We love real estate. We’ll get into the three reasons why in a second, but first let’s talk about how we choose to look at our real estate investments. A lot of real estate investors will buy a piece of property such as a single family home or a condo and bank on the appreciation. As an example, an investor will buy a property for $190,000. Their goal will be to rent the property for 3-5 years and then sell it for a gain of maybe 20%. Many real estate advisors and coaches will estimate that real estate will appreciate at an average of 3% per year.
If this is true, this $190,000 property would be worth just over $220,000 in five years, or just under a 16% gain on the investment. And this actually gets even better because as an investor, you can put 20% down on the property which would be $38,000. That means the cash on cash return is almost 80%! The investor made $30,000 ($220,000 minus $190,000) while only putting in $38,000 of his or her own money. Not bad, right?
However, there are a few issues with this strategy. If you only buy with appreciation in mind, you can get burned.
Why We Don’t Like to Buy Investment Properties With Only Appreciation in Mind
1. Negative Cash Flow
When investors buy for appreciation, they often forget to look at what their monthly cash flow will be on the property. Using the same example above, if the investor has a mortgage of $152,000, and at a 5% interest rate, which is pretty low based on historical rates, that leaves a monthly payment of about $1,015. Let’s say you can rent the home for $1,250 per month. That gives you a nice monthly cash flow of $235/month.
But we didn’t factor in a few other components. We didn’t factor in repairs, taxes, vacancies, or insurance. Honestly, those can add up to well over $235/month. It’s a good idea to estimate 1 month of vacancy per year to allow for time in between tenants. Estimating 5-10% for repairs will keep you in a good cash flow position as well. Just between vacancy and repairs, you’re at $230/month ($1,250 times 10% is $125 (for repairs) plus $1,250/12 is $105 (spreading the vacancy out over the year)).
At the end of the day, you’re paying money out of your own pocket to keep the investment running. It may not be much, but this is where investors get in trouble. Maybe you’re paying $50 or $100 per month to keep the rental occupied. That adds up to $600 – $1,200 per year. Over the 5 years you’re waiting for it to appreciate, that adds up to somewhere between $3,000 and $6,000. Already, that gain of $30,000 has dropped to somewhere between $24,000 and $27,000. And this gets really scary if the market turns or is flat and you experience zero appreciation or even a negative appreciation. You can’t sell the property, so you’re having to pay money out of pocket each year.
2. Commissions on Sale
When the investor goes to sell the property (let’s assume, it appreciated to $220,000 over 5 years), there are commissions to be paid to the realtors. Both the buyer’s realtor and the seller’s realtor. It’s safe to assume 6% of the proceeds will be lost to commissions. In this case, that totals $13,200.
Now, between the negative cash flow and the commissions, the total gain is somewhere between $10,800 and $13,800. Now that 80% cash on cash return is down to somewhere between 28% to 36%.
3. Taxes on Gain
In addition to commissions, you will also have to pay taxes on the gain since this is an investment property and not a primary residence. The tax rate is 15%. So, if we take the $200,000 minus the original purchase price, minus $13,200 in commissions, the gain on the property is $16,800. So, 15% of that would be $2,520.
Taking $2,520 out of the possible total gain range above ($10,800-$13,800), the total gain is now somewhere between $8,280 and $11,280.
This also assumes the investor is managing the property himself instead of paying the standard 10% property management fee. This feels like a ton of work to make about $10,000 over 5 years. Remember: these calculations assume the property actually appreciated that much. Sure, it could appreciate more, but that’s taking a pretty big gamble. It could also go down, and you’d be stuck paying monthly because of the negative cash flow.
Why You Should Buy for Cash Flow, Not Appreciation
When you invest for cash flow, you’re securing yourself a great investment. Here are the 3 reasons why we love our first rental property.
1. Money in the Bank
When you buy property with cash flow in mind, you’re setting yourself up for success. It ensures that you’re thinking through the investment with a business mindset. You have to look at several components to make sure you get it right.
Here are some of the core components I look at:
- Down Payment. How much cash are you going to have to take out of your pocket to acquire the investment?
- Repairs. Do you have to add cash to the investment to get it into a condition where it can be rented?
- Market Rate for Rent. How much can you realistically rent the property for?
- Mortgage Payment. What is your monthly commitment in terms of mortgage, interest, and possibly PMI.
- Estimated Expenses. How much will you need for vacancy, taxes, cleaning, tenant screening, advertising, HOA dues, etc.?
With our first property, I underestimated the expense side. We’re still cash flow positive, but in the future, I’d look for a higher monthly cash flow.
However, when I purchased the property, I was under a bit of a time crunch and my plan was to live in the property for a while. I’ll lay everything out in detail in the next section.
At the end of the day, acquiring real estate for cash flow puts money in the bank for you. You have to consider the core components above to ensure that your real estate can and will realistically cash flow.
2. Decrease Your Mortgage Timeline
The second reason we love buying for cash flow is that it allows you to speed up your mortgage timeline with other people’s money. Let’s say your mortgage payment is $1,000 and you’re renting your property for $1,800. After expenses, let’s say you’re cash flowing $500 per month. That’s an extra $6,000 per year in your pocket. After a year or two, you’ll have enough saved up to cover any major expenses and vacancies, so you can start applying some or all of this money to the mortgage principal each month. Even if you put half of that money towards the principal, that would be the equivalent of 3 extra payments per year towards your mortgage!
If you put 3 extra payments towards your principal each year, that will shave off roughly 10 or more years! Once the mortgage is gone, your cash flow skyrockets.
3. Appreciation is a Bonus
Appreciation is a bonus – it gives you the OPTION to sell which is the position you want to be in. If you’re counting on appreciation, you have nothing to fall back on if the market takes a dive. However, if you invest for cash flow, even if the market turns, it doesn’t matter because you don’t care about the value of your property as long as it’s still putting cash in the bank. On the flip side, if you invest for cash flow and the market explodes, you’ll have the option to sell. Maybe your investment increases by 50% or more and you want to sell. You can. You can take a huge influx of cash and re-invest it. You may even be able to leverage yourself into 2 smaller properties depending on the situation.
At the end of the day, you want to have this as an option if things are going well, but you don’t want to have to bank on it. If the market turns south, you’ll be in trouble if you’re in a negative cash flow situation.
Our First Rental Property Story + The Numbers
So, here’s our story of our first rental. Back in 2010, I was pretty fresh out of college, but I knew I wanted to get into real estate. I had been consuming real estate books and reading a lot of Rich Dad, Poor Dad. I wasn’t making a huge salary, but I had some money in savings, so I started looking at properties. I also knew I was planning to rent out part of whatever unit I purchased to help cover the mortgage. I ended up finding a townhome that I purchased for $142,000.
As I stated above, I would look for more cash flow in my next property, but I was under some time constraints trying to take advantage of an $8,000 first time home buyer tax credit the government was running that year. Luckily, I was able to sign the contract and complete the transaction 1 day before the tax credit expired. Since I didn’t have a ton in savings, I did an FHA loan which enabled me to put only 3.5% down. So, after it was all said and done, the down payment and closing costs totaled $6,500 and then I got $8,000 back for the tax credit.
I just landed myself a townhome with essentially no down payment and $1,500 more in my bank!! I still wonder to this day if I’ll ever have another awesome opportunity like this.
When I moved in, my total payment including mortgage, interest, PMI, taxes, and HOA dues was $1,070 per month. I spent the first month getting moved in and getting organized, but I also started advertising for a roommate. I was able to rent out the basement for $600 per month which left me with only $470 left to pay myself. Because my income was still pretty low, I wasn’t able to put as much as I wanted to towards the principal, but each month I added an extra $150 to the mortgage payment, which went straight to the principal.
Today, Rachael and I live in another home that we purchased in 2013, so we’re renting the entire first unit. Here’s what the numbers look like today:
- Rental Income: $1,250
- Mortgage, Interest, PMI, Property Taxes: $880
- HOA Dues: $178
- Insurance: $24
- Total Expenses: $1,082
This leaves me with a cash flow of $168 per month. This doesn’t factor in repairs or vacancy. As I said, if I purchased another, I would look for a property with $400-600 in cash flow per month, but because of the situation I was in when I acquired the property, it has been a great investment. Last year, the property put an extra $1,600 in the bank after a few minor repairs and the renters helped us pay $5,000 off the principal.
As a side note, the value of this property has increased from $142,000 when I acquired it in 2010 to $191,000. This has added $49,000 to our net worth in less than 5 years.
Was this property the best investment in terms of cash flow? No. However, because it actually put $1,500 in the bank and didn’t cost me anything out of pocket to acquire it and it is providing us with a positive cash flow, it has proven to be one of our best investments to-date.
We’d love to hear from you. Do you invest in real estate? How has it gone so far?