- To break the myths surrounding investment properties, I’ve done a simple financial overview of an investment in real estate.
- There’s a big difference between real estate investing and speculating that many don’t get.
- I find direct real estate investments an essential part of a well-diversified personal portfolio.
I know interest rates are expected to go up which should lower real estate prices, but to start things today, I want to first distinguish between two very important things when investing in real estate. Do you want to be a speculator or a real estate investor?
The difference between the two is that a speculator is primarily concerned with whether their investment, or rather speculation, will increase in price in the next year or two or so.
A real estate investor on the other hand is focused on the long-term return from their investment in relation to the risk they’ve taken on.
What I mean when I say “real estate investing” is that you buy and hold on to a piece of property at least until the prices in the area you’ve bought in are so ridiculously expensive that it would be wise to sell and invest somewhere else with a higher yield. So, a real estate investment should be held probably forever and has to be made with satisfying returns.
Another extremely important point when it comes to real estate that many fail to grasp, is that not every piece of real estate is equal, just as no stock is. This is even more important with real estate than with stocks as with stocks, it’s easier to be diversified. When you buy your first property as a diversification for your portfolio, the real estate part of your portfolio can’t be called diversified.
So there are two main points I want to cover in today’s article. The first is to elaborate on what you can expect from investing in real estate, and I stress the investing part of this statement. The second is how to find a proper real estate investment as there are a few important differences between investing in stocks and investing in real estate.
The Finances Of A Real Estate Investment
The simplest option when investing in real estate is to buy it with cash. However, as a proponent of temporal diversification—which looks to invest in things that are cheap in the current environment—I would instead look for a fixed-rate mortgage to take advantage of the insanely low interest rates we have in the current financial environment.
So what you’ll need is a 20% down payment, or even 25% if the lower interest rate justifies an increased investment, a little work as you are the manager of the property, and a clear set of buying criteria that we’ll discuss later on in the article.
The main premise behind following is that you are investing in real estate, not speculating. An investment in real estate should focus on the cash flows and not on the future price of the property. The future price is important, but let’s leave it as a potential bonus and not as the main focus of the investment.
I’ll assume that real estate prices will double in the next 30 years, which implies an inflation rate of 2% which is extremely conservative.
When investing in real estate, and not speculating, the most important thing is the cash flows and not the potential price appreciation. Focusing on the cash flow will also allow you to not care too much about how real estate prices move because no one can predict that in the short and medium term. Therefore, the most important thing is that the rent from the tenants covers the cost of the mortgage. When that is achieved, if there is some cash left after expenses, even better, you can call yourself a real estate investor. After 20 or 30 years the mortgage will be paid off and the rent will provide you long term passive income that will come from the small down payment you invested in the first place.
According to Zillow, the median home price in Boston is $561,400 while the median rent is $2,700.
Now, I know prices in Boston have almost doubled in the last 6 years, but we’re discussing real estate investing here and not speculating. To purchase a median home in Boston, you would need a down payment of $120,000 and your mortgage would be $450,000. With a 4% interest rate, your monthly payment would be around $2,150, which is lower than the $2,700 average rent payment. When we include vacancy periods, maintenance costs, etc., this property would bring in almost no cash flow if the market remains as it is now.
But even if rental rates remain stable and real estate prices go nowhere, your mortgage would be paid off in 30 years and you would own the property outright. The return on your $120,000 initial investment would be just north of 5% per year, which isn’t bad.
This calculation was based on the median home price in Boston and the median rent. Let’s now dig into some things to take into consideration when buying real estate. Things that might significantly increase that 5% return.
If real estate prices double in the next 30 years, you’re already looking at an 8% return, not to mention that the rent yield in 30 years will then be double and would provide you with a 50% yearly return on your initial investment (down payment of $120,000 – rent in 30 years of $5,400 per month – $64,800 per year, or 54% return on your down payment).
Real Estate Investing Tips
Your competition isn’t Wall Street investment bankers.
The difference between investing in real estate and investing in stocks is that with stocks, most of the competition comes from speculators, while with real estate, a big part of the competition is from emotional home owners who try to speculate with real estate. They usually buy high in fear that prices might go even higher and sell low in foreclosures. So make sure to take advantage of such predictable behavior.
Look for a moat.
Real estate is one of the few asset classes left in this fast-changing environment that has a moat.
You can’t add much to the number of cozy apartments in historical town centers or houses in certain districts. Therefore, if the area is nice and in high demand, demand will probably keep rising while supply will remain fixed.
Here we are entering a bit into speculation but if the investment part is solved, then why not try to increase your returns for the same risk? So as always with real estate, it’s all about location, location, location.
The more stones you turn, the better the deal you find will be.
The third tip is related to finding a proper real estate investment.
For the last property I bought, I analyzed every property in a 20-mile radius from where I was planning to buy, compared rent prices, and checked the price difference between well-maintained properties and those that needed fixing up.
With my wife, it’s always fun to do these things together. We checked more than 5 properties per week over a period of about 8 months. This led me to become an expert in the area and enabled me to find a property with a moat, lots of potential, and a great rent to price yield that is much higher than the mortgage costs.
So the more real estate you look at, the more you will find. And be sure sure to make offers that are ridiculously low. I made 4 such offers and the fourth was accepted, much to my surprise.
Distance yourself from the median – be ready to do more.
The detailed analysis above will allow you to distance yourself from the median that I used in the above example.
If you read our article on extremistan and mediocristan, you know that statistics show you one number from a wide range of numbers. Therefore, you can easily find properties below the median price that will have an above median yield.
The more effort you put in, the more opportunities you will find. Let’s say you manage to find a property of $500,000 that will give you a $3,000 monthly rent. Now the monthly payment will be around $1,900 on your mortgage, while the rent would be $1,100 higher. If we deduct $600 for the costs and expected vacancies, the free cash flow would be $500 per month, or $6,000 per year with a 6% return on the down payment. Add the 6% on the above mentioned inflationary 8%, and you find yourself with a 14% return that will probably only increase with higher rents.
Invest in real estate, don’t speculate.
To conclude, you have to look at real estate as a long term investment. If the cash flows are positive, you shouldn’t be influenced by short term price changes. This will also prevent you from seeking to buy real estate in temporarily hot areas that don’t have a moat but are just trendy.
As a reminder, I’ll show you a Spanish real estate ghost city. Many invested in property without looking for a moat while running after fast profits.
If you look at real estate from an investing perspective, even if real estate prices fall due to higher interest rates, your fixed mortgage is what gives you the value. Higher interest rates will lead to higher mortgage costs which will even out the eventual lower real estate prices. If there is more inflation and higher interest rates, real estate prices will rise further.
Think about how this would fit in your portfolio, your risk reward profile, and whether it fits your financial goals. In today’s environment, I see real estate as one of the best long-term risk reward investments to take advantage of.