How you make a
real estate investment worthwhile

(1997)
 

What an investment depends upon

Certainly many of us have already dealt with the subject of real estates. Hardly any other form of investment has been this much praised and appreciated, but in hardly any other field there is so much need of information. Because as a capital investment, a property is a complex instrument and in order to avoid a bad awakening in the years later it is vital that one checks several vertices before one purchases.

First of all one needs to ask the question: why is acquiring a property sensible to me? Several different reasons can be decisive factors hereby:

One certainly could list numerous other reasons or motives for acquiring a real estate property, but they generally can be referred to the ones mentioned here.

Which property for which purpose?

The second question is: which type of property best suits which purposes? Of course the owner-occupant will buy under different criteria than the investor. Those who want to live on the countryside will not buy a freehold flat in the city as an alternative; the same applies to the reverse. Those who are looking for a value-stable capital investment should rather buy in central locations or close to a large city than somewhere in the far hinterlands. Those who are looking for a real property as something to fall back on must not buy a property for saving taxes, and reversely, the one who predominantly wants to save taxes should preferably not buy a property with only 2% deduction.

One quickly gets to see that there are a number of several complex factors which contribute to an overall decision. They however can be summarized in three general groups:

Note:

The most important criteria when purchasing a real estate property remains the location.

If one has limited the choice under this aspect then one must ask oneself how much the magnitude of the investment should be. Meaning: how much money can I afford to buy a property? To this we first of all need to answer the question: how much money do I already have, and how much will I be able to get as a building loan?

Owner-occupant: unfortunately (usually) no tax advantages

The matters related to the owner-occupant are fairly simple: at least 20% of the purchase price should be available as savings – his own funds – as far as possible. The monthly charge for the loan can be offset with the rent currently paid and one quickly gets to see to what great expenses one needs to go every month in order to be able to afford one’s own home.

From a fiscal aspect, acquiring one’s own home (owner-used) has become practically uninteresting since 1996. The new home owner’s allowance of over 5.000 DM per year for new buildings and 2.500 DM per year for old buildings (but maximum as high as 2,5% of the acquisition costs) over a time period of eight years is only being granted additionally to the child allowance of 1.500 DM per year and child if it is proven that one’s income limit is 120.000 DM (240.000 DM if married).

There is only one exception how also the owner-occupant can get tax advantages: by the depreciation of special expenses regulated by the income tax law in § 10f for listed buildings used for residential purposes. To this, see our example further below – this can be highly attractive but seldom gets found.

Tax-savers: like Tarzan in the tax jungle

Let us get to category 2, the so-called tax-saver. Actually this term is misleading, since actually all of us want to pay as little tax as possible to the state. The tax advantages for constructing or acquiring leased living space or commercial space has been cut down more and more in the past years and also in future it is to be expected that these incentives will become less and less. Yet, at large, the taxation laws are mainly the following: highly complex, comparable to a jungle.

Important is:

Verify all factors in the calculation. Tax advantages might sound good, but are not decisive for the decision. So the consultation should be qualified accordingly and, at least for the “better-earning ones”, should occur in coordination with a specialist tax consultant.

Being highly meticulous when saving taxes

Let us have a look at the basic possibilities roughly, which one has in order to save taxes by real estates:

At this point it would go too far to talk about all these possibilities in detail. But it is plain to see what depreciation rates are interesting to the taxpayer with a high tax rate: of course the higher, the better. That is the reason why so-called tax-saving properties have often been bought by investors with a high tax rate, especially when these do not have any clue about the real estate market.

The danger simply is that the vendor is setting a sales price which might be attractive in regards to taxes – but is exaggeratedly high in regards to the market.

If the sales price is the 25X of the annual rental income or more then one has to examine if this property is really worth its price. If it is located very central and always easy to lease then perhaps the sales price is ok: yet in weaker locations one should set the limit to the 20-24X. 

Old building properties do not hold any more tax advantages worth mentioning, having a deduction rate of 21/2- i.e. 2%. But in exchange they are interesting to category 3: the yield investor.

Yield investors: Attention – interest-mathematics!

The investor acquiring for yield-oriented reasons first of all looks at the percental payment of interest of the capital he uses and only pays secondary attention to the tax advantages (if at all). For after all, yield means that the money invested by one brings in a certain percentage of return. If I bring it to the bank I get an interest amount of zero to currently 5%, but need to deduct inflation from this. If I invest my savings into a real property the money is invested in a way secure against inflation, but might not bring any return at all in the first years. But the bill generally looks better, on a long term, in case of a leased apartment instead of a money investment at the bank.

Many investors, righteously, have a hard time calculating the yield of a property. For what criteria does one want to set hereby? If one relates the return (the rent) to the own funds invested then the yield surely is far above any yield in case of any other investment. On the other hand one needs to use the rent for interest and amortization in the beginning, if most of the sales price has been paid by a loan.

If one relates the yield to the sales price and factors in the tax advantages then one also gets an attractive value which can irritating however if the exact personal tax rate does not underlie hereby (prospects often set a tax rate of 50%, which only few reach).

The clearest calculation which is being used by many is the net yield:

Annual net rental income divided by the net sales price, multiplied by 100.

Example:

The monthly rent is 850 DM net (= rent not including additional costs).
The sales price is (without additional costs) 199.000 DM.
Yield: 850x12=10.200:199.000=0,0512•100=5,12%

Since the rent can be raised year by year (or every three years) one gets an increasing yield, different than with the bank. The net yield, in the beginning, is at 3-4% for new buildings and at 4% or more for old buildings. Since the tax advantages for new buildings are higher one always needs to expect a lower yield in the first place – very simple, because the sales price in the relation to the new building is higher.

Example:

A new building in the urban area of a western-German large city costs 4.650 DM per m². In the neighbourhood an old building apartment which is in a very good condition costs around 3.600 DM/m². But the rents paid per m² hardly differ from each other: 13 DM in the old building and 14 DM in the new one. That gives us the following yield comparisons:

Old building: sales price 217.800 DM, annual rent 9.440, yield = 4,33%
New building: sales price 281.000 DM, annual rent 10.200 DM, yield = 3,63%.
Tax advantages:
The more so do these two properties differ in regards to the tax advantages (investor single, 100.000 DM taxable income, own funds 50.000 DM):
In case of the new building it is around 13.800 DM in the first year and 8.300 DM in the 7 years thereafter, after that it is 6.000 DM for 6 years.
In case of the old building it is around 9.100 DM in the first and 6.000 DM in the following 39 years.
Of course these are approximate values. One can assume that the annual taxable income slightly increases every year, but same applies to the rental income.

Note: the most decisive thing for availing oneself of the various tax advantages are, first of all, the date of the purchase and the completion of the property. In the first 14 years the buyer of the new building has a tax advantage of around 108.000 DM; on the other hand the buyer of the old building “only” has 87.100 DM. Yet the difference of the sales price only was 63.200 DM, which gives the buyer of the old building a net advantage of around 42.300 DM!

Of course such calculations are high-grade theoretical, for after all what counts is the location of the property, the value increase and the long-term raise of rents, as well as repairs on the house that become due (which certainly more often occur in the old building than in the new one).

 

Some rules of thumb

In order to not make the decision too complicated now, here are some rules of thumb which we use in our consultation:

1. Start off in a small way!

The first property should be a value-secure yield property in any case, of a manageable magnitude (sales price between 100.000 and 200.000 DM). Like this one “gets used to” dealing with such a capital investment.

By no means should one let oneself be lured by tax advantages which might sound cute and might look like a lot of money – but after all often has to be paid for with a high cost, by a sales price which is inappropriately high.

2. Pay attention to the location!

The location of the property is a very important factor (see our customer information no. 6/97). The decisive question is: at this location, can I persistently expect to achieve the rent which my calculation is founded on? (To this it is necessary to compare the rents common to the location.)

3. Look for bargains

Those who really want to save taxes should look for actual tax bargains. Part of this is e.g. a new building (with 5% depreciation over 8 years) or perhaps a property with special depreciation in the new federal states, whereby here one has to be more careful in choosing the location and evaluating the rents.

4. Quickly snap at the chance in case the right property is found

If one finds a real ultimate bargain it is necessary to take it fast, because they do not exist in large numbers. An example to this:

The investor from the earlier example acquires a 62-m²-apartment in a listed building, for a sales price of 268.000 DM. Since the monument gets reconstructed entirely, it has the same quality standard than a new building. The rent is 837 DM per month. Thus the beginning yield is 3,74%. And here is the calculation after taxes:

The tax advantage in the 1st year is 20.544 DM and in the following 9 years it is 12.300 DM per year. So the total tax advantage in 10 years = 131.244 DM.

So after all this investment possibility is the best one by far!

5. Pay attention to yield bargains

Of course there also are real yield bargains, e.g. when the rent is higher than the interest and the amortization. But also these are rare and require that one acts fast.

6. Also save taxes as owner-occupant from time to time

It becomes yet more interesting if one acquires a building monument for one’s own use, for as owner-occupier one cannot avail oneself of any other tax advantages, as mentioned above;

Example:

Sales price of the apartment in the listed building: 258.000 DM, all other information as above, rent up to now has been 1.100 DM including additional costs. This gives a yearly tax advantage of 9.300 DM for ten years and is less than the rent up to now by 301 DM per month!!! So one actually nearly gets the apartment “for free”!

(By reason of simplification, the fixed interest rate in all calculation examples is 5,75% over a period of ten years and 95%-disbursement).

Of course we also have to say the following about old buildings: the reconstruction costs are very high (but included here in the sales price) and the office of monuments always has a certain influence in it. So one has to live with certain limits. Additionally such properties are not always sitting in good locations; so here it is double as important to inspect the area (similarly to the new federal states).

 

In the end: investments of millions

For an investor who really wants to start off on a large scale and wants to attain a high yield as well as good tax advantages, there is the possibility of acquiring a residential building for sales prices within the one- to two-digit million range, or either a commercial property or property in need of refurbishment, e.g. in Berlin, with the possibility to get special depreciation. It would go beyond the scope of this information letter to go into this in detail. We are willing to make a calculation example. In any case such an investment is more than worthwhile for those who have inherited a lot of money or have a high taxable income!

 

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Important note: Any evaluations, advices and indications on our information and internet pages are mostly subjective evaluations and solely have the purpose of giving real estate investors a general orientation. They make no claim to be complete, right or constantly valid. Most real estate information is founded on conditions or legal regulations (taxes, regulations about apartment ownership, tenant’s rights and more) which might have been current or of interest for real estate buyers at the time the text was written. These conditions and legal foundations – especially also fiscal aspects – possibly have changed by now. Thus we recommend, before one does any property purchase, to get the current data on the real estate markets, tax- and other legal regulations and innovations, as far as these could be of importance to the objective and subjective success of the investment.