Young Investor's Guide to Real Estate

According to the National Association of Realtors, 39 percent of all homes bought last year where purchased by people aged 18 to 34.  It's widely understood that homeownership is the single most important element for building a sound financial foundation, so the proliferation of young buyers is an indication that more Americans taking responsibility for their financial future at an early age. 

Most of these homes were primary residences, but young buyers are making inroads into the world of real estate investing as well.  Real estate investment clubs are popping up at colleges around the country, anecdotal evidence that more and more young people are turning to investment properties as part of their financial strategy.  The most recent U.S. Census data on the subject shows that more than investors under 34 own over 700,000 units of single- and multi-family housing in the United States.   Generation X is becoming increasingly doubtful of the long-term viability of Social Security, and is less likely to expect corporate America to provide a pension.  This is an ideal environment for spawning aspiring young real estate moguls.
 
Time and leverage are your friends
Starting early is important.  Time and compound growth form a combination that can turn investing discipline into long-term financial security.  What an investor does in the early years can have a dramatic impact on the end result.  Consider the example of an investor who commits to investing $200 per month.  If she starts at the age of 25 this will produce a nest egg of about $400,000 by the time she hits 55 years old - assuming an 8 percent return and a 3 percent inflation rate.  If that same investor waited until the age of 35 to get started then the end total would only grow to about half that size.
 
The difference is even more dramatic when real estate is used as the investment vehicle.  This is because real estate investments offer an important benefit: leverage
Leverage multiplies the impact of your investment dollars.  Compare putting $20,000 in a diversified portfolio of stocks to taking that same $20,000 and using it to put a 20 percent down payment on a $100,000 rental property.  The real estate investment has two important advantages.

• The investor benefits from the growth of a larger asset - a $100,000 investment property as opposed to a $20,000 stock portfolio, and
  
• over the ten year period more than $11,000 of the mortgage principal will be paid down using the tenant's rent payments, decreasing the amount that the investor owes to the bank at the end of the period. 

If the stock portfolio grows at 8 percent per year it will be worth  around $43,000 in ten years.  Not bad.  However, the real estate investment will outperform the stock market investment even if the value of the property grows at a slower rate, say 4%. 

The figure below compares the two options:

The stock portfolio creates around $23k in capital gains over ten years at a return of 9%.  The real estate investment, on the other hand, generates around $60k in equity, even though the property only appreciated at 4% per annum.  

The Down Payment Obstacle
The largest single obstacle staring most young investors in the face is coming up with the down payment. Even disciplined savers may need years to squirrel away $20,000 in cash while trying to make ends meet on a starting salary. The banks are aware of this quandary, and increasingly they're offering mortgage options that require a lower down payment.  These rates can be a low as 5% - or even lower under certain circumstances. 

Lowering (or eliminating) the down payment increases your leverage, which also can increase the investment's return. But be aware of two key risks:   

• It will be more difficult for the property to generate positive cashflow on a month-to-month basis.  Not only does the investor have to finance a higher principal amount, but the bank often will charge a higher interest rate due to the perceived increase in the risk of the loan. Example: An investor who buys a $100,000 by putting 20 percent down and financing the rest w/ a 30 year fixed mortgage at 7% will pay $532 per month in interest and principal.  Contrast that with an investor who buys the same property with a zero-down 100% mortgage at 8%, resulting in a monthly payment of $734.  That's over $200 extra per month - and it has to come from somewhere. 
  
• A downturn in the market can leave the investor with negative equity in the property - meaning the investor owes more on the mortgage than the property is worth. This is a real estate investor's worst case scenario.

Investors who keep an open mind when it comes to financing will increase the chance of finding a mortgage that suits their needs. But be aware that even established, reputable banks often emphasize the benefits of creative mortgage options while downplaying the risks.  Buyer beware. 

Avoid the get-rich-quick schemes
Taking the plunge isn't easy.  The market can be a mysterious and intimidating place for young real estate investors trying to close their first deal.  But be wary of the advice that you find online and on late night television - much of it is designed use the lure of quick and easy profits to sell expensive courses and seminars.   The search term "no money down millionaire" gets over four million hits on Google, and most of them are from companies you probably want to stay away from.  When you're considering any sales pitch ask yourself: does this company offer knowledge that is designed to help me make smarter decisions, or are they trying to sell me promises of an affluent lifestyle?  The industry is full of unethical characters selling "secret techniques to generate wealth quickly." If you buy a product that uses wording like this in the sales pitch then expect to lose your money.

Remember, there's no magic key that unlocks the door to instant wealth, and every reward comes with some risk. As a young investor, getting into your first property will require knowledge and hard work - but by starting early you're putting time on your side.