Disenchanted with the stock and bond markets, investors are looking for safe, more profitable investments. What investment would you recommend?

Let’s think about this question together. What has been your best investment? Perhaps you bought Microsoft stock when the company was just starting out and the stock was really cheap at $2 per share. Can you do that again today with another common stock? Probably not. Can you earn profits in bonds today? The obvious answer is "no" because bonds are a place to "park" your money with an anticipated safe yield. But bond holders rarely earn substantial profits.

However, you’re evading the question. What has been your most profitable investment? For most of us, our most profitable investment has been our home, especially for those of us who follow the "buy and hold" strategy. Equally important, the leverage opportunities for single-family owner-occupied houses and condos are unsurpassed by any other type of investment. Sometimes we forget about and need to be reminded of real estate’s leverage advantages.

EXAMPLE: Suppose, a year ago, you bought a $200,000 home with a 10% cash down payment of $20,000. According to the latest statistics from the wonderful Office of Federal Housing Enterprise Oversight (OFHEO) – the same federal government bureaucracy which failed to spot Freddie Mac’s recent financial fiascos – during the last 12 months average U.S. homes rose 5.56% in market value. Many local markets, such as Washington, DC, most of California, Florida, and several other states showed home values rising, on average, about 10% during the last 12 months. However, let’s imagine our $200,000 home rose just 5% in market value during the last 12 months. Did your common stocks or bonds do as well? Probably not. A 5% increased annual value on a $200,000 house is $10,000. Not bad! However, please remember you only paid a $20,000 cash down payment. The happy result is your $10,000 investment produced a 50% yield on invested dollars! Yes, I know there were carrying costs such as mortgage payments, property taxes and repairs, but those expenses, especially after the itemized income tax deductions, are about the same as rent would cost you for an equivalent property. The point of this example is real estate leverage increases actual yields above actual home appreciation rates. As shown by this conservative illustration, no other investment offers the leveraged advantages of real estate with the same safety of investment. If you really want to get excited about the profit potential of single family houses, multiply the numbers above by five or more years. Should this $200,000 home keep appreciating 5% annually in market value, after five years it will be worth over $250,000 (ignoring the compounding). According to OFHEO, last year’s average U.S. home appreciation rate, however, was down from the previous 12-month’s 8.3% peak.

But let’s not get hung up on boring statistics – no house is average. If houses are not appreciating in market value in your town, however, maybe you shouldn’t invest there. Or, if your town is badly depressed (I’ve heard from readers living in towns where homes are declining in market value because major employers have cut back or moved out), the secret to earning big real estate profits is to buy far below market value if there are prospects for future economic growth. Another alternative – anyplace – is to buy below-market "fixer-upper" houses which can be profitably upgraded.

Real estate is usually not a "get rich quick" investment. Instead, it is a long-term investment for at least five years. To illustrate, although my personal residence has increased in market value at least seven times above my purchase price, I’ve owned it for 24 years! Considering my initial $40,000 cash down payment investment, as my friend Jimmy Napier would say, my return on investment is "good enough." My financial calculator can’t figure it out either – it comes up with the answer "inf" which means infinity!

Incidentally, you will find great long-term real estate investment tips from our loyal subscriber, David Schumacher, in his superb book The Buy and Hold Strategy. It is available at www.amazon.com or by special order at local bookstores and public libraries. David started out buying beachfront property in the Los Angeles area, mostly rental condominiums, and holding them. However, he does admit in his book to selling when he made a mistake – such as buying a rental over an hour’s drive from his home and not being able to manage it from a long distance. Now in his 80s, David Schumacher is an excellent role model for all real estate investors.

THE BIG DRAWBACK OF QUICKLY SELLING INVESTMENT PROPERTIES. In a nutshell, the big drawback of selling investment property for a "quick flip" profit is, as my friend Jimmy Napier says "You’re eating your seed corn." By that he means you have no investment left for next year’s real estate "crop" if you sell your fixed-up property and take your profits out. A better alternative, however, is to follow Schumacher’s buy and hold strategy, but periodically refinance every five years or so to take out tax-free cash from the property’s growing equity and use the cash to buy more rental property.

Occasionally, a quick profit property "flip" is all right, especially if the property is located in an area where you don’t want to own it for long term holding. "Quick" in real estate means one year or less. Sometimes, the "big boy" real estate investors do this.

To illustrate, long-time subscribers will remember the story of the real estate investor I met a few years ago on a flight to San Diego. As you may recall, he invests in run-down shopping centers and hotels, often to fix them up and "flip" them for fast profits. There are lots of opportunities for quick-flip properties like that, but the big disadvantage is the future profits which can be earned from long-term holding are lost when the property is sold.

EXAMPLE: A few days ago, I had lunch with one of my favorite local real estate investors, Karim. He usually buys real estate for the very long term, rarely selling unless he can earn a substantial profit. However, his two sons have different strategies. To illustrate, at lunch we reminisced about a house "the boys" bought from me a few years ago at what I thought was a very fair all-cash price. I had owned that house about 14 years and was selling at its fair market value. Frankly, it needed some fix-up. Karim’s sons tackled that house with a vengeance. They painted and fixed to make it sparkle, spending about $50,000, according to their father. Then they sold it, took their profits, and cleared about $75,000 net profit, setting a new neighborhood record sales price. But the big problem with the "flipping properties" strategy is the investor has to keep flipping other properties to do it all over again! William Bronchick and Robert Dahlstrom wrote the excellent Flipping Properties book, available at local bookstores and  public libraries. They suggest using lease-options or buying "subject to" existing mortgages to finance such acquisitions.

WHY INVEST IN SINGLE-FAMILY RENTAL HOUSES? The primary reason I recommend investing in single-family rental houses is they are so easy to buy, finance, manage, and profitably resell. Whether you select the "long-term hold" investment strategy for maximum profits, or you elect the quick-profit "flip" method, single-family houses have the largest potential resale market. The result is market values of rental houses appreciate at the same rate as owner-occupied houses – unlike apartments and other income properties whose market value depends on their net operating income (NOI).

But some investors recommend rental condos as an alternative. David Schumacher earned most of his real estate fortune by investing in rental condos and then holding for long-term investment profits. However, until the last few years, condos did not appreciate in market value nearly as well as single-family houses.

The big drawback of condos is their market value is held down due to many causes such as (1) weaker buyer demand compared to single-family houses, (2) condo market values are determined by recent sales prices of other similar units in the same condo complex and nearby competitive condos, (3) constantly rising monthly condo assessment fees for repairs and other expenses, (4) unexpected special assessments for major repairs, such as roof replacement, (5) petty politics with the condo association’s board of directors, and (6) periodic overbuilding of new condos in the community, thus holding down the market value appreciation of older nearby condos. As I said in the recent report "How to Avoid Buying a Bad Condo (or Co-op)," condos can be great personal residences, but they usually do not make great rental investments.

A special condo problem occurs when a condo complex gets too many rentals, usually over 20% to 25%, because then the mortgage lenders will often stop lending there or will charge abnormally high interest rates. The reasons are (1) the foreclosure rate is much higher in condo complexes with a large percentage of renters, and (2) the maintenance quality often declines because renters and their absentee landlords usually are not as concerned about maintaining the property as are condo owner-occupants.

As long-term subscribers know, I teach California Real Estate Law at the College of San Mateo. This is my twenty-ninth year there. This semester I have my largest class ever of 125 eager students. After class last week, one of my students asked me what I thought about buying mobile homes (also known as trailers!) for rental investments. My answer was today’s manufactured houses can be excellent investments if they are located on separate owned lots – just like single-family houses. But mobile homes or manufactured homes located in mobile home parks on rented land usually do not appreciate in market value unless there is a local shortage of housing or rent control which keeps the lot rent abnormally low.

DRAWBACKS OF RENTAL HOUSES. As we have already seen, with single-family houses appreciating at an average rate of at least 5% annually in most towns, the long-term market value increase potential for rental house long term profits is tremendous. But are there any drawbacks to investing in rental houses? Yes! However, please remember there is no "perfect" investment.

1 – NEGATIVE CASH FLOW. A major problem today in many towns is the rent from a rental house often isn’t high enough to pay the mortgage, property taxes, insurance, and repairs – unless the investor buys with a large cash down payment to reduce the mortgage amount and its monthly payment. Another way to reduce or eliminate a negative cash flow situation is for the property seller to carry back a large second mortgage with no or very low payments for the first five to 10 years.

Obviously, not all rental house sellers will help finance the sale – however, highly motivated house sellers will agree to "flexible financing" to get rid of a problem property. In his excellent new book Investing in Fixer-Uppers, long-time real estate investor Jay DeCima recommends buying houses and small income properties which nobody else wants. He looks for motivated sellers, usually absentee out-of-town owners who have difficulty managing their rental property from a distance, to get seller financing terms.

"Negative cash flow" is a major problem for rental house investors in expensive areas. Frankly, living in a high-cost part of California, I’ve had this problem for many years with my rental houses. In other words, I’ve had to "feed the alligator" every month. My attitude, however, is if the rental house is appreciating in market value by more than my negative cash flow, then it’s a profitable long term investment. Of course, as market rents gradually rise, if expenses don’t rise as fast, after a few years the negative cash flow gradually disappears.

2 – TENANTS AND TOILETS. That graphic phrase, originated by Jay DeCima, describes the second major drawback of rental houses. The same disadvantage also applies to apartment buildings. The investor not only has to keep the property earning rental income (the tenants), but it must also be maintained up to reasonable management standards (the toilets).

This aspect of owning rental houses can be overwhelming if the investor doesn’t properly screen tenants before they move in. However, I’ve had several good tenants go bad on me long after move-in! Sometimes, no matter how carefully a landlord checks out the tenant before renting, a few tenants radically change their behavior and have to be asked to leave. Drugs and alcohol are often, but not always, the problem.

To illustrate, a few months ago when I attended David Tilney’s excellent annual property management course in Las Vegas with about 75 other realty investors, I found it amazing how we attendees usually talked about our bad tenants – probably only 2% of all tenants – but we never talked about the other 98% of our superb tenants who make rental house profits possible! More details are in my recent report "How to Manage Your Rental Property Tenants and Toilets Without Losing Sleep."

To get on David Tilney’s mailing list for his next "Hands Off" property management seminar, just send him a brief note at David Tilney, Keyper Corporation, 316 E. St. Vrain, Colorado Springs, CO 80903; phone 719-632-7462. Rental house and apartment investors will especially love his simple technique for "automatic" rent collection which I had not encountered before! That technique is a primary reason why David and his charming wife, Mary, spend at least half the year in Naples, Florida while they long-distance manage about 100 rental houses in Colorado Springs.

AN IDEAL WAY TO PLAN RENTAL HOUSE PROFITS. At David Tilney’s seminar, I met a middle-aged couple from Michigan who shared their rental house investment plan which they started about five years ago.

EXAMPLE: Not having much cash to get started with their investments, they bought a run-down house with 100% PMI (private mortgage insurance) financing. After moving in, they started gradually fixing it up by remodeling the kitchen and bathrooms. Then, based on the home’s increased market value (it’s called "forced inflation" when the property owner forces the market value up by making profitable improvements), they refinanced it to take out tax-free cash. Their next step was to buy a larger fixer-upper house, again for nothing down with 100% PMI mortgage financing. They rented their former residence to tenants, resulting in a break-even cash flow. Now they are in the process of fixing up their second house. They plan to use the same technique over and over again with additional houses. After the renovation is finished in a year or so, they expect to refinance to take out tax-free cash, and then move on to another fix-up house.

The tough question that nice couple asked me was "Should we sell our first rental house before we lose our tax-free principal residence sale exemption? Or should we keep it as a long term rental property investment?" As you probably know, Internal Revenue Code 121 offers principal residence sellers a profit tax exemption up to $250,000 (up to $500,000 for a married couple filing jointly). To qualify, the seller(s) must have owned and occupied their principal residence an aggregate two of the five years before the sale.

That means this Michigan couple, who have about $120,000 capital gain so far in their rental house, can rent their former principal residence up to three years before losing their IRC 121 tax break. Presuming the economy remains strong in their town, I suggested evaluating the situation after about two years of operating that rental house. By then, the rental house will probably appreciate even more in market value.

Isn’t that a wonderful problem to have? If that couple decides to use IRC 121, they should be aware this tax break can only be used once every 24 months (with limited exceptions for job relocation, health and specified unforeseen circumstances). But there is no limit to the number of times IRC 121 can be used, although it can’t be used more often than every 24 months.

Become a "serial home seller." Another possibility for that couple is to become "serial home sellers" by "flipping" a house every two years or so. The result is to create a tax-free business by buying a fixer-upper house, move in for at least two years, fix it up, rent it for up to three years (perhaps on a lease-option, discussed below), and then sell it for up to $250,000/$500,000 principal residence sale tax-free profits. If you don’t mind moving every few years, this can be a wonderful profit plan.

LEASE-OPTIONS ARE ANOTHER EXCELLENT LOW-CASH METHOD TO BUY AND SELL RENTAL HOUSES. As long-time subscribers know, I’ve been using lease-options over 20 years as a low-cash method to buy and sell houses. In fact, I acquired my current residence on a lease-option. Lease-options can also be used for commercial properties and apartment buildings too. My experience has been lease-options are rarely advertised so house buyers need to create their own when they inspect a house which is suitable for a lease-option purchase.

One of the most productive sources of lease-option houses is the "houses for rent" newspaper classified ads. After you inspect the house and want to acquire it, ask the landlord if he or she will consider a lease-option. It’s best to do this face-to-face, rather than over the telephone as you call the landlords of the house rentals. The truth is many rental house landlords would love to sell on a lease-option but they haven’t thought about all the advantages for them. Another way to find house owners willing to lease-option is to run a classified newspaper ad for a few weeks under "houses wanted" such as "Executive needs 3 BR, 2 BA house for five-year lease-option purchase. Call Bob 555-5555." You won’t get many phone calls. But all you need is one!

In today’s slow rental market in most cities (too many house and apartment rentals and not enough qualified tenants – because so many renters bought homes during the recent ultra-low mortgage interest rate boom), many rental house owners would love to lease-option their house to you – especially if it’s a fixer-upper where you can make profitable improvements to increase the market value before exercising your purchase option. More details are in my special report "How to Profitably Use a Lease-Option to Buy or Sell Your Home or Investment Property."

THE OFTEN OVERLOOKED RENTAL HOUSE BENEFIT – TAX SHELTER. Until 1986, the tax shelter benefits of owning income property were the major motivation for realty investors. But the 1986 Tax Act changed that. Today, if you earn less than $100,000 annual gross income (AGI), you can deduct up to $25,000 tax losses from your Schedule E, including the depreciation deduction, against your ordinary taxable income from other sources, such as job salary, dividends, and interest. However, if you earn $100,000 to $150,000 AGI, the $25,000 deduction is gradually phased out. If you earn over $150,000, your tax losses from your rental property are not immediately deductible against your ordinary income – they are suspended for future use.

Because many taxpayers don’t fully understand the importance of the depreciation tax deduction, I must explain its extreme significance for saving tax dollars. Depreciation is a theoretical non-cash (the best kind!) income tax deduction for estimated wear, tear and obsolescence of a property. Although a rental house is probably going up in market value due to appreciation, for income tax purposes it is declining in "book value." In fact, Uncle Sam requires owners of investment and business properties to deduct depreciation on their Schedule E, even if that deduction doesn’t save any immediate income tax dollars.

EXAMPLE: Suppose you buy a $100,000 rental house (if you can find such an inexpensive property!). Your insurance agent estimates it will cost $80,000 to rebuild the house if it burns to the ground. By the way, when my tax returns were audited a few years ago (with no change incidentally!), the IRS agent checked my depreciation and said using an insurance agent’s estimated replacement cost is a superb way to determine depreciable basis. Some investors use the local tax assessor’s ratio of land to building value, but that method is usually inaccurate because the tax assessor doesn’t care how he arrives at that land-building ratio. The result is the other $20,000 you paid for the $100,000 property in this example is its estimated non-depreciable land value. Because the land value is considered non-destructible, its value is disregarded for depreciation purposes. In our example, $80,000 is therefore the depreciable property value of the rental house. Dividing $80,000 by the current 27.5-year straight line depreciation required by the IRS for residential properties (the number is 39 years for commercial depreciable properties such as office buildings), you can deduct an annual $2,909.09 depreciation deduction on Schedule E for the next 27.5 years. However, you didn’t have to pay out any actual cash to obtain this non-cash depreciation tax deduction. Isn’t Uncle Sam nice?

If you earn less than $100,000 AGI, the Schedule E loss from your rental properties up to $25,000 per year is subtracted from your AGI, thus reducing your income taxes. However, any Schedule E annual losses exceeding $25,000 are "suspended losses" which will save income taxes in future tax years, especially when you sell a rental property at a profit.

Please don’t forget about your unused "suspended losses" because they can be very profitable. Keep a careful record of their year-by-year total. You can be sure the IRS won’t remind you of the unused past-year suspended tax losses from your properties. To illustrate, do you remember that $250,000 rental house I sold to Karim’s sons? My depreciated adjusted cost basis for that $250,000 income property was only about $50,000 after deducting depreciation for 14 years. However, all my $200,000 capital gain on that sale was tax-free, thanks to my past unused suspended tax losses!

BUY AND HOLD? BUY AND FLIP? WHAT IS THE BEST RENTAL HOUSE STRATEGY? I can’t answer that question for you. As explained earlier, I like the buy and hold strategy for its long-term benefits from gradually appreciating property values. But there are occasional acquisitions which produce an almost immediate profit (usually due to buying low and fixing up to increase property value) which are ripe for a "quick flip" sale. Either strategy can be a winner in the right circumstances.

If you select the buy and hold technique, please don’t overlook the "exit strategy" of a tax-deferred exchange, using Internal Revenue Code 1031. Perhaps a rental house has high expenses and you want to get rid of it. But you hate to pay a big capital gain tax on your sale profit. A Starker tax-deferred exchange for another "like kind" rental property of equal or greater market value and equity is ideal for such a situation. The possibilities are virtually unlimited. For more details, please consult our special report "How to Exchange Your Way to Tax-Deferred Real Estate Wealth."

CONCLUSION. If your personal residence has been your best investment, why not own several more single-family houses? However, most of us cannot afford to pay the expenses for more than one home. That’s why we need renters who will pay most or all of our expenses for us! There are so many rental house profit opportunities, this report only scratched the surface of how to buy and hold, or buy and flip.