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Real Estate: A Hands-On Approach to Investing

Mary-Jo Kranacher, MBA, CPA/CFF, CFE

Many individual investors were attracted to the stock market in the late 1980s to mid-1990s to participate in the large gains the market was experiencing at that time. But shortly thereafter, well-publicized corporate scandals involving securities fraud, financial statement fraud, outrageous executive compensation packages, and stock price manipulation frightened away many investors from the financial markets. Stock price volatility in recent years has only increased investors’ hesitation about placing their money in the markets.

Finding suitable alternatives to fund life's big expenses—college tuition costs, weddings, retirement—has been challenging for investors. Savings and money market accounts offer little return on investment, and whatever pittance is earned is further reduced by income taxes. Historically, real estate has been the investment of choice for many because of good long-term appreciation, valuable tax deductions, and the security that comes with owning real property. The potential for earning rental income to defray the cost of monthly mortgage payments, property taxes, and insurance provides an additional incentive.

Historically, real estate has been the investment of choice for many because of good long-term appreciation, valuable tax deductions, and the security that comes with owning real property.

Challenges

Due to the demanding nature of property management, however, buying real estate for investment may not be the right choice for everyone. Anyone who has ever received a phone call from a tenant about a plumbing or electrical emergency at an inopportune time, such as late at night or while on vacation, can attest that being a landlord may seem at times to be more trouble than it's worth. Hiring a professional property manager can alleviate some of the responsibilities, but it also cuts into the profits. Real estate investment trusts (REIT) have similarly freed owners from personally handling these responsibilities but, in return, introduce the same disadvantages as investing in other publicly traded securities.

Property foreclosures—of which there were 102,000 across the country in September alone—have provided opportunities for investors. For example, these foreclosures have created a pool of potential renters. But the fallout from the large number of foreclosures has made financing more difficult for the average investor. Lending institutions are requiring more documentation from buyers to verify financial stability, establishing lower loan-to-value ratios, and estimating very conservative property appraisals for mortgage applications. The days of little or no money down with no income or asset verification are over; lenders want to know that buyers have a stake in the property and the means to pay back the loans.

Prompted by the continuing news of foreclosures and the high rate of unemployment, fears persist that real estate prices may not yet have hit bottom, although, based on historical experience, it seems likely that property values will rebound in the future.

The Upside

One of the primary rules of invest-ing—buy low, sell high—will serve investors well with appreciating property values as employment and housing slowly recover. However, keeping more of the capital gains requires some strategic planning. One tax strategy that has gained in popularity over the last decade is the 1031 exchange, named for the section of the Internal Revenue Code that refers to like-kind exchanges and allows taxpayers to defer capital gains taxes that would otherwise be due upon the transfer of the property. For those who are ready to cash in their chips in the real estate game, holding a note on the property for the purchaser is another option that can create an additional income stream for the seller.

There's no doubt that a sluggish real estate market presents some very specific challenges and opportunities—opportunities that a rising market doesn't have. But if investors are well positioned in the real estate market whenever it comes out of its free fall, there will be considerable long-term potential for profit.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA/CFF, CFE. Editor-in-Chief, ACFE Endowed Professor. Fraud Examination, York College, The City University of New York (CUNY), mkranacher@nysscpa.org.

 
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