So, you want to invest in residential real estate?
Find a property that needs some cosmetic updates and purchase it at below market value. After doing some minor renovations, rent the property to create positive cash flow. Refinance within that year and pull out the additional equity to use as the down payment for your next property. Rinse and repeat! After 20 years, you’ll have a portfolio of residential property worth millions that will provide you with plenty of passive income for retirement.
That all sounds like a great idea and, for some savvy real estate professionals, it’s an effective strategy for building wealth.
But the reality is that this strategy is far from simple.
Fifteen years ago, on the cusp of the Great Financial Crisis, my real estate business was focused on residential appraisals. Much of my work involved preparing Operating Income Statements and Rent Schedules for real estate investment properties. I had a front row seat to the rise and fall of many part-time real estate investors.
Here are just some of the things I learned.
Cost of ownership:
Typically, this was underestimated because the investor believed that Principle, Interest, Insurance, and Taxes (PITI) were the only things necessary to factor. But to accurately predict the cost of ownership, investors need to be factoring the replacement costs of all the major components of the property. Appliances, flooring, mechanical units, roof, etc. – they all have an expected economic life. Planning for that depreciation is part of the equation. For example, if the remaining effective life of the roof is 5 years and the replacement cost is $15,000, then $250 a month should be included in the cost of ownership.
Cash flow:
After appraising hundreds of investment properties here in Northern Virginia, I can count on one hand the number of properties that were cash flow positive assuming a conventional loan with a 20% down payment. Misunderstanding the true cost of ownership is always a factor, but overestimating rental income can come into play as well. Failure to understand that a property likely will not be rented 100% of the time (factoring in a vacancy rate) is often the difference between a property being cash flow positive and cash flow negative.
Property Appreciation:
Real estate always appreciates right? If you’ve only been in the market for the past 10 years you’ve known nothing but rising home values. But the real estate market is cyclical. It’s not a question of if your investment property will lose value at some point but when.
In 2011 and 2012, I saw many part-time real estate investors in a very difficult financial situation. They were cash flow negative on investment properties that they assumed would be worth more than when they purchased them. When their adjustable-rate mortgage reset to a market rate on a property that had become worth less than what they owed, they were left with few options, none of them favorable. Property short-sales, foreclosures, and often personal bankruptcies were common.
Some of the most beneficial tax laws in the country are available to real estate investors. In my opinion, it’s an asset class that shouldn’t be overlooked. Residential real estate investors that do well understand the market, know the numbers inside and out, and are prepared to weather the storm if the fundamentals shift.
Please don’t take this as investment advice! It’s just my perspective after 25 years of studying the local real estate market.
If you’re ready to put your real estate strategy to work, or just make your own home better fit your life, please give me a call. Helping you forge a successful plan given your individual goals and circumstances in today’s fast-moving real estate market is what I do.
Since 2001, JC has been involved in the Real Estate business. He spends the majority of his time as a Realtor®, helping buyers and sellers successfully navigate their real estate transactions.See SilveyResidential.com for more information.