Buying and managing rental properties is one of the best ways to build wealth. If you purchase the right properties in the right neighborhoods, and keep them in good condition with good tenants, you should be able to cultivate a favorable return on your initial investments, and possibly end up with a source of recurring monthly revenue.
One of the most important elements to this strategy is purportedly cash flow—the amount of money you’re receiving in the form of rental income, compared to the expenses you face. Ideally, you’ll generate positive cash flow; for example, if you have monthly expenses totaling $1,500 (including annual expenses and emergency savings, accounted for on a monthly basis), and tenants paying a cumulative $2,000 in rent, you’ll be making a $500 profit every month, or $6,000 a year.
But in some cases, a positive cash flow may not be possible. Rent prices in your area may not be high enough for you to close the gap in your expenses, or your property may be more expensive to maintain than your originally thought. If this is the case, is your investment property doomed?
Optimizing for Appreciation
While some landlords make property investment decisions to capitalize on steady, profitable cash flow, others prefer to optimize for property appreciation. In most areas, properties tend to increase in value over time; if you purchase a home for $150,000, in several years, it might climb to $175,000. In a hot neighborhood or a fast-growing one, this rate of growth can be exceedingly high. For example, it’s not unheard of for property values to double in the span of just a few years. This isn’t the norm, but it’s possible if you’re able to time the market correctly.
In this way, you don’t need to have a positive cash flow. Neutral cash flow, or getting enough rental income to cover your expenses, is plenty; if that’s the case, your property will appreciate in value while you face no monthly expenses. When it’s time to sell the property, you can cash in on the growth and put it toward another property or another investment.
It’s also worth noting that optimizing for property appreciation allows you to tap into financial leverage if you’re getting a loan. Leverage basically allows you to invest with money that isn’t yours. For example, let’s say you buy a $150,000 property with a $50,000 down payment. You borrow $100,000 from the bank to pay for the rest. Several years pass, and property values in this area appreciate; you decide to sell the property, and it ends up going for $200,000. Let’s ignore the complexities of increasing equity through mortgage payments for a moment and say you use the $200,000 to first pay off your $100,000 debt to the bank. This leaves you with $100,000, or $50,000 of direct profit, assuming you were cash flow neutral this whole time. In other words, even though the property’s value increased by 33 percent, you saw a 100 percent return on your investment, since you capitalized on financial leverage.
Finding a Balance
Still, most landlords find the best approach to be a hybrid one; buying properties with the potential for significant long-term appreciation is highly valuable, but it’s also comforting to have the steady monthly income associated with positive cash flow. An ideal property is one that gets you the best of both worlds.
When buying a property, you’ll want to carefully examine the following variables:
- Price (and monthly payments). Obviously, you’ll want to look at the purchase price and see how it compares to other houses in nearby areas. You’ll also want to factor in how much you’re putting as a down payment and how much you’re borrowing, ultimately accounting for your ongoing monthly expenses. If you’re responsible for utility costs or other fees, make sure you account for them too.
- Upkeep and maintenance expenses. Different properties will require different levels of maintenance and upkeep as well. Be sure to evaluate the condition of the property, and account for any extra repairs it may need over time. For example, if the property is many decades old, you’ll want to account for a few thousand dollars per year of additional expenses.
- Projected rental income. Estimating rental income can be challenging, especially if this property hasn’t been occupied in recent years. You can start by studying the rental history of the property (if it exists) and looking at current rental prices of similar properties in the neighborhood. Be conservative in your estimates here in case you struggle to find a tenant willing to pay your top-level estimates.
- Neighborhood factors. For appreciation purposes, look at the neighborhood and its potential for growth as well. You’ll want to look at demographic patterns in the past few years, the trajectory of rental prices, new job opportunities on the horizon, and nearby amenities.
Building a Property Portfolio
Instead of finding one perfect property, you can also hedge your financial risk by investing in multiple properties simultaneously, building an entire portfolio that allows you to accumulate wealth in multiple ways. For example, you may invest in properties in multiple neighborhoods, accounting for discrepancies between your projected neighborhood growth and actual growth. Or you may have two properties dedicated to generating positive cash flow, with your other properties focused on long-term appreciation.
If you’re new to property investing, it may be wise to start with one property. But once you get a feel for the responsibilities of a landlord and property investor, you can work on fleshing out your portfolio.
Regardless of whether you’re buying your first rental property or trying to manage an entire portfolio of houses, Green Residential can help. Green Residential is a property management firm with a full team of real estate agents who can help you make the right investment decisions. Contact us to learn more about our services today!