• Understanding amortization can help real estate investors reduce project costs and realize tax advantages.
• An alternative investment, real estate can be used as another tool for portfolio diversification.
• Yieldstreet offers a number of real estate investing opportunities in some of the most attractive markets in the country.
Amortization of a real estate loan refers to the process by which the principal amount of a mortgage is reduced with each payment. Borrowers typically receive an amortization schedule showing how much of each monthly payment satisfies interest obligations and how much goes toward reducing the principal amount of the loan.
However, amortization can also refer to the spreading of capital expenses related to intangible items over the useful life of an asset. While this form of amortization is like depreciation, there is one key difference, which we will discuss below. With those factors in mind, here is an overview of amortization in real estate and how it works.
The process of writing down a loan is referred to as amortization. An amortization schedule is employed to lower a loan’s balance as installment payments are made. In most cases, early loan payments are weighted more toward covering interest payments than reducing the loan’s principal. As time goes on, the balance gradually shifts so that more of the payment is applied to reducing the principal than covering interest payments.
With a fixed mortgage, multiplying the interest rate by the outstanding balance and dividing the product by 12 determines the interest payment. The percentage of the principal due that month is the difference between the established monthly payment and the amount of interest to be paid that month. As the term of the loan progresses, the principal amount becomes smaller, which in turn reduces the amount of interest due. However, because the total monthly payment remains the same, a larger percentage of it goes to reducing the principal balance. This pattern repeats throughout the life of the loan until a zero balance is achieved.
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Amortization vs Depreciation
In the case of assets, amortization and depreciation are largely the same. The difference is amortization applies to intangible assets, while depreciation applies to tangible assets.
For example, amortization can be applied to the costs of intangible assets needed for a real estate startup. To qualify as a startup cost, an expense must be one paid or incurred to operate a business prior to placing a property into service as a rental.
In other words, certain costs incurred prior to advertising the availability of a rental property can be tax deductible on an amortized basis. Startup costs over $5,000 can be amortized, as can costs associated with refinancing a mortgage loan and improvements made to the property.
To illustrate this, consider a scenario in which real estate startup costs of $12,000 are incurred. An investor can deduct $5,000 of those costs in the year the rental is initially offered to tenants. The other $7,000 must be amortized over a 15-year period and gradually recovered. Alternatively, the entire $12,000 can be amortized over that 15-year period.
Depreciation largely refers to the same practice, however, it is applied to tangible assets such as building equipment, office furniture, machinery, and the like. Loan and acquisition costs can also be added to the cost basis of an asset and depreciated.
To calculate depreciation, the value of the object at the end of its useful life must be estimated. The difference between that value and the original cost of the asset can be claimed gradually over the number of years the asset is expected to be useful.
Positive Amortization vs Negative Amortization
Getting back to mortgages, all of the amortization discussed until now has been positive in nature. A typical mortgage loan is structured such that the principal balance decreases with each monthly payment. This is positive amortization.
Negative amortization occurs when the principal balance grows because the minimum monthly payment does not cover interest costs. The unpaid portion gets added to the principal amount each month and, as a result, the amount of the obligation increases.
This can come into play with payment option adjustable rate mortgages. These instruments are structured such that investors can determine how much of the monthly payment is applied to interest costs. If the rate is higher than they elect to pay, the difference is added to the loan’s principal balance.
Graduated payment mortgages also entail negative amortization. Under this approach, early payments include partial interest payments, the balances of which are added to the principal.
While these strategies do give investors added flexibility, they can also make the loans more costly in the long run.
What Commercial Real Estate Investors Should Know About Amortization
Commercial property real estate investors have another consideration to make when it comes to mortgages and amortization. Generally speaking, most commercial real estate loans require balloon payments at the end of their terms. Properties are typically financed with 10-year fixed interest rate loans, amortized over 25 to 30 years.
The loan comes due at the end of the tenth year, at which point the principal balance must be paid in full. Investors will either sell the building when the balance comes due or refinance it. The resulting smaller monthly payment keeps costs lower, which improves the return on equity (ROE). This is why most commercial real estate investments are predicated upon carrying debt. The ROE is higher.
How to Invest in Real Estate
There are a number of different ways to invest in real estate. Among the more common are owning commercial and/or residential rental properties, joining a real estate investment group or participating in a real estate investment trust. Some investors purchase houses, rehabilitate them and sell them. Investing in a real estate mutual fund is another way to include this asset class in a portfolio.
Direct investments in real estate can be very “hands-on” experiences, unless the properties are turned over to a management company. While this does have the potential to reduce an investor’s physical involvement, it also increases costs. REITs, investment groups and mutual funds eliminate the need for such direct involvement.
Real Estate and Alternative Investing
Real estate is among the asset classes designated “alternative investments.” While they are hard to define, broadly speaking, alternative investments tend to be less correlated with public equity, and thus offer greater potential for diversification. Moreover, private real estate investments have outperformed the S&P 500 for over two decades. These assets were traditionally accessible to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums – often between $500,000 and $1 million.
Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors. While traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation, a more balanced 60/20/20 or 50/30/20 split, incorporating alternatives, may make a portfolio less sensitive to public market short-term swings. Yieldstreet offers several attractive real estate investing opportunities of this nature in some of the most attractive real estate markets in the country.
Amortization plays a highly significant role for individual investors in real estate. Understanding its varied facets can help improve returns on equity, reveal tax benefits and reduce costs.
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