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Every investor hears the advice to diversify his portfolio, but few seem to follow it. There’s no better way to diversify a portfolio than to buy real estate. Consider the past five years of stock market performance compared to the growth of the real estate market: While the stock market has been relatively flat, the average property in Washington, D.C., for example, has been appreciating at a rate of more than 10 percent per year. That’s a fact that not even the doomsayers who claim the housing market is a bubble waiting to burst can dispute. As a Realtor in the District, I’ve been hearing the skeptics lament the rising values of real estate for more than three years. But real estate, like every market, is driven by supply and demand. Supply continues to remain low in the District. Demand, in contrast, is unwaveringly strong. Even if the housing market takes a tumble, investors are still better off in real estate than in the stock market. Real estate is a physical asset. The property isn’t going to disappear one day in an Enron-style accounting scandal. More important, if the property delivers positive cash flow, it doesn’t matter what happens to the appreciation rate. There will still be income generated from the property, and that is the secret benefit of real estate: the ability to leverage an investment. Generally speaking, lenders require investors to put a minimum of 20 percent down on any investment property. With $40,000, for example, an investor can purchase a $200,000 property. Even if the market slowed to a so-called normal appreciation rate of just 3 percent, that $200,000 property would have increased $6,000 in value in one year. That amounts to a 15 percent return on the initial $40,000 investment � and that doesn’t even take into account whether the property has a positive cash flow. ALL ABOUT THE CASH FLOW A positive cash flow occurs when the monthly rent generated by the property is greater than the total monthly costs associated with owning it (i.e., the amount paid for the principle, interest, taxes, and insurance). Properties with positive cash flow allow investors to use the rent generated to pay off their mortgage on the property. It is not uncommon for investors to pay off their mortgage in less than 20 years solely by reinvesting the rent received into principle reductions. Admittedly, finding a property with positive cash flow is not easy in a strong seller’s market, where acquiring real estate often involves competing against multiple offers and paying significantly above the asking price. Real estate is unique among investments because the government allows landlords to depreciate much of the cost of the purchase over 27.5 years. That means that each year the landlord can take a “paper loss” of �7.5 of the majority of the property’s value over that period. (An accountant can explain what portion of this depreciation can be used to offset other passive gains.) One of the least-known benefits of real estate is that it is taxed at a different rate than normal income. If a real estate investment property is held for more than 12 months and then sold, any profits from the sale would be considered capital gains and taxed at 15 percent. By contrast, consider a married couple who, filing jointly, earn more than $117,250. They are taxed at 28 percent for normal income. Real estate investors can also participate in a little-known loophole in the tax code known as a “Section 1031 Tax Deferred Exchange.” Under this loophole, more commonly known as the Starker Exchange (so-called because of the court case that established its legality), an individual who owns real estate property as an investment can sell it and not pay any tax on the sale of that property at the time it is sold � provided that the profit from the sale is used to purchase another real estate investment. The practical application of this is most interesting to those who are approaching retirement. For example, let’s assume that a couple purchased small investment condos in the District several years ago. As they approach retirement, they decide they want to relocate to Florida. They sell their D.C. condos and “Starker Exchange” them for a house in Florida that they eventually plan to live in upon retirement but will initially rent out. Under a Starker Exchange, all of the tax on the gain from the sale of the D.C. condos is deferred until the couple sells the new property in Florida. But here’s the best part: They don’t have to sell the property in Florida, and when they do they can pay a reduced tax rate as long as they abide by certain rules. The key to this loophole is that they must rent out their Florida property for a minimum of five years, and then live in it as their primary residence for at least two years. If they meet those modest requirements, when they do decide to sell their Florida residence, they can take the first $500,000 of capital gains ($250,000 per individual) from that sale and not pay any tax on it at all. GETTING STARTED What should potential investors do to get started? Obviously, paying cash is the easiest and most secure way of purchasing an investment property. But be aware that when writing a contract to purchase a property with cash, sellers often require “proof of funds” (i.e., bank statements, brokerage statements, or other documentation demonstrating an investor has the funds to buy the home). Not surprisingly, most investors prefer to obtain a mortgage. But mortgages on investment properties are frequently offered at higher interest rates and require a larger down payment than mortgages for primary residences. Other financing options to consider are a home equity line of credit on an investor’s primary residence. Frequently, first-time investors have large equity stakes in their primary residence. Home equity lines of credit are frequently available at a lower interest rate than an investor mortgage. They also allow the investor to buy the investment property with no cash down and to leverage the entire purchase. Another option is to use stock holdings as collateral for a loan. This again will give the investor the option to buy a property with no cash invested in the purchase and still keep his or her stocks in the market. Once the money is sorted out, it’s time to find a good Realtor. Make sure you find an agent who has experience handling investment properties and who works in the neighborhoods in which you are interested. A good Realtor will know what rent a particular property is likely to support, what the return on investment for the property will be, as well as be able to smoothly handle all the elements of the transaction from successfully presenting an offer to the final day of settlement. Be sure to interview several Realtors before hiring one to be your buyer’s agent. Ask them whether they have attended additional training for investment properties. If they have, they will have certain “designations” after their name, signifying their additional training. In particular, look for an agent who is a GRI (Graduate, Realtor Institute), a CRS (Certified Residential Specialist), or a CCIM (Certified Commercial Investment Member). Finding the right property is going to be your greatest challenge. Currently, Washington and the surrounding areas are experiencing a very strong seller’s market. With few properties to choose from, buyers sometimes select a property as an investment that really isn’t a good choice solely because there is nothing else to buy. In this fast-appreciating market, it’s easy to get carried away and think the good times will never stop. But the most important factor in selecting a property should be whether it has a positive cash flow. Cash flow is key because when the real estate market eventually declines (and it will at some point) you don’t want to be caught holding a property that not only doesn’t pay for itself but also may be worth less than its cost. Investors should also search for properties where there is a strong demand for rental housing � such as neighborhoods bordering universities. Other desirable areas include those close to employment centers and near public transportation. HOT SPOTS In the District, neighborhoods such as Foggy Bottom, the West End, Dupont Circle, and Capitol Hill are excellent investment choices. In Virginia, Rosslyn, Ballston, and the area near Old Town Alexandria are equally viable options. In Maryland, Bethesda and College Park can work as well. These are just a few neighborhoods to consider. Ironically, the biggest fear most would-be investors have is that of the source of their potential revenue: tenants. No one wants to be stuck with a tenant who never pays the rent or destroys the property, and no one wants to get calls at midnight about broken toilets. That’s what property managers are for. A Realtor can supply the names of several property management firms. Finally, consider a jurisdiction’s friendliness to investors. The District, for example, has strong tenants’ rights laws. Virginia, by contrast, is known to be more landlord-friendly. Maryland falls in between, being the most balanced in terms of laws affecting landlords and tenants. Bottom line, there’s never a bad time to invest in real estate as long as it is approached in a level-headed way. Not only is shopping for real estate more fun than analyzing a stock prospectus, but also real estate investments enjoy lower taxes, greater stability, and are a better hedge against inflation than a stock portfolio. Joseph Himali, GRI, CRS, is the principal broker and founder of Best Address Real Estate, an independent real estate brokerage firm based in Georgetown. He currently serves on the board of directors of the Greater Capital Area Association of Realtors. Himali can be reached online at [email protected].

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