The 4 Money Makers of Real Estate:
|Appreciation: The value of homes can rise or fall. In the long run most homes will appreciate as long as they are maintained||Amortization of your Loan:This benefit is two fold.You can leverage your money with a loan.A portion of your monthly payment will go towards principle and you can realize that money if you sell or refinance.|
|Tax Benefits: I’m not a tax guy and I don’t want to give anything that resembles advice, but depending on your financial situation there are a multitude of ways to lessen your tax liability with real estate.||Cashflow:Renting out your property in some manner to earn money.|
I want to single out two in particular today, mainly because of the interesting relationship they have with each other. Cashflow and appreciation. This is not to say that tax benefits and amortization are any less important.
Appreciation and Cashflow’s Tangled Love Story.
As an investor and someone who works with a lot of investors I have the opportunity to run the numbers for a multitude of different properties to see if it would fit that particular investor’s needs. Pretty quickly after I started doing this I noticed something that is very obvious to veteran investors but may come as a surprise to beginners. Cashflow and appreciation have an inverse relationship. By that I mean in general if a property has a high cashflow it will have a lower expected appreciation and visa versa. This is not always the case, there are always exceptions of course, but why is this?
My opinion is that it all comes down to how desirable the property is. A gorgeous house in a great neighborhood will always command a premium price on the market, but rents for that same house won’t scale proportionally. As opposed to a run down house in a neighborhood that you are afraid to walk around in at night. The price drops to the floor, while still being able to get some form of rent.
Those two were extreme ends of the spectrum, but I hope you get the point. Where there is a lack of desirability the price drops to reflect that and with a cheaper price the ability for a high cashflow is there.
My Grandparent’s Mobile Home Park
My grandparent’s own a mobile home park that my grandpa lovingly called his ATM machine. This is a great example of high cashflow with very little appreciation. Every month it would bring in thousands of dollars, but I noticed something that would happen every six months or so. Grandpa would get approached by someone wanting to buy the park. They would offer what I would say was a very fair price, but Grandpa would always turn them down.
Was this because he thought his stuff was worth more than the market said, just like most sellers? Probably yes, however when I asked him why he didn’t sell it was because of the cashflow he would lose. The purchase price they offered could usually be made within five years of cashflow from the park. It seemed so shortsighted in his mind when after five years he would have that money and still have the cashflow for the future.
Now had the buyer lowballed him? I don’t think so. If you look at the assets; a few acres of land, trailers that only cost at the time $10-15k and utility hook ups it didn’t really add up to all that much. So this was the rub, he made great cashflow but the assets were hardly worth anything.
The Opposite End of the Spectrum
Opposite the heavy cashflow property would be something more like a luxury house in a desirable city with a rapidly growing population. Because of those factors you’ll pay a premium to purchase it and that will most likely negatively impact the cashflow you get from it. However those factors will also aid you in the years that you own it and when you go to realize the equity you have gained by selling or refinancing it will be much greater.
Benefits of Cashflow VS Appreciation
|Pros||Money in your pocket each month from cashflow (obviously)|
Ability to leverage extra income to secure more debt to buy further homes
Cheaper purchase price compared to the asset
Possibility of using income to replace your job
|Higher quality renters|
Great property that you would likely be proud to own
Lower maintenance costs
Easy to sell when necessary
Large payoff when sold or refinanced
|Cons||Has the propensity to have a lower quality renter that causes more headaches|
If the property is in poor condition then traditional financing can be difficult to secure
More difficult to sell, depending on condition
Less of a payout when you do sell because of lower appreciation rates throughout your time of ownership
|Little to no money in your pocket each month. Some even own these and it costs them money each month. (I don’t generally recommend this in most people’s cases)|
If using a loan it will impact your debt to income ratio
You won’t be able to use this strategy easily to replace your job income
More expensive purchase price
And before any disagreements come up this is a very general list. It doesn’t cover everything and not all of these will be true for every property.
How Should You Invest?
In short, anyway you want! That’s not the answer you were looking for I’m sure and so let’s breakdown how to decide which strategy would work best for you.
What is Your Preferred Outcome?
Would you like to make as much “passive” income each month as possible. Go for a cashflow play. Do you have a large chunk of money you would like to leverage and invest with the intention of not touching profits for a long time. Appreciation may be a better long term option to get you the best return. After you decide what you want your money to do for you need to look at where to find that deal.
Know Your Market.
Every local market will usually have a broad range of options that you can whittle down to get the perfect fit for yourself. However, that may not always be the case. For example I live and work in Fairbanks Alaska which is a small town without many towns surrounding it. In general we see great rental rates compared to purchase price giving us good cashflow but a slow appreciation. Now the last few years has been a huge exception giving us 20% annual appreciation, and rent that hasn’t quite kept up with that trend. Even still I do expect our appreciation to return back to more normal rates of about 3.5% annually in the next 3-5 years and for rental rates to catch back up. You can still get a good cashflow play here but I wouldn’t try to invest at this moment for a large appreciation play. The market likely won’t give you the return you want.
I recommend you start local because you know the area best and you have connections in the area to help you out. However, if you can’t find the deals that fit your lifestyle then it may be best to look abroad to find that deal. Without getting too much in the weeds of investing away from home you generally want to know the area, and have a team set up that can help you.
I think for people looking to get their first investment you should look at a kind of middle of the road approach. A house that is in a A- to B neighborhood. Meaning a good neighborhood that you’re not afraid you will get mugged in. With the tenants being generally blue collar and low level management type positions. This gives you a decent cashflow so you aren’t having to take money out of your pocket each month and when the time comes that you need to sell it’ll be in a somewhat desirable neighborhood. Likely in a median price range which is where most of the buyers will be so even in times when selling is tougher to do you will have options. Avoid the luxury properties where your tenant’s cashflow may not cover all the bills or if they lose their big CEO job they won’t just up and move to the next town with a better opportunity. Also stay away from the war zones where you might get shot walking down the street.
May seem obvious to some, but with a million ways to invest in real estate you need to narrow down your options so you don’t go crazy!
Where To Go From Here?
After you have decided what type of rental would best fit your situation it’s time to start looking. Your first conversations should always be with a local real estate agent and a lender unless you intend to buy cash. You can even start talking to a real estate agent before you know exactly what you want so they can help guide you.