Real Estate Investment Strategies: Rental Property
When most people decide to invest in real estate, they typically think about purchasing a rental property which makes this the most popular investment strategy. However, I cannot tell you how many times I hear, "I don't want to become a landlord. I don't want the headaches associated with managing my rentals." These comments usually come from people who wonder how to achieve success investing in real estate. The fact of the matter is that any successful real estate portfolio is built on strong rental properties.
The best part of owning rental properties is that you don't need to be a landlord. There are dozens of reliable property managers in every area who, for a small fee (about 7-10% of the monthly rent), will manage the property for you. Typically, these companies also have the best network of contacts for the variety of problems that can arise, making them a better option than managing the property yourself. It might also surprise you to hear that tenants are not always destructive and unreliable. People rent for a variety of reasons including: relocation to a new city, saving for a down payment, short term job transfer, interest rates are high, or the local housing market is flat. Fortunately for investors with rental property, this means that in every area there are always reliable people looking to rent.
Property Management
Not wanting to be a landlord is the primary complaint of investors considering rental property. Fortunately for them, there is an entire segment of the real estate industry devoted to managing rental properties for owners. For investors who wish to take a more passive role in managing their portfolio, property management companies provide an array of services including tenant screening and placement, collection of rents, general maintenance, emergency calls and even accounting services. For a percentage of the monthly rents, these licensed professionals will see to all of the day to day operations making rental properties hassle free for investors.
Investing vs. Speculation
There are typically two main objectives when buying rentals. 1) Buy a property where your rental income exceeds your costs resulting in a positive monthly cash flow. 2) Buy in a market expected to appreciate rapidly. While it is important to consider the monthly pre-tax cash flow scenario when purchasing a rental property, you may be willing to accept a neutral or even negative cash flow in fast growing markets because you will more than make up for it in appreciation. This type of investment strategy is typically referred to as speculation or speculative investing.
Many prominent investment gurus will strongly recommend that investors avoid properties that fail to generate a positive monthly cash flow. While these opinions are to be respected, there are always exceptions to the rule. Consider the investors who purchased in Las Vegas in 03-04, these investors rode a wave of nearly double digit appreciation quarter after quarter. It is safe to say that they more than covered any monthly losses incurred over that period of time. It is of course important to mention that had you purchased at the tail end of the Vegas appreciation wave, your experience would have differed greatly, with many investors caught in both a negative cash flow property and a competitive sales market. What it comes down to is accurately timing the market and evaluating your risk scenario. Timing the market may be an inexact science, but evaluating how much risk you are willing to take on is not. In summary, speculative investing, while risky, can be a very profitable strategy if done correctly while exercising caution.
It is easy to see that there is obviously less risk involved in owning property that has a positive pre-tax monthly cash flow, but you always hear "the more the risk you are willing to take, the larger the reward will be." If you truly analyze the different markets, you'll clearly see that in certain markets the rent for a property will exceed the cost of owning, while in other markets, the opposite will hold true. In 2004, rental rates in Dallas were about 1% of the purchase price, while in Las Vegas they were about 0.5%. Not coincidentally, the annual appreciation in Dallas was barely 3% while in Las Vegas, homes appreciated at an unbelievable 52% (July 2003 to July 2004). So unless you time the market just right, you will have trouble making the monthly pre-tax cash flow positive in rapidly appreciating markets. Yet in this example, even with the negative cash flow, the investment was still clearly profitable.
One thing that novice investors often forget to consider is the yearly post-tax cash flow scenario. Frankly, this can be more important than the monthly pre-tax cash flow picture. There are five main criteria that determine how you can take passive losses, but I'll focus on the two most significant. 1) Currently, you can only deduct $25,000 of passive real estate losses against your income. Any losses beyond that must be deferred to future returns. 2) if your adjusted gross income exceeds losses. You might be in a position where your W-2 shows you receiving over $100,000, but it's your accountant (everyone in any form of investing is wise to use a CPA) who's job it is to bring that amount down as low as legally possible to minimize your taxable income. You'd be amazed by how little you can legally report to the government with the right accountant in your corner. Even If you still show more than $100,000 adjusted gross income, you can write off your losses albeit only 50 cents on the dollar. Unfortunately, once you exceed $150,000 annually, you must defer all of your passive real estate losses to future years. (Please note: Real Estate Professionals working more than 750 hours annually and more than at any other job, can write off unlimited passive losses each year. Ask your CPA for details.)
It is easier to think of negative cash flow as relative to the down payment. For example, lets say you put 20% down on a $300,000 property to generate a break even cash flow. Or, for example, you put 5% down on the same property and have a negative cash flow of -$500. So instead of putting $60,000 down, you only put $15,000. That $45,000 difference will mean you could pay for 90 months (7.5 years) before you reached your initial investment. This isn't even considering that once you have 20% equity in a property, you can remove the mortgage insurance which will further reduce your payment. So at an appreciation rate of 7.5% it would only take you two years to reach that mark, when you will have only spent $27,000 ($15,000 down and $12,000 for 2 years on negative cash flow) as opposed to the $60,000 had you invested 20% into the property.
Leverage
Because rentals are a long term investment, it is important to discuss the concept of Leverage. Simply put, leverage is best described as using other people's money to purchase property instead of your own. For example, if you purchase $20,000 worth of stock, you only receive $20,000 in stock certificates. In real estate however, your $20,000 can be leveraged into acquiring $400,000+ of property. With the advent of interest only loans in recent years, it is even possible to leverage 100% of your investment by not bringing any of your own money to the table. This principle is what makes real estate such an attractive investment option. Consider this example: Using the scenario above, if your stock increases by 10%, you net a return of $2,000, but if your investment property goes up 10%, you realize $40,000 in appreciated equity.