If you're just starting out, here's how to choose your investment property and increase its value for maximum return on investment. Whether the amount you can invest is $10 or a million dollars or more, it’s important to understand the fundamentals of real estate investing, how to get started and, most importantly, how to select investments that will yield the maximum return.
Predicting cash flow: The 50 percent rule
There’s a simple rule to follow called the 50 percent rule that is a pretty accurate predictor of whether a property will have a positive or negative cash flow. This is based upon the fact that your non-mortgage expenses generally come to about 50 percent of the rent. This includes your property taxes, property insurance, repairs, maintenance, vacancy rate and management fees.
The correct calculation is that the cash flow is the rental income, minus 50 percent for non-mortgage expenses PLUS the mortgage payment.
Leverage magnifies your returns, whether they’re positive or negative
Leverage is one of the greatest advantages and potential disadvantages when it comes to real estate investing. Everyone is familiar with putting 20 percent down to buy a home. In that case, the buyer is leveraging 80 percent of the purchase price by using the bank’s money.
To illustrate this point, if you buy a $500,000 property with $100,000 down and it increases in value by 10 percent ($50,000) during the first year, your rate of return using leverage is 50 percent ($50,000/$100,000 =50 percent) vs. only 10 percent if you paid all cash for the property.
On the other hand, if you buy a bad deal, you’re going to end up with terrible returns because you will be paying all those expenses every month to cover both your mortage payment and your negative cash flow. The result is that you will have a major “liability” rather than an “asset.”
House hacking: A great leverage play
Let’s say you purchase a triplex using a three percent down FHA loan. You leveraged your purchase by using only three percent down from your funds and using 97 percent of the bank’s money. You also have additional leverage in that your two tenants are paying you rent, plus about 2/3 of the utilities on the property.
In contrast, a single-family residence would have you bearing all those out-of-your-pocket costs as opposed to only one-third of them.
Rents increase with inflation and flatline in down markets. They almost never go down
While home prices dip with recessions, rents do not. The worst-case scenario is that they flatline for a year or two.
Your monthly cash flow calculation should include money for major expenses you should typically allow about 10 percent to 15 percent of your rents for maintenance, depending upon the age and condition of the property. Vacancy rates typically run 4 percent to 8 percent. A 4 percent vacancy rate comes out to one month of vacancy every two years. Eight percent is one month every year.
Avoid purchasing a multi-unit building with master meters
While you can certainly include utility costs in the rent, the smart move is to purchase a property that has individual meters, and have the tenants pay their own utility bills. That will really help you if you get a very cold winter or hot summer.
Once you have a handle on the fundamentals, here are several great choices to get started real estate investing, even if you don’t have that much money: - Crowd-funding: A different way to invest
- The B-R-R-R-R model. “BRRRR” is an acronym for “Buy, Renovate, Rent, Refinance, Repeat.”
- Syndication
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