Real estate is all about asymmetric risk and reward. When the government gives you subsidies in the form of mortgage interest tax deductions, a $250K/$500K tax-free profit, and bailouts for overextended homeowners over and over again, you’d be silly not to invest in real estate! When you can invest lots of other people’s money and not have to split the proceeds if you make a killing, that’s a wonderful thing!
There’s a reason why every rich person you know owns multiple properties. There’s a reason why enormous fortunes have been made through real estate as well. How can President Donald Trump still be a billionaire after declaring bankruptcy? Asymmetric risk and reward.
It’s no wonder property owners were once called lords, or now more colloquially, landlords. The wealthy own assets, while the not-so-wealthy lease assets. After 30 years of paying $2,000 a month in rent, your return on $720,000 is negative 100%. At least through a mortgage you’ve got an asset which you can live in rent free or pass on to your children once paid off. You might not make money as the downturn has certainly shown, but at least you have a chance.
When it comes to making money, if there is no risk, there is very little reward. The biggest reason for the widening wealth gap is due to the ownership and lack of ownership in real estate. Here are some key points for better real estate investing.
1) Choose the best location in a strong job market.
For long-term equity growth, a residential rental property in a good location is key.
Look for proximity to major roads, public transportation, and most importantly, schools. Research rents in the area you want to pursue, both in as-is condition and with repairs or improvements.
You also want to get inside the minds of your audience: If you are in a college town, for example, it’s important to know how students think, the maximum distance they’re willing to be from campus and the locations they consider ideal, so you can buy a property that will be in high demand.
Above all else, make sure the property is located in an area where the job market is robust and there is an influx of residences. Job and income growth are the key when deciding where to invest property across the country.
2) Start small and slowly work your way up.
Start with an affordable initial investment like a single unit or a duplex versus a whole apartment building. That way if things go south and you are unable to afford to pay for mortgage or maintenance, you are not running the risk of going bankrupt.
Because you’re just getting started, avoid properties needing significant repairs, since these could cause you to overextend yourself.
Consider using a property manager and ask friends for referrals for attorneys, contractors and other real estate professionals who can help you and will become valuable contacts over time, Coon says.
One of the best ways to build a real estate portfolio is to buy your primary residence first, live in it for 2-5 years, then buy another primary residence, and repeat. Over a period of 20 years, you’ll be able to amass three or four properties with relative ease. The great thing about this strategy is that you get to find enjoyment in your properties, write down the mortgage interest and property taxes, slowly make improvements to the home, and take your time finding a new home.
3) Do the math over and over again.
It’s important to treat each rental property like its own business to serve as a good investment.
The most important consideration for prospective landlords is to accurately estimate rental income and the costs associated with leasing. Until a landlord has a precise grip on these issues, they risk owning a property that — rather than a profitable investment — is a net loss every month.
Betting on appreciation alone is not a good idea.
Rental purchases should have positive cash flow and good rate of return after putting down the mandatory 20% – 30%. The higher the yield, the higher the cash flow. Investment real estate is often valued by its capitalization (cap) rate, which is computed by taking the net operating income divided by the going cap rate in the neighborhood to come to an appropriate price.
Your monthly expenses will include the mortgage or debt service, taxes, insurance, lawn and pool maintenance, property management (optional) and insurance. At least 20 percent down payment will likely be required if financing the purchase.
Vacancy, turnover and eviction are realities of leasing any property, so wise landlords must assume at least a month’s rent loss annually.
4) Improve the property just enough to attract high rents.
To keep your cash flow at optimal levels, don’t spend too much on upgrades for a rental property that will likely need maintenance and repairs during turnovers anyway.
Imagine a box of minimum standards and never go outside that. This keeps your monthly rent at an appropriate ratio of about 1.2 to 1.4 times the monthly cost of the property, with plenty of cushion.
Because maintenance is also a given when owning rental property, a home warranty that costs $500 per year may be a good idea, depending how handy you are. Getting property insurance is a must.
Consider what type of maintenance is required based on the type of property you purchase. For a single-family home, the landlord is generally responsible for things like lawn mowing and snow removal, but if you buy a condo or townhouse, that maintenance is included in the condo fee, resulting in a more hands-off process.
5) Choose tenants like the CIA.
Dealing with tenants can be stressful, but it doesn’t have to be if you properly screen your applicants thoroughly. Ask for the credit report, credit score, bank statements, resume, LinkedIn profile, references, proof of employment, and income statement. Definitely call the previous landlord and the one before that to ask if there are any issues.
If you’re likely to waver with applicants who are not qualified, or with late rent payments and other lease violations, you may need to hire an agent [property manager] to protect your investment.
Tenant income should be at least three times the rent and verified by having their employer sign a form. One bad dead who doesn’t pay for a month can ruin your rental returns.
Related: The Best Rental Lease Form To Use
When To Sell Investment Property
Owning rental property is like a war of attrition. The longer you can hold on, the likely the wealthier you will be. But you might not necessarily be happier since it takes time to maintain and manage. Since real estate is also cyclical, there are times when it might be better to sell than to buy.
I’ve thoroughly gone through a list of 13 items to consider if you’ve been thinking about selling investment property in this latest article: When To Sell Investment Property.
Real Estate Recommendation
Explore real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns.
Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
About the Author: Sam owns rental properties in San Francisco, Lake Tahoe, and Honolulu. He spent 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.
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