Topic 17.3: Advantages of Real Estate Investments

Learning Objective

After successfully completing this topic, you will be able to identify the advantages of investing in real estate.

Overview

Investors tend to search out investments that provide them with the highest returns, based on a given risk level. There are many advantages to investing in real estate including
• rate of return,
• tax advantages,
• hedge against inflation,
• leverage, and
• equity build up.

Rate of Return

Historically, real estate investments have produced higher rates of return than many other types of investments. According to the S&P 500 Index, the average return on investment in the US real estate market is 8.6%. The average return on investment differs based on property investment strategies. Residential real estate has an average ROI of 10.6%, commercial real estate has an average return on investment of 9.5%, and REITs have an average return of 11.8%. Tax advantages and leverage are important factors in rates of return.

Tax Advantages

Real estate improvements offer tax deductions for depreciation.

Real estate investment is attractive because of tax deductions available to investors. Depreciation deductions are the difference in profitability to many investment professionals. Very often, a property that produces a positive cash flow also shelters the investor from taxes on these profits. Other tax incentives include property exchanges and installment sales.

Hedge Against Inflation

Historically, real estate has been a very good hedge against inflation. In recent years, however, inflation has been insignificant, so this advantage is not as important in today’s climate. Should inflationary pressures return, however, real estate investments will help preserve values.

Leverage 

Leverage is one of the most important factors that make real estate investments more attractive than stock market returns. A property investor who is buying a small apartment property may be able to borrow up to 75% of the property’s value. If you assume that the interest rate on the mortgage is 5%, and the capitalization rate on the property is 8%, there is positive leverage, so the investor’s return on investment may increase significantly.

Equity Build Up

“A person who borrows $1 million on an apartment property with a 15-year mortgage, will be worth at least $1 million when the last payment is made.” This is an old expression that reflects the notion that when a property makes more than enough to make the mortgage payments, the equity buildup is an additional return.