Are you looking to invest in Real Estate but have doubts on how to get the most optimal return on your investment given your risk tolerance and investment objectives? Real Estate investing can provide a consistent cash flow and long-term appreciation in the value of your properties, but before getting your foot in this industry, it is important to understand the risks, commitments, and potential returns associated with this type of investment.
Real Estate investments are usually associated with two types of return
- Land Appreciation – Historically, land has been appreciating. The land has a fixed supply, and as the population grows, so does the demand for land. Since the land has a fixed supply, the value of land also tends to increase as the population increases. Even though the price of land fluctuates continuously, an investor can get the benefit of appreciation only when a property is sold.
- Rental Income – People need properties for a living, conducting business, and storing their possessions. Investors tend to rent their property out to people who want to use the facilities for their purposes. This type of operation creates a steady monthly, quarterly, or yearly income depending on the terms of the rental agreement.
Usually, investors consider both of these incomes to find an optimal rental property ROI for their objectives. Financial independence starts from a healthy monthly cash flow that can cover all the expenses of a person who is trying to become financially independent. For this reason, the investor may put more weight on the importance of rental income rather than on the importance of land appreciation since the gains from land appreciation are accessible only after the sale of the investment property.
The path to financial independence through rental properties may vary from person to person because of the difference in regulations, economic conditions, and financial instruments available. Even though cash flows and risks associated with properties vary for different properties, there are several steps that many investors may take to maximize their rental income.
1. Review Your Objectives
Before jumping into the analysis of the market, it is important to understand why you want to invest in Real Estate. Unlike traditional asset classes like equities, bonds, and cash equivalents, Real Estate is highly illiquid, which means that it will be difficult to sell the property fast in case of an emergency. In addition to that, Real Estate is expensive, and most real estate investors choose to take out a long-term mortgage even if they have enough cash to purchase the property. A mortgage, just like any other loan, requires consistent payments. Failure to make those payments on time down the road may lead to a foreclosure of the property and large losses for the investor.
Without clear objectives and a plan to meet those objectives, an investor risks missing on required returns, and not meeting their expectations in managing a Real Estate portfolio. There are a few factors to consider before investing in Real Estate:
- Capital Availability – A very important factor in determining whether a person should invest in real estate is the amount of capital that is available to the investor. A property might require renovations after the purchase, and it also requires constant maintenance. Taxes and mortgage payments also must be paid on time, and if the property does not generate enough income to cover those costs, the investor must cover them out of their pocket to avoid foreclosure. An investor without enough capital set aside may face hardships keeping the property if unexpected expenses arise.
- Time Commitment – A Real Estate investor is also a landlord who is responsible for maintaining the property. Numerous property management companies may take on the responsibility of keeping the rental property in a good shape and occupied, but their fees will affect the profitability of the property. An investor should calculate the revenues and expenses associated with the rental property before deciding on whether they can afford to hire a property manager. If the investor chooses to maintain the property and the occupancy on their own, they should be prepared to put in enough time and effort into it.
- Value Appreciation – If an investor has enough capital to keep the property running, it is important to estimate the long-term return on the investment. An investor who is buying a property for retirement may be more interested in capital appreciation than in the cash flow for the near future.
- Income – An investor who is looking for financial independence might not be interested in value appreciation as much as in consistent cash flow from renting out the property. Even if the investor is interested in cash flow, it is wise to also consider capital appreciation as it might be a great way to complement retirement savings for the future.
- Capital Preservation – Some investors might want to use as much money as possible during their lifetime. If it is the case, then the investor needs to have a plan on when and how to convert the property into cash. Real Estate is a very illiquid investment, which means that if the owner wants to sell the property, it may either take a long time or they may sell it at a big discount. Having a reference point for when to sell the property may be very helpful for getting the full value out of the property without worrying about running out of funds.
- Speculation – As a rule of thumb in investments, the higher the risk the higher the return. This rule applies to real estate investing as well. Assessing the amount of risk an investor is willing to take is a crucial part of making a wise financial decision. Generally, an investor who is looking for financial independence should try to avoid speculative real estate investment because a poor real estate investment decision may ruin not simply destroy the investor’s savings but also have a long-term negative impact on the credit score.
2. Consider Taking a Mortgage
Real Estate is expensive, and not many people can afford to buy a property without taking out a loan. Even if an investor has an opportunity to buy a property with cash, there are reasons why the investor may still prefer to take a mortgage on the property:
- Low-Interest Rates – Mortgages tend to have lower interest rates than any other type of loan. If an investor can have a higher return on their money than the interest rate they pay on their mortgage, then the investor is essentially making money from the difference between the return on their investment and the interest payments on their mortgage.
- Tax Benefits – Interest payments are tax-deductible. The US Government taxes rental income minus certain expenses that include interest payments. This means that the interest on the principal of the mortgage lowers the taxable base, which may benefit the investor.
- More Opportunities for Expansion – An investor may not want to stop Real Estate investing after the first property. Ultimately, a mortgage provides an opportunity for an investor to own more properties than the person can buy with cash. Generally, an acceptable down payment for a long-term mortgage is around 30%, which means that an investor may control more than 3 times the amount they have in cash.
Even though mortgages help improve the cash flow of an investor, it is important to remember that any debt is risky, and missing payments may lead to default, foreclosure on the property, and public record of default for at least 6 years. Even though there is a period of pre-foreclosure during which an investor may still reverse the default, it might be difficult to catch up on late payments and keep the property. Too much debt may be unsustainable due to interest rate fluctuations and uncertainties in the stability of rental income.
3. Analyze the Market
Before looking into properties, an investor should analyze the market to make sure that the investment in a particular market can meet the personal investment objectives. One crucial aspect in determining where to purchase a property is the proximity to the investor. If the property is located far away from the place of residence of the investor, it might be difficult to establish proper operations without hiring a property manager. In this case, if the investor lives in a prohibitively expensive area or in an area with low rental occupancy, purchasing a property close to the owner may not yield the desired results.
Apart from proximity, there are also several ways to approximate potential long-term and short-term returns on the investment property:
- Find an Appropriate Market – There are several signs to look for in a neighborhood that might be growing rapidly in the future. As an example, a booming retail industry may be a good sign of a growing neighborhood. If the streets are full of coffee shops, restaurants, juice bars, and other retail establishments, then the neighborhood is likely to be full of people who have enough disposable income to enjoy these shops. It might be a sign of people from the middle class moving into the area.
- Look at Historical Data – Before understanding where the market is going, an investor should understand where the market has been. Historical data may not be the indication of future returns, but it can be a good starting point to understand what direction the market is moving and more importantly at what pace. Historical data can help identify the trends in property appreciation to estimate long-term expected returns on the capital.
- Understand Economic Factors – A prosperous neighborhood should have high-paying jobs around the area for people to be attracted to live there. Even though retail activity is a good indication of economic growth in the area, the decision to purchase a property there should not be based solely on the number of coffee shops opening on one block. Demographics, jobs, number of investors, supply of houses should all be considered before making a decision.
4. Find a Property
When an investor has a clear idea of the investment purpose and the funds available to them, the investor has to pick an optimal property to buy. Numerous factors may be of interest for the investor:
- Location – Location is very important for a consistent rental income. When buying a rental property, an investor should not look for a place they would like to live in, but rather look for practical neighborhoods with a lot of amenities, schools/universities, and work opportunities. A villa on a beach may sound fancier than a multi-unit property close to a cluster of offices, but the multi-unit property has more potential to generate rental income year-round than a villa on a beach.
- Condition of the Property – Properties vary in age and conditions. Some properties can be sold at big discounts for many reasons, but it does not always make them appealing investments. Some investors specialize in fixing old abandoned properties and receive a large ROI on them, but new investors should look for well-maintained and lien-free properties as it takes knowledge and experience to profitably operate abandoned properties.
- Type of the Property – There are various types of properties, and they all differ from one another. Condominiums or apartments may be a good option for rental since it does not require a lot of maintenance from the landlord, but the fees associated with Body Corporate services need to be taken into account when calculating the cash flow of the rental. On the other hand, properties like detached houses may not have any extra fees associated with them, but the landlord must spend time to figure out how maintenance is done and who is responsible for it.
Other considerations come in place, and investors usually take several different factors to make a decision. They may be objective like the price of the house, the number of rooms, amenities included, and subjective such as how far away from where the investor lives.
If an investor is knowledgeable in real estate, they might want to look for properties that are on “Short Sale” or are in foreclosure. These types of properties are usually sold at a discounted price, but at the same time, long-term they might require urgent repairs that may add up to the costs for an investor to pay. In addition to that, if there are other savvy investors in the area looking to purchase a foreclosed property, it might be problematic to find a good deal because other investors may compete for the same properties.
5. Optimize Your Cash Flows
When the investor has a property in mind, it’s important to understand what is the Net Operating Income (NOI) on the property. Casaplorer defines Net Operating Income as “the amount of money that a rental property makes after subtracting the costs to operate the property.”
The investor has to analyze the rental market and determine an optimal value of rental payments given what is offered on the market. An investor may use the help of Real Estate Agents to maximize rental income and find tenants.
Don’t forget about the expenses! Maintaining a property may be costly, and it is never a good idea to rely on your tenants to take care of the property. Make sure to have allowances ready for cleaning, lawn care, plumbing, HVAC maintenance, and unforeseeable expenses. This practice helps better estimate approximate income from the properties during bad months.
6. Find Good Tenants
Finding good tenants is one of the most important tasks. A bad tenant may cost an investor a lot of money in cleaning and repairs, and a lot of time in unreasonable requests and pointless arguments. One of the goals of rental properties is to be as close to passive income as possible, and with the right tenants, this goal is easily achievable. Even though it is impossible to always be right when picking tenants, there are still some ways a landlord can increase their chance of getting a good tenant:
- Design the Ad – It is important to indicate what you are looking for in a tenant before posting the ad because it may save a lot of time by filtering out the candidates that do not fit the description even before they try to contact you. An investor should indicate the number of rooms and bathrooms included, what amenities a unit has, how the utility bill is split, and the length of the rental agreement. An investor should not discriminate by gender, age, race, and sexuality as many states have laws prohibiting such discrimination.
- Ask for References – Most of the tenants looking for a property to rent have rented another property from someone else. It is possible to request a reference from the previous landlord, but it might be difficult to confirm the authenticity of the letter, so it is better to be skeptical about the references.
- Run a Credit Check or Verify Income – One of the best ways to make sure that the tenant can pay for rent is to verify their income and ensure that the tenant can afford rent. Pay stubs for the last few months are an acceptable way to verify income. If the tenant cannot provide pay stubs, running a credit check may be another good option to make sure that the tenant can pay their bills on time.
- Conduct an Interview – It does not have to be as formal as a job interview. A chat with your potential tenants may be helpful to identify their personalities and habits. Most landlords want their tenants to be careful with their property. As a rule of thumb, landlords do not want the tenants who smoke heavily, have addiction problems, or tend to party a lot. These characteristics may be an indication of negligent tenant behavior, which may lead to damages that will have to be fixed by the landlord.
- Do a Criminal Background Check – It may be possible to run a background check on your tenants with their permission. This should be done if the landlord is overly cautious choosing their tenants or if the area is known for criminal activity. Appearances can be misleading, so if you feel like something is not right, and you want to ensure that your tenants have not broken the law, ask them for permission to run a background check.
7. Reflect and Learn
Everyone makes mistakes, and real estate is the field where mistakes happen. A successful investor needs an understanding of economic concepts that drive the real estate market, technical knowledge on how to maintain the property, strong sales skills to attract good tenants at a market price, and managerial experience to run the operations consistently. A new investor may be able to achieve the investment objectives they set, but with time they may find new opportunities to generate more income from the property by either attracting higher-paying tenants, decreasing costs of running the property, or even using the income-generating property as leverage for expansion.
Reflection on what has been done right and what could be improved in the future can help the investor to identify opportunities for future growth. An investor may find it beneficial to run the investment as a business conducting periodic analysis of cash inflows and outflows, looking at the depreciation of the items in the units, and asking for reviews from the tenants.
Proper accounting techniques may help an investor understand their financial position, risk exposure, and sources of revenue and costs. Building a network of real estate investors in the area may help an investor to gain insights on how to improve their existing cash flow as well as what opportunities to look for in the near future. Getting acquainted with contractors may help them find cheaper and more qualified experts to take care of the property in case of emergency.
Being an investor and a landlord means constantly learning and adapting to evolving market conditions. If you get into real estate, you will likely make mistakes. If you are consistent in your efforts to make a profit, the mistakes will become opportunities to maximize your profits in the future rather than being serious threats of losing the money invested.