Real estate investing isn’t for the faint of heart. While investing in income-producing real estate, whether it be commercial or residential properties, can seem like a great way to create cash flow and diversify your investment portfolio, there is a learning curve that often trips up novice investors as they get started.
If you don’t do your homework, you could buy your way into a property that bleeds cash rather than creating a net positive cash flow. Below are some things you need to consider before you buy that first property.
Start with the Big Picture
Before you even begin looking at properties, you need to reflect on your goals. Is your goal passive income, value appreciation, or tax advantages? Or all of the above? Another potential goal may be vacation property that you occasionally use, and then rent out the rest of the year.
Choose a Market
Once you understand your goals, you should study the markets where you wish to purchase. How strong is the job market? Are there more jobs being created, and are wages increasing? If you are looking at vacation property, look at the seasonality. Are there certain times of year where demand is low? Or are there local amenities or destinations that draw year-round vacationers?
Answering these questions is important. You don’t want to purchase a property in an area that is losing jobs, because you may find yourself without tenants. Similarly, if your dream vacation location has long periods of down time (such as during hot summer months or bitter winters), you may find it difficult to book enough renters to maintain even cash flow.
You may think that being your own property manager will save you money. However, you may find yourself spending much more time than you want taking care of your tenants. Paperwork, accounting, billing and collections, hiring contractors, finding tenants, marketing – it can quickly become a full-time job and much less “passive” than you anticipated. And if you turn out to not have a talent for it, your property could lose value and you could lose money with a vacant property on your hands.
Hiring a good property manager is the way to ensure that your passive investment stays that way. Let a professional handle all the details, and you can spend your time finding more properties and building your portfolio. Ask around and get recommendations, join a real estate investor community, find out who other investors are using. Then interview several to ensure that your mesh well and check into their statistics. If you choose wisely, your property manager will be an integral part of the growth of your investments.
Analyze Potential Investment Properties
Once you have determined your goals, chosen a market, and hired a property manager, you are ready to start looking at properties. When choosing your investment, you need to consider:
- Management costs
To achieve a goal of passive income, the property you choose should command enough rent that you have a positive value after subtracting your mortgage payment and operating expenses. Your property manager can help you determine what rent you may be able to charge for properties you are considering and help you estimate the operating expenses.
Know How to Measure Success
You may be tempted to self-finance, especially if you have the financial resources. However, many successful real estate investors will tell you that the ultimate key to success is applying leverage appropriately. For instance, if you tie up your own funds in purchasing a property, then you will have to wait until you collect enough rent to save for purchasing additional property.
If you use a bank loan to purchase your property, your profit could fall into five categories:
- Appreciation: You gain as the value of the property increases. If you are using leverage, you “return” is not only on the amount you invested, but also on the amount the bank loaned you. So your total ROI on the amount of your down payment is significantly more. For instance, let’s say home values are growing at a 4% rate. If you put $100,000 down on a $500,000 property, the value of that property could be $520,000 in a year. Because your stake is only $100,000, and your asset increased by $20K, your rate of return is 20%. If you had put up the whole $500K yourself, your rate of return would only be 4%.
- Cash Flow: As previously mentioned, your cash flow is the amount of the rent minus your mortgage payment and your operating expenses. Let’s say that you have $500/mo in positive cash flow, which over the course of the year would be $6,000. Divide this by your initial investment of $100,000, and your cash-on-cash return is 6%.
- Amortization: Your tenant is paying your mortgage for you. This is the beauty of investing in real estate. Using the same example above, your mortgage of $400,000, in a 30-year loan at 3,92% interest, the monthly payment would be $1,891. Over the course of the first year, your tenant will pay approximately $10,700 in principal on your mortgage. Divided that by your initial $100,000 investment, and your return on amortization is 10.7%.
- Tax advantages: It’s difficult to quantify tax savings from depreciation, mortgage interest deductions, and the use of 1031 tax-deferred exchanges to avoid capital gains tax. But while difficult to quantify, this return is tangible. Your tax advisor could probably help you estimate this savings, but getting to more concrete numbers would require selling the investment. A good ball-park is about 5% if you are taking advantage of all the possible tax savings.
- Inflation: Did you know you can profit from inflation? Who knew? Basically, when you use leverage to purchase investment property, the bank will get a fixed payment until your renters pay off the loan or until you sell the property. So, the bank bears all the inflation risk. Since your rent receipts will increase with inflation, but your mortgage payment is repaid in nominal dollars (the value of the dollar at the time you took out the mortgage) the rate of inflation (around 2%-3%) can increase your return.
Your total ROI is the annual return in these 5 categories added together, or around 43%.
Now, obviously, there are risks involved with any investment. Natural disasters, declining economic indicators (which could lead to declining home values, declining rents, or long periods of vacancy), poor investment choices, or a poor choice in property manager could impact your overall return. There are also other factors not discussed here, such as the impact of buying a home in a competitive market, where buyers often pay their own closing costs and may even pay more than the asking price, which is common in the NoVA area. This will all impact your ROI.
It’s important that you regularly analyze the assets in your portfolio to ensure you are achieving maximum return. Not paying attention to the profit centers could cause you to leave money on the table, or worse, lose money.
We can help you find potential investment properties, or even make referrals to lenders who work with investors or to quality property managers. We would love to help you get started! When it comes to buying or selling your home, we are here to help answer any questions and guide you through a better understanding. Please do not hesitate to contact us at firstname.lastname@example.org or phone us at 202.800.0800.