Newspapers, magazines and blogs are loaded with articles and discussions of why investment real estate is a bad idea. However, the number of people looking to sell their real estate is actually down from previous highs. The reason for this is that a number of smart investors still realize that real estate is an extremely compelling asset class. Not only does it provide annual returns equal to or in excess of any other asset class, but it also offers unique tax benefits.

Investors in real estate are typically looking for a combination of three types of benefit: appreciation, cash flow, and preservation of equity. Of course, every investor says that they want all three, but, in reality, they do not. The investor that looks to purchase a run-down house to fix up and sell quickly for profit is likely not concerned with cash flow or preservation of equity, since the property generates no income and the area could continue to deteriorate. Conversely, the investor who pays a premium price for property in an extremely good location and uses no leverage will likely see relatively little appreciation in a normal market and little cash flow. The chance of them losing all of their money, though, is extremely low.

A fourth factor is typically mentioned as a reason to purchase real estate—tax shelter. The tax shelter benefits of real estate are considerable. One form of tax shelter is the increase in net annual income due to depreciation reducing the tax bill on net operating income. The other tax shelter inherent in real estate is that not only does growth occur without annual taxes, but thanks to the Section 1031 tax-deferred exchange, assets can be sold without incurring capital gains taxes. The first form of tax shelter increases cash flow, and the second preserves investment equity. Both are parts of the three key factors.

Different property types and qualities will provide different mixes of the three reasons to buy. For instance, class B apartments and shadow-anchored retail centers tend to provide healthy cash flow above all else. An investment-grade single tenant real estate asset like a US Post Office will provide preservation of capital, but little cash flow or appreciation. For those who are looking to build their empires and portfolios, properties requiring work and which can be bought heavily leveraged can offer the promise of significant growth in value, even if they are upside-down from a cash flow perspective.

Please note that the amount of effort required for ownership of a property is not necessarily a factor in this consideration. Although most preservation-of-capital properties are easy to own, and most appreciation-heavy real estate requires effort, this is not necessarily the case. That being said, most investors who want to put some effort into ownership will find the greatest return in appreciation and cash flow-heavy properties.

The secret to strategic real estate investing is to understand where one fits on this spectrum. With this knowledge, one will realize where to put one’s energy and equity and be able to identify the perfect deal for one’s specific situation.

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