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Personal Financial Planning — Part 5: Managing Investments · 6 of 10
Personal Financial Planning — Part 5: Managing Investments
finance HIGH

Real Estate & REITs

Personal Financial Planning — Part 5: Managing Investments Gitman, Joehnk, and Billingsley
real-estate REITs leverage depreciation tax-shelter cap-rate

Key Principle

Real estate adds portfolio diversification (less correlated with stocks), offers tax advantages through depreciation, and magnifies returns through leverage. However, direct ownership demands active management, leverage can cause bankruptcy when overused, and raw land is pure speculation. Most investors are better served by REITs than direct property ownership.

Why This Matters

The leverage effect is dramatic but symmetric: the same $100,000 property yields 9.36% ROI with all-cash purchase vs. 28.80% with 75% borrowing — but if earnings don't cover interest, the investor faces default. Real estate depreciation shelters income from taxes with no cash outflow, but passive activity rules limit deductions to passive income (with a $25,000 active-participation exception below $100K AGI). (pp. 462-463)

Good Examples

Leverage magnification. All-cash: $100K property, $9,360 annual profit = 9.36% ROI. With 75% leverage ($25K equity): same profit minus $6,000 interest = $3,360 / $25K = 28.80% ROI. (p. 462)

REIT evaluation. Four metrics: (1) AFFO (adjusted funds from operations), (2) NAV per share, (3) loan-to-value ratio (lower = safer), (4) property holdings quality. (p. 465)

Cap rate valuation. Cap rate = NOI / Property value. Use to compare income properties; higher cap rate = higher yield but typically higher risk. (p. 464)

Counterpoints

Leverage cuts both ways. If earnings fall below interest costs, the investor faces bankruptcy. "Excessive leverage has driven many investors into bankruptcy." (p. 463)

Raw land is speculation, not investment. No income stream, relies on predicting future demand. (p. 463)

Direct ownership requires active management — leasing, maintenance, repairs, tenant issues. Budget your time, not just capital. (p. 463)

Key Quotes

"Hire a tax consultant before buying investment real estate — depreciation and tax rules are complex enough to require professional evaluation." (p. 462)

Rules of Thumb

  • Use REITs for real estate exposure unless you want active management responsibilities (p. 464)
  • Evaluate macro factors before buying: economy, interest rates, supply/demand, regional conditions (p. 461)
  • Leverage only when expected profit clearly exceeds borrowing cost (p. 462)
  • Hold depreciation-generating properties in taxable accounts (not IRAs) to use the shelter (p. 462)
  • Passive activity losses limited to passive income; $25K exception below $100K AGI (p. 462)
  • Three REIT types: equity (own properties), mortgage (own loans), hybrid (both) (p. 464)
  • Prefer equity REITs for appreciation; mortgage REITs for income (p. 464)

Related References