Many Americans consider their homes to be their most important (and often largest) investment. This makes sense, right? Generally speaking, homes appreciate (gain value) over time, and they can do this while serving many valuable functions as a primary residence for the owner. This makes home-ownership a very practical investment for many, especially at a time when families are struggling to find money to invest.
Many are also now dabbling in real estate investing – flipping houses here or there, building up rental portfolios, developing small plots of land, and so on. In other words, a lot of people now, just like always, view real estate as an important investment. But where do you begin in trying to think like an investor when looking at real estate? [Disclaimer: I’m not a financial/investment advisor and do not know your individual financial situation. If you are thinking about investing in real estate, you should consider getting professional advice on investing.]
There are a lot of ways that we could look at this, but here are three of the simplest yet most essential concepts to thinking like an investor when purchasing real estate.
Weigh the Risks Against the Rewards
Every property has risks with it, but some things are riskier than others. What do I mean by “riskier?” That under most circumstances, there is a greater risk of problems arising – problems which can cause you to lose time or money.
Generally speaking, a home on a crawl space is riskier than one on a slab. An older home is riskier a newly-built one. A multi-story home is riskier than a ranch. A home with a pool is riskier than a home without a pool. A home that uses a septic tank is riskier than a home that utilizes public sewage. A home in a rural area with few comps is riskier than a home in a dense subdivision with a lot of comps. These are fairly common sense, but you’d be surprised how few people objectively consider the risks of purchasing a home.
When it comes to “reward,” the logic is pretty simple. If you want to know what the ARV (“after-repair value”) of a home is, look at the comps (i.e. comparable, nearby properties that have sold recently). Then you simply need to apply the following formula to figure out your potential reward (i.e., profit): [ARV] – [expenses] = [profit]. Generally speaking, expenses should include purchase price + purchase expenses (such as closing costs, taxes, etc.) + repair/maintenance/utility expenses + sale expenses (such as realtor fees, taxes, etc.).
Once you have that figured out, you can assess the risk vs. the reward. Maybe there is a home you want to flip that you believe you could make $40,000 off of, but it comes with a fairly high risk, whereas another home is fairly low risk and you believe you could make $30,000 off of it. In that case, the lower reward may be worth the substantially lower risk. On the flipside, a substantial reward may be worth a substantial risk. For instance, I know someone who made a killing by buying a property in a hot area and then adding an entire second floor to it. High risk but high reward. He tells me it was worth it, but it may not always be. Your individual situation combined with what is happening in the market determines how much risk you should be willing to absorb for the reward.
Consider Short-Term vs. Long-Term Strategies
There are a lot of different ways to invest in real estate, but they all boil down to essentially two strategies – short and long-term investing. To say it another way, real estate investing generally involves either a quick flip or a buy-and-hold strategy.
The strategy you employ dramatically changes how you look at property purchase. For instance, if you’re looking to hold onto a property long-term, you may not be as concerned that you’re buying it at a higher price point than you’d like to because you are confident that down the road, you will still make good money off of it. On the flipside, if you are employing a short-term strategy, you want to make sure you absolutely get a lot of equity in the home you’re buying, otherwise you will likely end up losing money on it.
Here are some considerations and generally accepted advice for short-term vs. long-term real estate investing:
Short-term (less than a year):
- Purchase properties with substantial equity to ensure a profit even if the market takes a sudden downturn.
- Focus on small-to-medium-sized projects. Large projects run the risk of taking too long and tying up capital.
- Low-risk homes in areas where there are a lot of comps are the best. There is always the temptation to buy a home in an area without a lot of comps (such as rural regions), but the likelihood of it taking too long to find a buyer is too great.
- Look at neighborhoods where homes sell quickly (i.e., less than 30 days on the market). This is one major indicator of the desirability of the location.
- Obtain financing/capital that is conducive to a quick payoff, such as a hard money loan. The interest will usually be high, but since you are only borrowing for a few months, the net cost will not be as high as a low-interest loan with high closing costs or an early payoff fee.
Long-term (multiple years):
- Determine if the goal is cash-flow (i.e., a rental property) or appreciation (i.e., a property which will increase in value substantially in the near future). Oftentimes the properties that appreciate the fastest aren’t as strong for cash-flow.
- Look realistically at where the market is moving. As urban and sub-urban areas keep expanding, it dramatically impacts home prices, and it’s not hard (especially with the help of a REALTOR®) to see where the market is heading.
- Be careful not to be too speculative. You may think that a part of town is really up and coming but only have limited data to support your theory. BEWARE! Without data, your theory is speculation and nothing more, and more than a few real estate investors over the years have lost the shirts off their backs by investing on a hunch.
- Obtain financing that is conducive to the length of time you plan to hold your property, and if you aren’t sure, err on the side of longer – 15 or 30-year mortgages.
Remember: Cash is King
When buying a property, there are three times that cash is important – at purchase, during ownership, and at sale. Consider the following.
At Purchase
A lot of formulas out there (such as the famous “cap rate” formula) don’t take into consideration cash used up front. Yet, this is one of the most important considerations, especially for someone with limited financial resources.
For instance, let’s say that Investor A bought a house with cash for $250,000 and Investor B bought a $1,000,000 property with financing and a 20% down payment (i.e., $200,000). Investor A paid more up front but has no mortgage payment since he bought the property with cash. Investor B paid less up front but has a mortgage payment of $4000 per month. Now let’s assume that both properties bring the same amount of cash-flow each month (even after paying Investor B’s mortgage payment): $2,000.
Even though Investor B’s home had a larger purchase price ($1,000,000) than Investor A ($250,000), he essentially bought $2,000 per month in cash flow for less money up front ($200,000) than Investor A ($250,000). Therefore, strictly from a cash standpoint, Investor B did the better deal. Here is a table to depict what I’m talking about:
| Purchase Details | Investor A | Investor B |
|---|---|---|
| Purchase Price | $250,000 | $1,000,000 |
| Total Cash Up Front | $250,000 | $200,000 |
| Total Rent | $2,000 | $6,000 |
| Mortgage Payments | $0 | $4,000 |
| Cash Flow | $2,000 | $2,000 |
| Rate of Return | $2,000/$250,000 = 0.8% | $2,000/$200,000 = 1% |
For what it’s worth, I’m not suggesting that Investor B got a good deal (a 1% return is lousy), only that he bought more cash-flow for less money than Investor A did, although Investor A did not take on any debt.
During Ownership
If you have a cash-flow property, the number one thing to consider during ownership is [drum roll] cash flow. If that seems obvious, it should.
So what about non-cash-flow properties (such as homes that the owner lives in) or properties purchased for appreciation more than cash flow? In these instances, the main consideration is cash-savings. This can come in a few different forms:
- Low maintenance – a property that is low-maintenance is valuable because it will cost less than a high-maintenance property over the course of ownership.
- Inherent savings – when you move from a larger, energy inefficient home to a smaller, energy efficient home, your housing change is bringing about inherent cash-savings. Remember, “a penny saved is a penny earned,” so inherent savings are just as valuable as cash-flow.
- Indirect savings – if you move to a home that is 30 minutes closer to where you spend most of your time (such as work, friends, etc.), then you’ve just saved yourself an hour or more of driving per day, which results in savings on fuel and car-maintenance. These types of savings are easy to miss since they are indirect, but they are crucial to understanding the full impact of a home purchase.
At Sale
How much has your investment in a property grown since you’ve purchased it? This question becomes particularly important when you sell your home as it will decide how much money you walk away with. Most people understand this, but what they can forget is that they must be thinking about this at the time they purchase the home, not just years later when they sell. If you wait until it’s time to sell the home, it’s too late.
It’s been said that the money you make selling a home is actually made when you buy the home. In other words, whether you make money or not on a home sale depends largely on whether you bought it for a good deal or not. This statement is somewhat of an exaggeration, but it carries a lot of truth. If you fall in love with a home and pay above market value, don’t expect to be able to turn around in two years and sell it for a profit. The type of bargain you purchase it for on the front end will have a major impact with the profit you make on the back end.