As home prices soar, many are looking at real estate as a bigger part of their retirement income schemes. According to the Office of Federal Housing Enterprise Oversight, home prices increased 11.2% from the 4th quarter of 2003 to the 4th quarter of 2004…the first time we have seen annual double-digit growth in more than 25 years.

More telling on the investment scene is the fact that 23% of all homes purchased last year were investment properties, according to the National Association of Realtors.

Investors find the idea of collecting a rent check from property that is increasing in value a compelling reason to add this asset class to their retirement income plan.

Before answering the “Siren’s Song” for real estate investing, I suggest doing the math and examining all financial aspects of investing in income property.

An excellent place to start is an investment real estate spreadsheet found at
www.mortgage-investments.com [no longer available]. On their site find the “10-year Investment real estate Net Operating Income and Profit on Sale” spreadsheet. Input purchase price, down-payment, mortgage information, rental income and the several other assumptions regarding appreciation, expenses, vacancy rates, etc.

The calculator will give you before and after tax cash flows, returns on equity over ten years, and a wealth of other financial information you will need to evaluate your potential investment. Play “what if” by varying inputs to see what happens if rents go up or down, property values change or tax rates vary.

Of greater importance…this calculator will help the investor understand the concept of “capitalization rate,” known as the return a property would provide a hypothetical all-cash buyer. For example a $400,000 property generating $20,000 in cash flow after operating expenses has a 5% cap rate. This same property, priced at $600,000 would have a 3% cap rate. The higher the cap rate, the better the return potential.

The inflated real estate markets have made it difficult to find properties that provide a positive cash flow and have raised the risk levels involved in investment real estate by lowering the cap rates. Since all-cash purchases are rare, most properties are purchased with mortgages of 50% to 75%, making it likely the investor is looking at a negative cash flow. Further, the tax benefits of owning investment real estate are generally too small to make up the out of pocket negative cash flow.

Therefore, the investor must plan to carry the negative cash flow, have money set aside to cover contingencies such as vacancies and repairs, all in anticipation of rentals increasing to cover the outlays. The real carrot of course, comes with potential property appreciation.

This appreciation means little until the property is sold. Here the calculator does an excellent job of comparing after tax investment returns resulting from a sale. Gains for properties held longer than one year are taxed at advantageous capital gains tax rates.

It also helps to have a working knowledge of how income from real estate is taxed. Rents received are considered taxable income in the year received. Expenses of renting property can be deducted from gross rental income in the year expenses were paid. Expenses or services provided by a tenant are considered rents.

Passive investors who do not actively participate in the management of the property cannot write off rental losses in the year of the loss. Losses can accumulate year to year until there is enough rental income to offset the losses or the property is sold. Unused losses can be added to the cost basis to reduce the gain.

An investor who actively participates in the management of the property and has an adjusted gross income of less than $100,000 can write off up to $25,000 in rental losses. This amount is proportionately phased out between $100,000 and $150,000. Income levels above that are taxed as passive investors.