To make a rental property purchase successful, owners must find a bargain — paying no more than 80 percent of the home’s value when factoring in purchase price, closing costs and renovations. But what happens when an owner wants to own multiple rental properties? How does someone go about acquiring them?
Say you had $40,000 cash and bought one property all cash, but the property was worth $50,000 and rented for $500 per month. Then you went to the bank and refinanced that property for 80 percent of its market value. That means the bank would give you back your $40,000. I estimate that you’ll make about $50 per month in positive cash flow on the rent after you refinance. Then next year you do it again, and you repeat the process for 10 years.
- Purchase one property per year all cash.
- Property value is $50,000, but you pay $40,000, giving you $10,000 equity on Day One.
- Property value increases 3 percent each year.
- Gross rents stay steady for 20 years (rents historically go up significantly).
- Rent deposited into a noninterest-bearing bank account.
- Refinance the property with a local bank pulling all or most of your money out to repeat the process each year.
- Tenants pay down your debt. Debt pay-down and property appreciation increase your equity.
Based on these assumptions, at the end of 10 years, your $40,000 investment would grow to more than $256,000. If you didn’t buy any more homes and let the investment ride for another 10 years, that would grow to $643,000. If you continued buying homes for 20 years, it’s easy to assume that your $40,000 investment would grow well into the $1 million range.
You can easily pick these calculations apart. I admit they’re very simplified. For instance, I’m assuming that the purchase price of the next property stays the same year after year. In five years, you probably can’t buy the next property for the same $40,000 you bought your first property. Your price will fluctuate, but the forces of wealth creation will continue to work the same. The process will work no matter what the price, as long as you buy at the correct percentages.
Rental properties are a powerful wealth builder because they grow value in three ways: They typically appreciate in value over the long run, they harness the power of debt leverage, and they provide monthly income. Most years the value of your property goes up and your mortgage goes down. That’s why you want to use debt in your real estate investing, but you need the right amount of debt. Overleveraging is a financial killer.
I add a big caution: You must calculate your expenses correctly. There are far more expenses with a rental than just your mortgage payment, taxes and insurance. Vacancy, management and maintenance are real costs. Make sure you account for all of them.
These are just my projections on what I believe to be the most likely outcome. Individual experiences may vary. Market conditions can change, and historical performance is no guarantee that real estate values will continue to go up. There is always risk of significant financial loss whenever you purchase a piece of real estate. Proceed with caution.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.