Real estate is a viable and productive way to build great wealth over time, but learning how to do it takes patience, knowledge, and the careful evaluation of individual properties for their income-producing potential.
There’s an old adage in real estate investing that you make your money when you buy, not when you sell. That’s because unlike buying a residence to live in, buying an income property for investment is all about the numbers, and there are many more metrics than just a simple sales comparable analysis to consider. You’ve got to have wiggle room for mistakes, market fluctuations, and loss.
Buying an investment property at the right price, with the right type of loan, and with the right expectations for your projected income in mind is how you make money and increase the value of your investment over time.
It’s not just about sales comps
When you buy a property to live in, you’re mostly looking at just one metric: sales comparables. You want to see that the house is priced appropriately on a per-square-foot basis compared to other houses like it in the neighborhood. If the house needs work, you want to make sure the cost of the work won’t make the cost of the house higher than that of others around it once the repairs are completed.
If you’re buying that same house as an investment that you plan to rent to tenants, you not only want to run sales comparables, but you also want to make sure that the monthly rent you’re likely to get is much higher than your monthly expenses and mortgage payments on the property. That number times 12 is your called your cash flow.
For example, let’s say you want to buy a $200,000, three-bedroom home that you will rent to tenants. You expect the rent to be $1,500 per month, because you have done your research on the property by talking to local real estate agents and using rent comp estimators on sites like Zillow.com. Then, you need to account for the following expenses:
|Mortgage principle and interest||$859|
|10% of gross rental income allotted for vacancy and loss or damage||$150|
|5% of gross rental income allocated for maintenance and repairs||$75|
In this scenario, you would only have $116 in monthly cash flow, or $1,392 in annual cash flow. If you had to put 20% down on your mortgage, plus 5% in closing costs for a total of $50,000, you would be receiving a nearly 3% annual cash-on-cash return for your money, or close to what a certificate of deposit or bond might pay you should you put the same cash there.
The benefit of putting your cash into an investment property is the appreciation of its value over time. If this single-family property appreciates 3% annually, after 20 years its value will have grown to about $425,000, netting you a substantial gain that you can roll over into a bigger, more profitable property through a 1031 exchange. Simultaneously, the rent you’re charging should be rising up to keep up with inflation.
Commercial property requires more evaluation
If you’re purchasing a multifamily, retail, office, or industrial property as an investment, appreciation is a factor, but the property’s value is determined by the income it produces, or can produce when performing optimally.
In addition to cash-on-cash return, you’ll want to look at the capitalization rate, which is essentially the rate of return on your money as it would be if you had paid all cash for the property. The capitalization rate (cap rate) of the property is determined by dividing your net operating income (NOI) by the current market value of the property.
The NOI is factored by taking your gross annual rents and subtracting your expenses, including mortgage interest if there is any, but not mortgage principal (so you need to break out your payments).
If you bought an apartment building for $1 million with $50,000 NOI, your cap rate would be 5% and your cash-on-cash return, if you put $250,000 in the deal and mortgaged the property, would be a whopping 50% annually.
Turn your home into an investment
Most people don’t think this way when buying a piece of real estate for personal use, and that could be a mistake, especially if we see an ugly recession occur again, or if you need or want to move to a new home or city. One of the claims to fame by Robert Kiyosaki, a real estate mogul author of the bestselling book, Rich Dad, Poor Dad, was that your primary residence is not an asset. It’s a liability. That’s because it doesn’t make you money; it only costs you money to upkeep and maintain. Sure, your home will likely appreciate a lot over the long haul, but Kiyosaki claims appreciation should be the icing on the cake, not the primary reason for buying a home or property.
If you’re interested in learning about investing in real estate but don’t yet have the capital to purchase an investment property or if you’re not sure you want to be a landlord, you could turn your home, or a portion of it, into an investment property in one of the following ways:
- Purchase a home with advantageous owner-occupied financing terms, such as putting just 3% down and living in it for a couple of years before moving out and renting it to tenants. You can keep doing this as much you want, and eventually build a portfolio of homes in markets you know inside and out because you’ve lived in them. If this might be your plan for when you buy the home initially, check to see whether market rents would cover your mortgage and other expenses.
- Purchase a home with a basement apartment or the ability to create a separate living space for you to rent out. Then, you can see what it’s like to be a landlord, and bring in income that covers part or most of your living expenses. If you ever move out, you can rent out both units separately to increase your cash flow.
Considering these factors even when buying property for your personal use can help you make a good and potentially profitable choice.