, while the cap and floor strategy produces 6.37% return.
Finally, please see the comparison of the actual S&P 500 index return with zero floor and 12% cap in down market from 2000 to 2010. The actual return is -1.41%, while cap and floor strategy produces 5.64% return.
There is no mutual fund management fees as they are not actually investing in the funds, but only buying the option of various stock and bond indexes. Finally, see on the following page an illustration of the power of combining two economic powers of accumulation and distribution rates with section 7702 tax advantages. The following comparison of Premium life is a concept of indexed universal life insurance and taxable account with investment in S&P 500 index with the same investment return and expenses.
Summary
The cash value life insurance is probably the most misunderstood investment vehicle. We are used to allocating any type of insurance into an expense category, and that is true about term life insurance, but one needs to look at any financial instrument based on its utility rather than its name or type of service. Most people think that the term insurance is the cheapest, and it is true in the short run but it gets more and more expensive as you own it. In the Penn State University’s 1993 study, close to only one percent collect death benefits. Term insurance failed to take advantage of one of the most important benefits of life insurance, the tax-deferred growth and tax free withdrawal under IRS Section 7702. Term insurance has its necessity when one needs the coverage, but it does not have any cash flow to pay a premium like the cash value life insurance provides. It does not mean all types of cash value life insurance are worth considering. In fact, variable universal life insurance is probably the kind of cash value life insurance that should be avoided based on the investment expenses of underlying separate accounts similar to managed mutual funds even though, variable universal life insurance enjoys same tax advantages of other cash value life insurance.