Using financing, especially in a low interest rate environment, is a great way to leverage the property while keeping the risk low. The downside is that it adds to the cost and reduces the profit margin. If you are looking at it from a pure investment perspective, the question is: How much can I make on the investment? Financing allows you to keep more of your cash (or use less) and diversify your investment portfolio. Financing also allows for the ability to build a real estate portfolio for long term income generation. Over time, the loans will be paid off and you can maximize the cash flow.
One popular formula to help you decide if a property is good investment is the 1 percent rule, which advises that the property’s monthly rent should be no less than 1 percent of the upfront cost, including any initial renovations and the purchase price. For example, if a property costs $300,000, it should rent for at least $3,000 a month. Analyze rental rates of similar properties in the neighborhood to determine a property’s likely rent.
Given the high real estate prices in the Washington area, it can be difficult to reach the 1 percent metric. In these cases, you will need to hold on to the property longer to build income over time and increase the amount of rent received. While time is not guarantee of growth, it allows for more opportunity.
You should have a clear goal in mind and understanding of the market. If the goal is to keep the property as an investment for income and to have a long time frame, purchase price is less of a concern as long as cash flow is positive and trending upward. Over a decade or more, the positive rate will grow with inflation and as costs decrease. If the goal is to maximize profit, the price you pay is important.
A second rule of thumb is the capitalization rate, also known as a cap rate, which helps determine the rate of return expected compared to alternative investments. To determine the cap rate, first calculate net operating income, which is the expected annual income from rentals minus costs for taxes and maintenance. When estimating the expected income from rentals, be conservative; there are likely to be periods of vacancy between tenants. Then, divide the net operating income by the current market value of the home.
For example, if the net operating income for a home is $30,000 and the property value is $300,000, the cap rate would be 10 percent. A cap rate between 4 and 10 percent is generally considered a good rate because it is comparable to other investments such as Treasury bonds or stocks. On average, Washington properties fall into the 4 percent range because purchase prices are high, and rents are somewhat stable. Although this is a reasonable cap rate, when you compare it to historical market returns of 8 to 10 percent, you would probably do better investing in a long-term, diversified portfolio.
Both of these formulas provide a general guideline to help you narrow down your options, but they do not guarantee success. The real estate market is extremely speculative and can fluctuate wildly.
Investment properties should be viewed as a complement to an investment portfolio and a way to diversify your investments. Capital appreciation is what many are after, but cash flow from rental income is a much more realistic benefit. To monetize the property for capital gain, time of ownership is very important. Typically, you want to own a property for 20 years or more to see significant capital gains, but because real estate is unpredictable, capital gains should not be part of your analysis. For example, many believe that Arlington will see an appreciation boost once Amazon builds its new headquarters nearby, but that is speculation. Assuming that a neighborhood will change is a risk that can cost you the value of your investment. Instead, talk with a real estate agent to find a location that has and is likely to remain desirable.
Potential tax write-offs can help make bottom line returns more attractive and help to keep more money in your pocket. But there is a downside to taxes when you sell the property because years of depreciation can create a large tax bill.
Reinvesting the income from the property can also play a significant role in maximizing wealth. If the cash flow is not needed to supplement current income, reinvest the money into a market-based investment or additional rental properties. This enables you to further increase long-term gains. To further maximize the investment, minimize the outflow of costs. Every additional dollar spent on high-end renovations and property management works against your profits.
It’s important to do your due diligence and understand the commitment of an investment property. You may need to invest a lot of time and effort to keep up the property, unlike other investments.
An investment property may be worth considering if you want to diversify your portfolio, can afford to own the property for a longer period of time and do not need to rely on it for liquid assets. Investment properties can have inconsistent income – there is no guarantee of renters every month – so if you will need quick access to the funds, it may not be a fit with your financial plan. To determine if an investment property fits into your portfolio, talk with a financial adviser.
David Mount is a director with the Wise Investor Group at Robert W. Baird & Co. Incorporated in Reston, Va. Baird does not provide tax, legal or real estate advice.