Does Real Estate Make Sense?
I’ve never really hidden the fact that I’m not terribly big on real estate investing. The recent bubble / collapse simply firmed my decision that real estate was not for me. Besides my primary residence, of course.
However I’m beginning to open my mind to the possibility now. For years, smart investors have been doing quite well for themselves by investing in real estate. Sure, you read about the “crash and burn” type stories lately. A 1 BR 700 square foot dilapidated house in San Francisco isn’t worth $700k? Really? But for the most part, real estate investors seem to come out ahead in the long run, as long as they don’t get foolish and greedy.
Cash flow - it’s your friend
When you buy a house and rent it out ( becoming a landlord ), your first goal should be to generate a positive cashflow. What is cashflow? Basically, the difference between your mortgage payment and the rent your tenant pays. If your mortgage ( principal, interest, taxes, and insurance ) are $1,000 , and you charge $1000 per month for rent, then your monthly cashflow is $100. That’s a positive number, and certainly a good thing.
Cashflow doesn’t make you rich
The key to making money in real estate isn’t the cashflow. Really a positive cashflow just keeps you out of the poorhouse while your property is busy appreciating. Ahh, appreciation. If it weren’t for this, then real estate would be the worst investment ever. But even at a modest 4% per year appreciation in the value of your house, you can make quite a bundle. Just as a quick example, a $200,000 home would gain $8,000 in value the first year. The second year it would actually gain $8,320 - it compounds.
Leverage can be powerful
If you manage to put down, say, $40k on your purchase to avoid PMI, take a look at this. Say you spend your $100 per month cashflow on regular maintenance and repairs - so it’s a wash. Your net worth grows by $8000 in that first year though, solely due to appreciation. That’s $8k on a $40k investment, or 20% in a single year. If you’re feeling frisky you can get by with less money down, and possibly generate some insane percentage returns. You will have to get around PMI though, probably with an ugly 80/20 loan of some sort.
Reward does not come without risk
Cashflow, equity growth, leverage, huge returns - what’s not to like? Well, lots. For one, you have to make sure your property can generate enough in rent to cover your mortgage at the very least. If you’re buying an older house, there will be repairs and maintenance to pay for. Finding tenants can be difficult, and finding good tenants can be harder. Playing landlord isn’t something I’ve done yet, but it doesn’t sound terribly fun.
There is always the chance that your property won’t appreciate as fast as you were hoping. It can even decrease in value - something we’ve seen in some areas across the country recently.
I’m still on the edge
After considering the positives and negatives, I am still in doubt as to whether I’ll buy an investment property. I want to increase my net worth long term, and I think that real estate has a lot of potential to help me diversify in that. However, the risks are big, and they are very real. I also don’t like the idea of going $200k more in debt than I am now, while I’m busy trying to pay off my other debts. Time is also a factor, as I don’t really have much to spare. Currently I’m working on the world’s largest spreadsheet to help me decide if real estate makes sense for me financially. I would only consider buying a local property, so I can keep an eye on it. If rents in my area don’t support a mortgage, then the idea is out for now.
So anyway, that’s enough from me. Have you ever bought / sold an investment property? Would you do it again? Any tips?
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April 8th, 2008 at 7:23 pm
You gave an example above, which happens every day by the way, that demonstrated how one could realize a 20% ROI in one year - can you please tell me another investment vehicle in this economy that can give that kind of return on a consistent, annualized basis?
Real estate investing is a skill, a talent. You must do your homework, develop a competent team to advise you, invest without emotion, and sell when the time is right.
Also, my rule of thumb for calculating cash flow is as follows:
Principal
Interest
Taxes
Insurance
Maintenance
Utilities
Management (property)
Vacancy
If a property cannot cash flow after subtracting all of those factors from the rent, then I don’t buy it. That way, I am not a landlord. What this means is that you may not be able to purchase cash flowing property in the area you live. That’s why you need a team!
I have a 30 year property management veteran who has managed up to 1000 units at once, owns over 20 himself, and personally inspects any property I want to purchase, and I live 3000 miles away from my investing area. This is much less risky than the folks who turn their 401K portfolios over to a financial planner and hope all is well.
A lot of investors got into trouble by over leveraging themselves with short term loans. My personal purchasing parameters is to put 20% down on all properties to hedge against future declines. This also helps me cash flow.
Obviously, I’m a huge proponent of real estate investing, but only done with care and seasoned advisors. But, to each their own…….
April 8th, 2008 at 9:13 pm
Does Real Estate Make Sense? This article presents a lot of interesting points. There are certainly values out there in residential and commercial real estate for long-term investors seeking value.
The challenge, however, is getting a loan that makes sense in this market for the lender and investor. It takes a lot of equity to produce positive cash flow from residential property and lenders are reluctant to give money to investors without substantial equity in most cases. No mone-down loans appear to be a thing of the past and how many consumers have an extra $60K in their pocket to drop down on a $300,000 residential property?
April 9th, 2008 at 8:06 am
[...] Money asks Does Real Estate Make Sense as he weights the pros and cons of buying a rental property. I have 150 acres of land in south [...]
April 9th, 2008 at 8:50 am
Sharon, 20% per annum is quite doable with a variety of investments in any economy. An intelligent hedged stock strategy can get there with less risk and less work than real estate if you do it properly, for instance. There’s more than one road to Jerusalem. Real estate investing is great, but it’s not a utopia. And it’s a lot of work! Owning real estate is more like a part-time job than an investment.
April 9th, 2008 at 9:09 am
I’m totally a novice at real estate, so it’s great to hear from a pro. Sharon it sounds like you have been doing this for awhile - long enough to get a solid team with you. For a new investor, doing long-distance deals seems like a bad idea. But if you’re living in California or another high-dollar area, then rents couldn’t come close to covering your mortgage, so it makes sense.
Having that 20% down rule is great. You avoid PMI, fancy loans, and also get your hedge against a market drop. That’s the difficulty for me, since I couldn’t come close to 20% down on a property right now. Perhaps the time isn’t right yet for me.
April 9th, 2008 at 5:09 pm
Hi Llama Money - you are correct, I live in California. But, we have our eye on a couple of areas that if they continue to decline further, will actually cash flow, so I’m pretty excited about that.
Right now, however, I’m investing in areas where you can buy cash flow homes for between $50-80K, so between down payment and closing cost, you need about $18K. Compared to areas where homes sell for $130-150K, that’s much more doable. Of course, you should also set aside approximately six months of mortgage payments in reserves, but with $400 mortgages, I’m still able to buy a property for about $21K. Not a small amount of money, but no as large as other areas. That’s why I choose to go to another state.
If it’s something that really interests you, though, you’ll know when the time is right! I’d advise finding a partner or a mentor for your first couple of deals, just to be safe.
April 9th, 2008 at 5:13 pm
So Kyle, are you a hedge fund manager? I have a couple of family and friends who would love to make those kinds of returns in the stock market (I’m talking people who actually know what a put, call and option are). All I hear them whining about is how their portfolio is dwindling daily. Seriously, e-mail me and I might be able to give you some referrals.
But as I said at the end of my first post, “to each their own.” I know not everyone should invest in real estate - I think sometimes my enthusiasm for it makes me appear as if I do think that though
My family personally thinks I’m nuts, but only time will tell.
In the meantime, the age old debate of real estate versus stock market is alive and well. Success in all You Do!
Sharon
April 10th, 2008 at 8:02 am
Sharon:
I would be deathly afraid of buying a $50-$80k home. I guess it’s very dependent on the area, but that would buy a really trashed-out home in a poor area here. It’s starting to sound like I’ll really need to look elsewhere if / when I decide to buy my first rental.
Kyle:
20% per year in the stock market is a fluke, not the rule. Unless your last name is Buffet, you can’t count on returns like that. At least not long term anyway. Of course, buying Berkshire Hathaway stock could have similar potential
I’ve gone back and forth between stocks and real estate ever since I’ve started caring about money. I don’t think there’s a clear cut answer on which one is best. That’s why eventually I would like to have stakes in both, to hedge my bets.
April 10th, 2008 at 8:17 am
Actually, all of my homes are in awesome shape in great neighborhoods and school districts. I don’t buy in high crime areas or poor school districts (I’d never sleep at night). I purchased my homes wholesale (20-25% below market), put in some carpet, appliances and paint (around $2-3K), and am now getting top rents!
I’m not sure where you live, but I think that may be what you’re using as a reference point - perhaps by you $50K would buy a crummy home. It’s all about research and finding the right area at the right price. Believe it or not, they still exist!
April 10th, 2008 at 9:12 am
Sharon:
I guess that’s why real estate requires a TON of homework - something I haven’t done yet. I live in southern Texas, which is a pretty low-cost area as far as housing goes. Still, to buy a decent home in a decent area here will run well upwards of $100k. Maybe the Corn states are a better choice. When I have the cash reserves built up, I’ll look into it more. I must have patience, for now, so I can get to that point.