You’ve saved some cash and you’re ready to take the plunge… you want to invest in real estate. Now what? Start with your goals. Would you rather put in a lot of work over a short amount of time for a quick profit? You might want to buy and flip a single-family home. Or do you want to invest longer term for cash flow and eventual capital appreciation? Buying a rental property might be your path; beginners do well with one-, two- or three-family properties.
Why Invest in Real Estate?
Real estate helps diversify your investments. Similar to owning stocks, it can give you short-term gains, or “dividends” and long-term capital appreciation. If you’re buying for the long term, real estate often performs well even when stocks take a dip—so if you buy right, real estate can be less volatile. The average annual return for the S&P 500 from 1957 to 2018 was approximately 8%. The average return on real estate investments is about the same or better (8–12%).
For a relatively small down payment, you gain access to a larger investment. With 20% down, you’re leveraging 80% of your investment—higher than the 50% allowed most stock investors. For rental properties, you can deduct property improvements, lowering your taxable income. And over time, rents usually rise and mortgages get paid down, increasing your income.
Run the Numbers
Whether you buy to rent out or you want to flip, learn to read the signs that the property and the deal are right for you… whether they’re more or less likely to make you money.
The 1% rule. This prescreen will help determine whether your rental income will equal or exceed your mortgage payment—whether you’re likely to break even or have a positive cash flow every month. Look at your rental market: will you be able to rent out the property for at least 1% of the acquisition cost? If so, the property passes your first test. Keep in mind:
- Acquisition cost includes costs associated with closing, remodeling and repairs in addition to the purchase price.
- If your property passes the 1% rule, to make money, your monthly mortgage payments must be less than 1% of the acquisition cost.
The 2% rule. The same as the 1% rule, except you use 2% as your benchmark. If rental property income will equal 2% of your acquisition cost, you’re even more likely to realize positive cash flow.
The 50% rule. The 50% rule says that about half of your gross rental income will go toward expenses—taxes, insurance, repairs, HOA fees, property management fees and vacancy losses. (Expenses don’t include mortgage payments.) So if the property rents for $1,000, you might net $500 a month. If you want to earn $100 a month in net income (a standard expectation), your monthly mortgage needs to be $400 or less. (This Rental Property Calculator can also help you with quick estimates.)
If you’re flipping a property for quick sale, the idea is to buy low and make improvements to the property to increase its value for a quick, hopefully profitable sale. Location is everything; if you can buy a distressed $75,000 property in a $200,000 neighborhood, there’s potential for a good profit. It’s important to know the market and to realize that flipping is a competitive sport. Even fixer-uppers can go for close to market value in a prime location. Flips also require extra capital to make improvements, and to maintain the property while you’re selling it.
The 70% rule. This can help you decide whether the flip is a good deal. If the purchase price is less than 70% of the after-repair value MINUS repair costs, that’s a good sign. Example: If a $100,000 property has an after-repair value of $200,000, and repairs will cost $50,000, the $100K purchase price is 66% of $150,000 ($200,000 – $50,000). So that deal could be a Go.
Review Your Timing
While it’s ideal to buy when the market is down and sell when it’s up, it’s not always possible. Timing usually has more to do with when you’re ready to invest. When your student loans and credit card debt have been paid off, and you’ve saved the recommended 20% downpayment for a mortgage (more if you’re flipping)… you’re probably ready. If you can’t swing the 20%, you can buy private mortgage insurance (PMI). But you’ll have less equity in the property and more expense, and if you have to sell early, you won’t realize as much from the investment. You could borrow from friends or family—but as hard as would be to lose your money if something goes wrong, it would be even harder to lose theirs.
A rule of thumb for rental properties is to also save 6 months of cash reserves to cover mortgage payments, insurance, taxes and expenses—for each property. Your lender may require it so you can make payments if you lose your job, or if the property needs big-ticket repairs or goes unrented. Even if it’s not required, it’s a good rule. If you have to replace an HVAC system and a water heater at the same time, it could wipe out your rental income for a several months.
What about buying during an economic downturn? Consider that people still need a place to live… that you may find some incredible deals… that you may lose out by sitting on your cash instead of investing it. Recessions create opportunities, but definitely run some worst-case scenarios that involve slower sales (for flips), higher rental vacancies or late rent payments. Know your market and keep an eye on the National Multifamily Housing Council’s Rent Payment Tracker, which analyzes national rental data on a weekly basis.
Know the Caveats
One important thing to remember about rentals—they involve responsibilities. You must:
- find tenants, screen them, collect rent from them and sometimes evict them.
- maintain and repair the property, vetting and hiring contractors as necessary.
- handle the admin (contracts, taxes and paperwork).
A good property manager can save you from getting out of bed at 3 am to fix an overflowing toilet—and much more. Property management can cost up to 10% of your rental income (remember, it’s already part of your 50% rule), but PM companies can relieve you of a lot of responsibility and headache.
Flipping is often less investment and more job—sometimes a full-time job. You must study the market so you can buy right. You must find everything that needs to be repaired—or be able to absorb the time and money for expensive discoveries. At least some home improvement knowledge is required, unless you have a hands-on partner or a team of reliable, skilled contractors at your disposal. A good real estate agent can really help you learn the property market and help you make a quick sale with effective marketing.
Consider Creative Solutions
If you’re short on money but long on ambition, there are workarounds. Sweat equity is one—the more labor you put in, the less you have to pay someone else to do whatever-it-is. House-hacking involves buying a multi-family property, living in part of it and renting out the rest to make your mortgage payments and expenses; it also reduces your living expenses. If projected rental income is too low, you can lower your mortgage with a higher downpayment, negotiate for a lower purchase price, or ask for better loan terms or higher rents. Flipping? Our team at Gaskill has deep market knowledge that will help you buy right and sell well. Renting? Our property management services can help you maintain your property, and find and keep happy tenants in your rental property at optimal rental rates. Call us today!