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“If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game.
My buying decisions 10 years ago were based almost exclusively on which housing markets were appreciating the most and the fastest. At the time, it didn’t seem very important to look into “the details”, like whether the rent on the property was able to generate positive cash flow after all expenses (if not, who cares, I was expecting a major capital gain and I figured that would compensate for negative cash flow that I had to pay out of my pocket during the holding period).
I also didn’t look to see whether home price appreciation was in any way tied to sustainable market growth, whether people living in that market making the median income could actually afford to buy the houses (kind of important for an exit strategy), or much of anything else. Although I thought at the time that I was investing in real estate, looking back on it now, I realize I was doing nothing more than speculating on home price appreciation..
And then, THE CRASH…
As soon as the real estate market turned and home prices started going down I was stuck with properties all across the country that were not performing—they all had negative cash flow. I wasn’t going to make another capital gain anytime soon, and I couldn’t afford to pay all that negative cash flow. I was stuck, I was scared, and as it all came crashing down, I got an intimate lesson in short sales and foreclosures as I lost property after property.
I had TWO CHOICES..
When that happened, I really only had two main choices:
1) I could lament myself as a failure, curse real estate as an asset class, quit, resume putting my money into CDs and mutual funds, and keep quiet about my experience for fear that my peers would view me as a failure because of my mistake.
OR
2) I could take it as a valuable learning experience (It certainly cost a lot of money for that lesson!), reflect on the mistake to understand exactly what went wrong and why, commit to intense study of how to avoid the mistake in the future and how to approach real estate investing differently, and then share the mistake with others so they don’t make the same one.
Here are some of the basic factors we help our clients assess when identifying “investor-advantaged” markets and buying opportunities:
How low is the purchase price of the property and how high is the market rent? Often expressed as a "Gross Rent Multiplier", this is an important basic metric to review when buying rental property.
The next layer of real estate investment analysis adds in the monthly expenses, such as property taxes, which vary by market and by individual property, and can substantially affect your cash flow. As a result, the property with the best price to rent ratio does not always produce the highest net monthly cash flow. So, always ensure you determine how much income the property produces after property taxes, insurance, homeowner association fees, property management fees, and an estimate for future maintenance and vacancy. If you are financing the purchase, be sure to factor in your mortgage payment too and ensure that the property still produces a positive cash flow after you subtract all of the expenses from the rental income. This way, whether home prices go up or down, you are still producing a positive monthly cash flow that flows to you regardless of what the housing market does.
It is crucial to look at demand trends for the property and market you are considering. Is there job growth and corresponding population growth occurring to drive rental demand, or is it a declining market? What percentage of the population rents? Are you buying in a highly desirable real estate market that will generate consistent rental demand? Is there a re-sale market for the type of property you are buying so you will have an exit strategy when you are ready to sell? These are all very important considerations when selecting exactly where to buy your property.
The next piece of analysis relates to how much supply there is vis-à-vis demand. What is the market rent and what is the local vacancy rate in the micro-market where the property is located? How many properties are available for rent and how long are comparable properties on the market before being rented? Ask similar questions for home sales, so you will understand the re-sale market for the property you are buying.
An important factor to consider when evaluating any market is whether rents and home prices are in line with median incomes for that market. Specifically, is your property going to rent for an amount that most people can afford (and is it within the high-demand rent range for that market)? Similarly, are you buying the property at a price point where it has space to go up in value and still be affordable to people who make the median income so that they can buy it from you down the road?
When I started buying rental properties over 10 years ago, I didn’t find any writing on mistakes people had made. I only found advice by 2-bit real estate gurus that seemed to advance the speculative strategy I was pursuing.
So, I am hoping this post serves as a warning to this generation of real estate boom-cycle investors about the dangers of speculating. The lesson to take away is always to buy based on real estate fundamentals. Ensure you are happy with the way the property is performing the day you buy it and that you are not dependent on market appreciation in order to make it a successful investment.
I believe residential investment property is the single most advantageous asset class for building wealth, developing streams of passive residual income, hedging against inflation, legally reducing tax obligations, and that it is the premiere vehicle for cultivating the freedom and mobility to design your dream lifestyle. But that is if and only if you are investing in real estate, and not speculating.
We are not a tax professionals, this is not tax or legal advice, and tax laws are constantly being changed and revised and may change the day after you read this. So, this is for informational purposes only, and it is your duty to consult with your own tax professional about your individual situation and the most updated applicable laws before attempting to implement any of the content in this post.
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