Inflation has been on a steady rise in the past 6 months and real estate prices, especially, single family homes have been skyrocketing ( single family homes are more preferred after advent of Covid pandemic due to privacy and distance from the neighbors). In this environment, where the markets are pricey and interest rates might shoot up from all time lows in the coming years, it becomes more critical to do due diligence and make sure you are comfortable with home numbers calculated before investing your hard earned money in a single family home for rent. I am a real estate investor and own quite a few single family homes. In this post, I want to share with you some of the factors that I look into evaluating a single family home investment before I sign the dotted line. The scope of this post is about investing in single family homes for rent and does not cover primary homes ( homes in which you would live).
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Location
In real estate, everything is location. How do we determine which location to buy? Every financial site might have a post such as “Top twenty Cities to invest in 2021”. What I meant is there is ton of information available online to research about places to invest. Basically, we need to look for cities that have huge population growth along with considerable job growth and is land lord friendly. Currently, Florida is considered one of the best locations to invest as it is landlord friendly, less taxes, rising GDP due to huge influx of population. Atlanta and Dallas are also great places to invest purely from location perspective. I personally like investing in areas that have not had the growth yet but have huge potential such as Cincinnati Ohio , Kansas City, Missouri, Birmingham Alabama etc. As you are reading this, you might be thinking that it might be challenging to manage these long distance investments and it may not be for me. It is not as hard as you think. I would highly recommend to read this book ( available in Amazon) to get more information.
Neighborhood
Here, I am assuming that you are knowledgeable of the neighborhood classifications and not going into detail. I prefer to invest in Class A and Class B. I invest in Class C only if the deal is too good to ignore numbers wise ( look at next sections) and completely avoid class D ( too much hassle). Class B and Class C provide good cash flow whereas Class A provides good capital appreciation. It is recommended to have a balanced mix of Class A, Class B and Class C properties in your portfolio for cashflow and appreciation.
Property Age
It is always preferred to buy newer homes as you might have negligible maintenance. In fact, lot of real estate developers are building the newer homes for renting it out ( build to rent) to attract investors. These homes are designed to attract tenants by providing aesthetic features preferred by most renters. It is very easy to rent these homes and need not worry about maintenance in the short run. Also, these homes appreciate faster due to the rising demand. However, it comes with a price. As the construction costs are rising due to supply demand issues and inflation, these homes can be very expensive and may not fit in the budget of many real estate investors.
Traditionally, Turn key properties have been the best bet for optimal cash flow with considerable appreciation for real estate investors in the long run. However, there are some challenges with these properties. These properties might be very old ( anywhere ranging from 20 to even 100 plus years [ built in 1900]) and may have older wiring and pipes. And as the age of the home increases, there might be foundation issues. Turn key developers do a great job renovating interior of the house and provide newer appliances to attract renters. They also verify that there are no known structural and foundation issues with the home. However, it is just a matter of time before we might get affected by these issues as the age of the home increases and might affect your cash flow
So far, we talked about what we need to look for in an investment property. Whether you are buying a turnkey or new construction, I would highly recommend a real estate investor to have a long term mentality ( assume at least 5–7 years) and pay importance to the numbers (explained in the following sections) to have a healthy cashflow even on rainy days (vacancy, Capex etc)
50% Rule
As per this rule, assume that 50% of the rent received goes for operational expenses ( insurance, property management, utilities etc). How much of the remaining 50% is left after paying the mortgage including property taxes . Ideally, I would recommend to have at least $200 per unit to consider the home.
1% Rule
As per this rule, calculate the percentage of the rent received w.r.t to the value of the home. I would recommend this percentage to be around 1%. For example, if the rent received is $1000 for the home valued at $100000, the ratio is 1%. When you are purchasing a property, I would recommend to have this ratio to be greater than .8 to not lose money.
Traditionally, rents do not increase proportionately with the prices. As this ratio decreases, it would be wise to consider selling the property and buying less expensive properties for more cashflow.
Cash on Cash Return
Cash on Cash return is the percentage of net income for the year w.r.t to the initial costs . I would highly recommend this ratio to be around 12% for a healthy cashflow
Traditionally, a real estate investor pays 20–25% down payment and about 2.5% closing cost for purchasing a property. Based on the figures mentioned, total initial costs for $100000 would be 27500. Let us assume that the property is rented from day one and is fetching 1000 per month with all utilities paid by tenant.
Also let us assume that mortgage interest is 4%. Property taxes for the month is around 2% and insurance is around 1%. Based on these percentages, mortgage would be around 350, property taxes will be 200 and insurance would be around 100. So, total expenses would be 650. Cash flow for the month would be $350 and for the year would be 4200
Cash on cash return for this home would be an awesome 15.27% ( 4200/27500 *100)
As per 50% rule, we allocate 50% of the rent to operational expenses- $500. our mortgage rates are 350. So the net cashflow for month is 150$
As per rent to value rule, we are at 1%.
Did u see how these three rules align and show the positive cash flow for this scenario?
Interest Rates
Real estate investors are in a dilemma currently with the price of the homes rising and interest rates though rising are still at all time low. Every one knows Fed will start rising interest rates next year and that will bring the market prices down because of affordability.
Million dollar question would be should I wait until the market prices come down or should i buy now. Thats a great question. General rule of thumb as per experts in the industry is that the property of the price should fall by 10% if the interest rate goes up by 1%. But, will it happen? No body can predict.
Personally, I think real estate prices go up over a period of time and is the best hedge for inflation. And as long as the numbers crunched through 50% rule, 1% rule and cash on cash return are aligned with expectations mentioned, there is a very good possibility that you will be making a healthy cash flow.
Summary
Real estate through single family homes is a great investment vehicle for equity, cashflow and taxes. I was very skeptical a few years ago until I bought my first investment home and fell in love with passive income (icing on the cake is that you do not even pay taxes on this income because of depreciation) generated monthly through rents along with my net worth ( appreciation)rising every year.
However, buying single family homes involve considerable amount of hard earned dollars. Bad decisions can lead to catastrophic losses and might be hard to recover. Hence, it is very critical to be diligent and follow a system that works with discipline. In real estate, we do not need lot of investments but do need a few good investments to enhance life style. So, it is worth rejecting a lot of homes that do not satisfy system criteria before choosing one.
Happy Investing !!
Crypto is another asset class that we can invest to diversify. If you like this post, you might also like how to invest in crypto to understand the various crypto types available currently, what to invest and how to invest.
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