The idea of passive income, or the ability to make money from a source other than a typical paycheck, drives many Americans to consider real estate investments. Cash flow from rental income combined with long-term appreciation makes investment homes seem appealing … at least in theory. Is buying a house a good investment, truly?
In reality, the world of real estate investing is much more complicated than you’d imagine, especially when you start talking about taxes, appreciation, returns, and optimal markets.
To get some insight into the realm of real estate investing, we talked with real estate agent Jason Mancuso, who specializes in investment properties in the upstate New York area. Mancuso’s Rochester, New York, market draws investors from around the globe, due to lower-than-average entry points and high rates of return. But despite the booming industry, he points out that real estate investing is not for everyone.
Consider the following strategic tips to help you decide whether or not real estate is the best investment for you. No matter what, one thing will become crystal clear: The idea of “passive” income is a myth!
Define your criteria
“As Realtors, we encompass both the entry to the market and the exit,” Mancuso says.
“We want to make sure there’s a game plan and a criteria, and that a particular investment is going to fit.”
Ideally, an investment property will yield gains in the short term and the long term. But that’s not possible for all investors in all markets. Sometimes buyers are forced to choose one or the other: immediate income or appreciation over time.
Immediate income criteria
Buyers who are interested in real estate investments as a way to supplement their monthly income will want to look for properties that maximize rental profits. Cash flow is the focus here, so buyers will need to work to keep expenses low and rental income high.
To meet this criteria, buyers may want to consider:
- A higher down payment: More money down will decrease the mortgage payment each month and yield greater net income from tenants.
- Multifamily properties: Additional units bring in additional rent while minimizing some expenses, as insurance, taxes, and some maintenance costs are shared beneath a single roof. Living in one of the units increases the savings!
- House-hacking: Renting out rooms of a larger home can maximize income; this strategy is popular in suburbs just outside major cities.
- Vacation rentals: In some locations, renting by the week brings in more cash than long-term leases. But beware of higher upkeep costs.
Appreciation growth criteria
Investors who are looking to get into real estate for the long-term gains will have different goals and therefore might want to look into different strategies. Long-term growth is the focus here, so buyers will want to think through asset development over time.
To meet this criteria, buyers may want to consider:
- A lower down payment: A low down payment on the front end increases your return on investment later. But watch those interest rates!
- Retirement properties: Consider purchasing a house that you will eventually live in full-time to potentially decrease capital gains taxes.
- Flip-and-sell properties: Buy low, remodel, sell high — certain markets can support profitable flips either in the short or long term. Timing is key!
- Markets of scarcity: When demand is consistently higher than supply, appreciation tends to be more secure. Waterfront communities and revitalized downtown properties usually represent two markets of scarcity.
Set your purchase budget
Some investors choose to build their real estate portfolio using the BRRRR method, which stands for: buy-rehab-rent-refinance-repeat. This type of strategy relies on cash upfront, either from personal savings or from other investors such as friends or family members.
If you plan to follow the BRRRR method, then your purchase budget is pretty firm in terms of the sum total that you have to work with. At that point, the challenge boils down to negotiating a purchase price that leaves enough cash available for renovations. And don’t forget to budget in any closing costs, inspections, appraisals, and expected carrying costs prior to placing tenants.
If you’re not paying cash for an investment property, you’ll need to figure out what kind of mortgage payment you can afford while still bringing in cash flow from your investment. Understanding the potential for returns can help.
Consider potential returns
Return on investment is an important accounting measure regarding the value growth of a property. However, for real estate investments — especially those that produce income — returns are not always easy to calculate, and the standard varies based on how the return is being calculated.
Return on investment
In its most basic form, ROI is expressed as a percentage and can be calculated by the following formula:
ROI = (investment gain – investment cost) / investment cost
Let’s take a simple all-cash purchase scenario for the sake of basic illustration. If you bought a home for $100,000 and it has since appreciated to $150,000, then your ROI is 50%.
($150,000 – $100,000) / $100,000 = .50, or 50%
Of course, that example assumes no additional expenses whatsoever, so it’s not entirely realistic, but you get the idea. In real life, you’ll need to account for all costs, including (but not limited to) closing costs, interest payments, renovations, repairs, vacancy costs, and much more.
Many investors talk about the health of their investments in regards to the capitalization rate, or cap rate. Cap rate takes the production of income into account and indicates whether or not the property is profitable.
Cap rate = net operating income / total investment
Again, let’s take a simple all-cash purchase as an example. Say you buy a home for $100,000 and you make $12,000 in rental income over one year. Your cap rate for the year is 12%.
$12,000 / $100,000 = .12, or 12%
This example is very basic, but it does assume that your income (that $12,000 figure) has been adjusted for operating expenses. Net operating income is gross income minus operating expenses (items like principal, interest, taxes, and capital expenditures are not included as operating expenses).
It’s worth noting that some investors prefer to calculate ROI differently, particularly if they’ve leveraged the sale by obtaining a mortgage loan. Seek assistance from a financial advisor regarding the various ways to calculate your personal ROI, based on your criteria as well as your financing situation.
Once you figure out your anticipated rates of return, that will help you narrow down your property search. Rates of return will vary significantly depending on the location and type of property. A good return in one city could be considered a poor return in another. This is where an expert real estate agent comes in.
Find a property that fits your criteria
A good real estate agent will be able to help you find a property that best fits your investment goals. Again, a property that offers both cash flow and appreciation is ideal, but often investors are forced to focus on one goal more than the other.
Consider how the following property features might fit into your goals.
Number of bedrooms
More bedrooms mean you can charge more for rent, though the actual dollar amount varies by locale. In California the average monthly rent increase from a two-bedroom to a three-bedroom home is more than $1,200; in Ohio the figure is closer to $150.
Number of bathrooms
More bathrooms also mean you can charge more rent. One Atlanta study estimates that rent could increase by around 3.1% for additional bathrooms.
Make sure there’s adequate space for multiple cars, especially if you’ll be renting to multiple roommates (house-hacking).
Catering to urban professionals requires easy access to transportation options.
Being within close proximity to grocery stores, shopping, and restaurants make your property more desirable to tenants. The neighborhood influences rental decisions for 52% of tenants.
Good schools are important if you intend to rent to families.
An outdoor space could allow you to open up homes to renters with pets, which increases your pool of potential tenants.
Storage is especially important for vacation rentals, where you’ll likely want to keep certain personal items locked away.
“Many investors come to the table with preconceived notions about the types of properties that they want to pursue or that they’re used to owning,” Mancuso says.
In his experience, an in-depth discussion about what you really want to get out of your investment can help your real estate agent direct you to the best purchase. Or they may tell you to look elsewhere.
Look outside your current market
Sometimes the best investment opportunities may be outside the area where you currently live. If your local real estate agent can’t find something that fits your investment criteria, you may need to expand your search.
A recent analysis of nationwide rental markets indicates that the following cities could be good options for investments, based on three factors: job growth, population growth, and property affordability.
- Orlando, Florida
- Tampa, Florida
- Huntsville, Alabama
- Birmingham, Alabama
- Dallas, Texas
- Houston, Texas
- Cleveland, Ohio
- Atlanta, Georgia
- St. Louis, Missouri
- Albuquerque, New Mexico
Settle in for the long haul
Real estate investing is not a get-rich-quick scheme. In most cases, you’ll need to adopt a long-term perspective to realize the most benefits.
Also, if you sell your property too quickly, you may risk paying short-term capital gains taxes, which are usually much higher than long-term capital gains taxes.
That said, most people will eventually have to pay long-term capital gains taxes on any profit made from the sale of an investment home (unless you’ve lived there yourself for two or more years before you sell, or you reinvest the proceeds into new real estate within six months). As you’re planning for the future, be aware of that potential dip in your appreciation profits. Long-term capital gains taxes are currently 0%, 15%, or 20%, depending upon your tax bracket.
Talk to a financial advisor about the reality of capital gains taxes. (And talk with your accountant about minimizing taxes on a yearly basis through depreciation!)
“Investing is cyclical,” Mancuso says.
“There are ups and downs. But you’ve got to roll with the opportunities when they’re there.”
With all these factors to consider, real estate investing clearly isn’t a kick-your-feet-up kind of “passive” income. Investors need to be savvy and intentional in order to find properties that will maximize their gains while minimizing their risks.
If you’re interested in real estate investing, set up a consultation with one of our top-performing real estate agents in your target area. The right agent will help make the investment process a lot easier!
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