Page 68 - amm1

Financial advisory
Continued from page 67
a risk – but the potential reward makes this risk worth it. I didn’t start my article this way to give stockbrokers a hard time or to convince you to buy real estate investments. As you are reading a publication that caters to landlords, I know that I am preaching to the choir. Although there are many risks in buying real estate, I wanted to focus on a few specific ones this month:
INCOME RISK
Income risk refers to the risk we are taking that our income will continue. In the case of Net Leased Properties – will the tenant keep paying rent? If the tenant’s lease expires, will they renew? If not, what are our prospects for finding another tenant to move in and keep the income coming? We can address these risks by sticking to tenants with strong credit and long-term leases. Additionally, we will want to buy in robust metropolitan areas to make re-leasing the property as easy as possible: should we ever need to do that.
In apartments, will we be able to keep occupancy and rent levels high enough that we see a profit every month after the bills are paid? Will unexpected expenses impact our future income? A careful analysis of the property and its surrounding market is needed here. After a thorough inspection of the improvements are done, future costs of any capital expenditures (large maintenance jobs) need to be estimated. My managers will typically create a reserve fund to pay these costs over the ownership period.
INFLATION/APPRECIATION RISK
If your money isn’t growing, it is shrinking – thanks to the power of inflation. I’ve never been a big fan of bonds because, when I buy a 10-year bond I’ll pay $1,000 (If I buy at par.) When the bond matures,
I get my $1,000 back – but it is not worth as much as it was when I paid it 10 years before. The income I receive from the bond needs to make up for this difference. If a California 10-year municipal bond has a yield to maturity of 3%, will that be enough to cover inflation and provide a profit for us? I don’t think so.
While we want to be confident that the income from our properties will rise to beat inflation, we want the same for our property values. I buy real estate for income and growth – and I expect to see both from my properties. How can we give ourselves the best chance to achieve both? For Net Leased properties, we need to take a look at the rent increases that the lease contains. If there aren’t any rent increases, we likely don’t have much appreciation potential. In apartments, we can stay ahead of inflation by purchasing in growing metropolitan areas. Rising demand for housing, a growing population and growing employment could continue to create growing rents and growing value for us.
LEVERAGE RISK – TO BORROW OR NOT TO BORROW?
When I borrow money to buy a property, my #1 risk is that the property’s income decreases, I cannot pay the mortgage, and the bank takes my property from me. So any property that is bought with a loan certainly carries more risk than one without leverage. There are, however, significant benefits to using leverage that many of my investors find makes it worth this risk.
The largest benefit is depreciation: When I sell a property that was fully paid off, I have likely used all my depreciation, so I get zero tax benefits every year. Buying a property with leverage, through a
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68 JUNE 2021 - APARTMENT MANAGEMENT MAGAZINE AMM1/6
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