Portfolio diversification is a basic tenet of any investment strategy. Yet, some investors stay unilaterally-focused, choosing only to diversify the components that make up their stock portfolio. There is no shortage of ways to diversify a stock portfolio. Investors can choose to divest across sectors that generally move oppositional to one another, or by tactically hedging inflation, or whatever strategy du jour is preferred.
And while these clever financial maneuvers are valid, and often successful, an investor invested entirely in the stock market lives and dies by the movement of the stock market – bull or bear, good or bad.
But what would happen if the stock market started moving wildly, reacting more to the emotions of consumers than reasonable economic modeling forecasts, experienced pundits, and proven metrics?
The short answer for investors is to sit up and take notice of these dangerous signs of instability.
Instability in any market, at a bare minimum, is a red flag – something that should not be ignored in terms of your portfolio. Instability creates a great opportunity to
- Revisit your investment objectives.
- See if your risk tolerance level has been altered by the uncertain time and events of 2020.
Based on the results of the above considerations, one could begin to reinvest – transferring investments from a worrisome stock market to another investment that offers proven stability over time – by way of real estate.
The presence of instability in the stock market today is the result of the uncertain times brought on by the coronavirus’ spread across the planet. For those investors seeking the safe haven of other investments (as the stock market tumbles and rises erratically) – with a health pandemic painted as its backdrop, consider a different type of investment – an asset of another class – a rental income property.
Historical trends reveal that the real estate market remains relatively unimpacted by the inevitable volatility characterized by the stock market.
This is the stability real estate offers investors in troubled and uncertain economic times.
The 5 Benefits of Investing Right Now
#1 – With the COVID-19 pandemic upending everything and anything in its path, no one is quite certain if the current economy has hit a recession skid, although many economics gurus speculate it has. Housing and economic data have taken borrowers (and the entire industry/country/world) on a neck-craning ride, with data and news revealing contradictory data, often simultaneously, leaving economic pundits scratching their heads looking for answers to questions never before posed.
However, if a recession has begun to topple the economy, history teaches us that home prices have actually risen in the last three of five recessions. In this regard, it is advantageous to get as early a jump on the changing market in the recession if you are to be able to take advantage of likely price movement upwards.
#2 – Another great benefit for investing in rental property now is that, unlike stock investing – where it is irresponsible for an investor to jump into an investment using borrowed capital (rather than their own funds), real estate allows (and some would argue that real estate encourages) investors to take advantage of the concept of leveraging – with abundant financing available at historic interest rate lows!
It is essential to recognize that an investor purchasing a rental property can take advantage of this financial tool known as leveraging, without taking on an overabundance or unnecessary risk. This managed risk is a complete diversion from the strategic stock management views that generally frowns upon this investment tactic that is considered reckless and even negligent, depending on who you ask.
To help clarify the power of leveraging, here is a simple example–
Scenario One – You invest in a property that is valued at $100,000. In one year, the property appreciates by 4%, which would translate to $4,000. By owning the property, you have earned a 4% return on your $100,000 investment – the math is as follows – $4,000/$100,000 = 4%.
Scenario Two – You invest in a property that is valued at $400,000 with a $100,000 down payment and obtains financing (a term closely related to the concept of leveraging) for the balance of $300,000.
As in Scenario One, the property in Scenario Two appreciates at a rate of 4% during the first year of ownership. This given appreciation translates to an increase in the property’s value of $16,000 – the math is as follows – 4% of $400,000 (.04*400,000) = $16,000.
Here is where leverage puts the pedal to the medal in terms of optimizing one’s return on their investment. In the first scenario – where there was no leveraging present in the investment strategy, the $100,000 investment earned the investor a 4% return.
In Scenario Two, however, the investor’s $100,000 investment (while returning the same appreciation rate of 4% on real estate owned for the same amount of time), appreciated in value in an amount equal to $16,000 – four times the return received in Scenario One using the same investment amount.
While this example is admittedly a bit simplistic, it highlights just how important leveraging is to an investor seeking to maximize their return.
As a heads-up, it is noted that rental income properties typically require larger down payments by lenders than those mortgages used to finance an individual’s primary residence. This additional required down payment by the lender is due to the additional risk created. This elevated risk is a direct result of the fact that the owner of rental property is generally considered a riskier lending scenario, than when lending to the owner of a primary residence.
Think about it – If you were the owner of both a primary residence and a rental income property – at the same time, and on any given month, you could only afford to pay one of those monthly payments, which mortgage payment would you choose to make?
Clearly, the most likely of answers is that the investor would make the payment that is applied towards the balance due on the primary residence mortgage balance – on the property that protects the investor and the investor’s family.
Would anyone believe that an investor would forsake their own family and their family’s safety and security by deciding to pay the monthly mortgage payment due on the rental property instead?
Note – If that were to happen, there would truly have to be extenuating circumstances to justify what is a difficult decision to justify.
This logic and reasoning is the exact reason Fannie Mae, Freddie Mac, and the other mortgage giants require larger down payments for the purchase of a rental property. If a mortgage for a rental property purchase allows for a smaller down payment, it is highly likely that the interest rate for this mortgage product will be higher to reflect the additional risk the bank is absorbing by lending to an investor rather than an owner-occupied buyer.
#3 – On July 16, 2020, Freddie Mac reported a new 30-year fixed-rate mortgage interest rate all-time low– for the first time, which fell below 3% to 2.98%. This newly-recorded mortgage interest rate was the seventh day of record lows that had been recorded by Freddie Mac since March.
Let’s put some context and see how much savings this historic drop in interest rates will translate to. Consider the following scenarios which delineate how mortgage payments compare when priced at 5% (which historically is still a remarkably low-interest rate), against today’s mortgage historically low-interest rates of 3%.
|Monthly Payment at 5%
|Monthly Payment at 3%
|Yearly Savings of Interest
A 21%+ Savings
The interest saved over the life (which is money in that stays in the borrower’s pocket) is $12,218. The math is as follows 0
- Total interest paid for the life at 5% = $289,884.
- Total interest paid for the life at 3% = $277,666.
#4 – One of the primary reasons to decide to invest in rental properties is that the real estate is likely to appreciate value, especially if the investor chooses to hold the property for a reasonable amount of time.
However, a rental property is chosen as an investment is also to generate passive income each month – by paying tenants. The rental income by the rental property generated will hopefully pay for the costs of maintaining the property and put some profits into the investor’s pocket.
As logic dictates, a positive rental cash flow happens when the rental income on the property exceeds the property’s operating costs.
Many first-time rental property investors often choose to follow a more conservative approach by choosing to invest in a multi-family dwelling, in which the owner will live in one of the units. This type of setup is often preferred by those new to real estate rental investing because:
- The lender is likely to provide more financing because the multi-family property is being purchased as an owner-occupied primary residence.
- The owner lives on the property, which allows the owner to keep an eye on things at all times.
- The rent from the units – other than the owner’s unit – will help pay the costs of maintaining the multi-family property.
#5 – The Tax Advantages of Owning Real Estate
The IRS allows for the deduction of the required, but ordinary expenses for the management and conservation of the rental real property. However, the costs to improve a rental property are generally not deductible, except when the restoration is to create a different or new use.
According to the IRS, the following deductions are available to owners of a rental property. These rental expenses include –
- Mortgage Interest
- Real Estate Taxes
- Property Insurance
- Operating Expense, and
- Depreciation – Depreciation is an acceptable method used to allocate a percentage of an asset’s costs/improvements that were used to generate some form of income. There are several applicable ways to depreciate an asset; however, investors are encouraged to speak with an accounting professional or Certified Public Accountant (CPA) to determine which of the depreciation methods would be most beneficial.
The IRS advises rental property owners that some or all of the expenses related to the improvement of the rental property are recoverable by reporting depreciation – non-cash expenses – each year, using IRS Form 4562. A depreciable expense is charged against rental income, which then lowers the amount of taxes due in a given tax year by the property’s owner.
Note, though, that only a certain pre-defined percentage of the depreciated value may be deducted in any given year.
Welcome to the new world of real estate. Welcome to a real estate market defined by uncertainty.
Investors – looking for diversification and safety – are encouraged to look outside the box, to investments that be less familiar but great tools to help diversity a portfolio to withstand the cyclical nature of real estate, the stock market, and the economy, in general.
The decision to make a move during the COVID-19 pandemic may the next great real estate buying opportunity – if an investor chooses to buy prudently, with appropriate due diligence.