Investment

Tech Founder’s Guide to Real Estate

Part 4: Real Estate as an Investment Asset

This article was originally published on FORBES.COM on March 12, 2021. Written by Peyton Carr.

For many people, real estate has been the best investment in their lives. However, stocks have actually been far better at generating long-term returns for investors. Why is there such a disconnect?

Misconceptions on Real Estate Returns

Peeling back the layers reveals some of the key factors that make real estate seem like the better investment:

1. Immense use of leverage – No other common investments will allow an investor to take on the same level of debt to make an investment. Mortgages allow 4:1 leverage with a 20% down payment and even far higher levels of leverage when using smaller down payments. The leverage magnifies even small gains in the property value, but remember, it can cut both ways if the property value declines.
2. Illiquidity prevents human error – Real estate transactions have high costs and take significant effort. This is usually enough to deter investors from making hasty, panic-induced decisions during market volatility. Poor decisions are more prevalent in the stock market, where selling investments can happen in seconds with no material transaction costs.

Real estate also receives tax benefits from capital gain exclusions on primary homes to rental depreciation on investment real estate; however, this is somewhat offset by holding property tax costs, which stocks do not incur.

Converting a Primary Residence to an Investment Property

When moving on to a new house, some individuals decide to convert their original home into a rental property that becomes an income source.

You can convert your primary residence into a rental property by making a few smart moves. You start by determining your property’s tax basis to calculate depreciation during the rental period. When you eventually sell, this will factor into gain/loss calculations. The conversion date varies in your favor based on whether there was a gain or a loss.

Once you’ve converted your primary residence into a rental property, you must adhere to landlords’ tax rules, but with that, you will gain a number of favorable benefits. You can deduct real estate taxes and mortgage interest on a rental property, and you do not have to pay self-employment tax on landlord income. You can write off your operating expenses, such as maintenance and repairs, association fees, utilities, and lawn care. You can also depreciate the cost of the property over 27.5 years, even if the value increases. This depreciation can offset a significant portion of your rental property income, which translates to very low taxes on this income stream. You may run into issues if you have a tax loss, but you should be able to offset this over time with increasing rents. When you sell the investment property, you can use a 1031 exchange and defer taxes if you “swap” the property with another investment property of like kind and equal or greater value.

It is also important to carefully weigh the costs of being a landlord. To start, rent must cover all carrying costs, as you certainly do not want an asset to cost you money. Also, you need to make an allowance for unexpected periods where you may not have a tenant and would have to float the carrying costs out of pocket. A mistake you often hear of is an investor who over-leveraged and owned ten houses, then had to sell them all at a loss in a downturn.

Perhaps more importantly, you should never ignore the qualitative question of whether or not you want to be a landlord. It can be time-consuming and even take an emotional toll on you as you worry about the property or your tenants. Not everyone wants to deal with late rent payments, requests to fix bathrooms and leaky ceilings, or property damage caused by untrustworthy tenants.

In this four-part series, we covered answers to many of the questions that come up when our tech founder clients consider a real estate purchase.

In Part 1, we offered founders a framework to decide whether renting or buying is the right choice. Part 2 explored how a home purchase could potentially fit into your overall financial plan. Part 3 of the series discussed real estate financing options, taking into account the entire process, including risk, taxes, cost savings, profit, and legalities. And in Part 4, we dove into the topic of real estate as a financial asset, examining common misconceptions and opportunities.

This concludes the series. We hope you’ll find this information helpful as you think through your decisions related to real estate and navigate your next steps.

This article is Part 4 of the Guide to Real Estate series. Click here to read Part 1, Part 2, or Part 3.The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Tech Founder’s Guide to Real Estate

Part 3: Buying Real Estate: A Personal Financial Venture for Founders

This article was originally published on FORBES.COM on February 17, 2021. Written by Peyton Carr.

Buying real estate as a founder is a serious undertaking — a venture on its own, not entirely unlike your entrepreneurial endeavors. You will likely want to finance your home with a mortgage, so it is important to know your options and understand the process to properly assess your risks, make sure you have your legal house in order, and position yourself for profit, tax savings, and cost savings opportunities.

Financing Your Home

If you’ve come into a big windfall, you could buy your house in cash. But many people choose to finance their home even if they have the money in the bank.

As you are building wealth, it can make sense to keep more of your portfolio invested in the stock market or more liquid investments in case you need it for other purposes. This also allows you to invest and target long-term equity-like returns while borrowing at lower fixed interest rates.

The alternative is to purchase with cash, which can save you in financing costs and make your offer more attractive to sellers, but it leaves you with less liquidity and entails opportunity costs. So think carefully about how to proceed. In a competitive real estate deal, a good backup solution is to have a line of credit that you can access to quickly close in cash, then refinance the property after closing.

Applying for a Mortgage

As an entrepreneur, qualifying for a mortgage presents unique challenges. Even though you have a higher earning potential than most employees, fluctuating income from year to year appears more unstable to banks. You may be taking a below-market salary in exchange for equity ownership; however, most banks will look to income when qualifying you for a mortgage.

If you plan to purchase and finance a home soon, it would be wise to set yourself up to look more favorable from a bank’s perspective. You’ll want to show a stable income, clean business records, and strong personal credit over the last two years of your finances. That said, money trumps most other factors, so if you have a sizable down payment and cash reserves, you will have a far easier time getting qualified.

Start by getting pre-qualified, which gives you an idea of the loan size you will likely get approved for. To get an initial idea of your overall budget, consult a mortgage calculator. The next step is pre-approval, which is the bank’s conditional commitment to grant the mortgage to you.

Types of Mortgages

Many different types of mortgage loans exist. The most common type of conventional loan is a fixed-rate loan. You will make the same monthly payment, with the same interest rate, for the loan’s life. An adjustable-rate mortgage (ARM) typically has a lower interest rate than a fixed-rate loan for the first five to ten years, and then the rate changes based on an index and may go up over time.

Generally speaking, adjustable-rate mortgages are best for people who plan to be short-term homeowners, expect to see a notable increase in income within the next few years, or plan to pay off the loan quickly. Fixed-rate loans tend to be better for people who want certainty in their mortgage payments and plan to hold the property long-term.

Be sure to shop around for the best mortgage rather than sticking with your home bank; doing so can save you a significant amount of money.

Qualifying for a Mortgage

Mortgage loan underwriting is the process your lender uses to assess the risk of lending you money. The underwriter uses a set of criteria to approve or deny your mortgage.

If you fail to meet standard underwriting criteria, you have other options, such as asset depletion underwriting, which allows you to use your liquid assets to qualify. This is a good option for individuals with a decent amount of funds in the bank or investment accounts.

Tax and Cost Savings Opportunities

Many of the top tech hubs are also the most expensive places to own real estate. However, the tax benefits of owning real estate are often touted as some of the biggest advantages of buying versus renting.

The mortgage interest deduction is a tax deduction for the interest paid on the first $750,000 of your mortgage debt, which may reduce your taxable income and cut your tax bill by the amount you’ve paid in mortgage interest throughout the year.

There are also tax benefit opportunities upon selling your home. If you have a capital gain on the sale of your home and you satisfy certain criteria, you may be able to qualify for the Section 121 exclusion which allows you to exclude some gains from taxes when selling your home.

Risk Mitigation and Home Insurance

Homeownership comes with insurance and mitigation costs. Go into any deal with eyes wide open, knowing what it could really cost.

As your home is exposed to the elements, this will call for additional costs to mitigate risks such as shoring up the structure with the right roof, shutters, and other materials. You should know whether the home exists in a catastrophic (CAT) area — a location susceptible to floods, wildfires, earthquakes, or hurricanes.

Ownership Titling

Another factor to consider is how you will hold the title of the home. The way you hold title to real estate is how ownership is conveyed and transferred upon a property’s purchase or sale.

There are five main types of ownership titling — joint tenancy, tenancy in common, tenants by entirety, sole ownership, community property, and corporate or trust ownership — and each method has pros and cons from the perspective of tax, control, and asset protection.

The Bottom Line

A lot of work goes into becoming a homeowner and upholding the responsibilities that come with it, but in most cases, it’s well worth it.

This article is Part 3 of the Guide to Real Estate series. Click here to read Part 1 or Part 2.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Tech Founder’s Guide to Real Estate

Part 2: How Does a House or Condo Fit Into Your Financial Plan as a Founder?

This article was originally published on FORBES.COM on January 27, 2021. Written by Peyton Carr.

If you are considering buying a house or condo, there is a lot to consider. It’s about far more than finding a nice place to call home. A home is an investment — a major asset to add to your portfolio. So it’s important to explore how your home purchase will fit into your overall financial plan.

Financial and Investment Planning

Buying a home impacts your personal finances in significant ways, so it’s important to evaluate a home purchase from a financial planning perspective. While plans change, you’ll need to be of the mindset that this investment may require a five to ten-year commitment or more.

Transaction costs alone mean it could take years to break even on the purchase. Upfront expenses can add up quickly, such as your down payment, mansion tax (for New Yorkers), other taxes, legal fees, amongst others. In general, it takes homebuyers around five years to recoup this investment. (ref)

As a homeowner, you are tying up your personal cash flow in ways that renters don’t have to consider. You will be committing to a long-term mortgage. Maintenance and upkeep are sure to cut into your monthly budget, and you will need to keep emergency cash reserves to pay for repairs.

You will feel wealthier if you are not using the maximum mortgage you qualify for. Taking on a smaller mortgage gives you more cash flow, which offers more flexibility and freedom. The term “house rich” and “cash poor” comes from people who need to cut back on everyday expenses and travels in order to support their mortgage payments.

You also have to factor in that your home purchase might turn out to be a poor investment. The house could be an unexpected money pit with undisclosed problems. You may inadvertently buy at the height of the market. Neighborhood values could drop. Your income could decrease due to an unexpected rough patch in your business.

From a financial planning perspective, you need a strategy for managing various possibilities should the investment or life go awry. A general rule is to build in a healthy margin of safety. This can take the form of being conservative on your estimates of homeownership costs, taking less mortgage than your max qualification, not depending on the bonus portion of your income, and more.

Is Now a Good Time to Buy?

Whether the economy is up, down, or volatile, much of the trepidation about real estate has to do with timing. Nobody wants to get in at the wrong time or get caught in a real estate bubble. And of course, they want to know if real estate will go on sale.

Trying to time the real estate market may not matter in some cases. If you have the excess capital, your career and family size are relatively stable, and you know where you want to live for the next 5+ years, then there is a bias to purchase a home in most cases.

If, for example, you are renting a home for $6k/month, you would be spending close to $72k/yr in rent. Over five years, that would amount to $360k in rent expense. If you bought a $1.5mn home, even with a market downturn of 10-15%, you would still be breaking even. Anything better than that and you are coming out ahead.

While you can never time the market precisely, look carefully at the history of real estate performance for clues. In San Francisco, the tech bubble burst of 2000 saw values drop by 10%, and the financial crisis of 2008 triggered more than double those losses in some areas. However, historically, a full recovery has come within five to seven years in most cases. (ref) In New York City, the dot-com bubble stopped a real estate upswing, and the financial crisis saw prices in Manhattan drop by 12%, while boom years show steady and sustained increases. (ref)

While this data can’t predict the future, it does show you that riding out a real estate downmarket can take years. Go in prepared to own the home for at least seven years in case there is an unexpected real estate downturn in the near future.

Understanding the real estate market cycle can help you gauge where you sit in the cycle and utilize appropriate smart strategies. During the expansion phase, where growth happens, you may want to get in early and ride the wave. When the market starts to stabilize during equilibrium, it may be a good time to sell, particularly if your home has increased in value. When the market is in decline, this could be a good time to buy a property at a discount. During the absorption phase, when prices stop falling, you can take advantage of good deals in solid neighborhoods. (ref)

Looking carefully into exactly where to buy also makes a difference. Hot “up and coming” neighborhoods may fizzle out during a bust or be slower to recover on the other end, whereas established, central neighborhoods may be affected to a lesser degree and rebound more quickly. Established suburban neighborhoods with aging demographics can be vulnerable to market corrections as well, while strong school districts tend to be more resilient. In short, ask around and get a true feel for where you are buying before committing. Though identifying the right neighborhoods is more challenging to pin down than it was in the past, the importance of “location, location, location” continues to ring true.

We always recommend partnering with a financial advisor that can help create a plan that includes your house, your portfolio, and your other financial needs. Managing your finances is an art of balancing a portfolio against short and long-term goals while accounting for uncertainty and risk. A comprehensive approach can be beneficial, offering a clearer picture of whether buying or renting is right for you.

This article is Part 2 of the Guide to Real Estate series. Read Part 1 or Part 3.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Tech Founder’s Guide to Real Estate

Part 1: Rent vs Buy Real Estate: How to Decide Which is Right for You

This article was originally published on FORBES.COM on January 6, 2021. Written by Peyton Carr.

When speaking with my clients about financial planning, real estate always comes up early in the conversation. Should I upgrade to a larger house? Should I get more land? Should I leave New York? Is San Francisco too expensive?

This four-part series answers the questions you may have, addresses common myths and concerns, provides critical insights about challenges and opportunities in real estate, and uncomplicates the process. I’ll walk you through a framework to think about how to evaluate a home purchase from a financial planning perspective, the nuts and bolts of the homebuying process, and ways to leverage real estate as an asset.

The company founders I advise are often coming into significant wealth, sometimes for the first time in their life. Suddenly, they can afford a house or condo — a big one, maybe even the home of their dreams. Past generations would’ve jumped all over this opportunity in a heartbeat. Dumping your first hard-earned windfall into your first home was just something previous generations did, without questioning it.

But is buying real estate still a smart move to make? And where should I buy if so?

The answer depends on a number of factors and is something you should not take lightly.

Rent vs. Buy

The decision to rent or buy is one that’s rife with both emotional and practical considerations. On the one hand, most of us have been raised to believe that owning a home of your own is a measure of financial success. It comes part and parcel with achieving the American Dream. So even the most independent thinkers among us are susceptible to the traditional pull of ownership.

On the other hand, the analytical thinking that got you this far in your career knows better than to give in to the conventional wisdom of property ownership. You know that alternatives exist for building wealth. Maybe you’ve noticed some of your peers forgo the real estate route and wonder if there might be something to this trend. Are they simply taking a cavalier YOLO approach, bucking the traditional path of ownership in fear of settling down? Or do they know something you don’t about the risks of getting into real estate?

Perhaps it’s a little of each. If your career is stable and family size won’t change much, buying in a particular locale can be a better choice than renting. However, tying yourself to one place by buying into a particular market can be a hindrance if you want to retain the option to easily move for a different opportunity or if you may need a larger home for a bigger family in the coming years. What if you can’t sell the property or you’re in a down market and lose money on the property? This would be the risk you take.

When you rent, you’re free to go where you please — worst-case scenario, you’re out of pocket for a few month’s rent to break your lease. If your family grows, you can move down the hallway for an extra bedroom. If the neighborhood loses its appeal, you can move across town next year without taking a big hit. Plus, you don’t have to worry about maintenance or upkeep.

Maybe you consider yourself a maverick or disruptor, and that part of your personality is urging you to buck tradition and avoid any anchors at all costs. I say honor who you are, but not at the cost of waking up five to ten years from now having burned through $500k-$1mn on rent that could’ve been directed at building your equity in a home, all because you bought into the idea that homeownership is old school. Buying real estate might not be the right choice for you right now, but go into the decision with the right data and facts.

Ownership comes with other costs and risks that I will address in the next article in this four-part series, but renting also comes with its fair share of drawbacks. Most significantly, rent tends always to increase, and it can increase dramatically in hot markets, whereas mortgage payments can be fixed. And to a certain extent, the old adage is true — when you rent, you’re making your landlord rich — at least relatively speaking. Instead of depositing funds into an asset, you are giving money away that you will never see again.

Use an online ‘rent versus buy’ calculator to help determine where you get the most value depending on your situation.

Deciding whether to rent or buy is not an easy decision; you can lose or gain either way. Before moving forward, think through your 5-10 year plan and do your due diligence.

The next article in this series will dive into the dynamics of the real estate market, break down the costs, benefits, and risks associated with homeownership in the context of your overall financial plan, explore the ins and outs of real estate financing, and clarify how to incisively navigate the process of buying and holding property.

The Bottom Line

Real estate can be an asset or a liability; it comes with considerable pros and cons as well as tremendous costs and benefits.

As a founder, your ultimate goal considering a real estate purchase is to make a well-informed decision based on quantitative data while factoring in qualitative measures. Knowing what you have to gain or lose makes all the difference, and doing your due diligence will ensure you are making a sound decision.

This article is Part 1 of the Guide to Real Estate series. Read Part 2.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.