Many real estate investors and investors-to-be have second thoughts about their investments. They want to know with certainty that the investment they make will be profitable and perform as desired. Other investors have more foundational questions about real estate as an asset class in general. In this article, we will cover how to determine if real estate investing is for you and discuss how to select a suitable investment property.
Is real estate a good investment?
Real estate is a unique and profitable asset class. We believe that investors should have as many asset classes as possible in their portfolios. We find it helpful to remain asset class agnostic and, instead, focus on the returns you seek.
Furthermore, it is helpful to think of our end outcome. Literally begin with the end in mind. This will provide greater clarity beyond any one asset class.
It’s helpful to not think of real estate as an investment at all. In fact, thinking of it like a business is one of the healthiest ways to approach this asset class- especially for income production. We hate to make this analogy, but it’s a good one. Used cars are not an investment. However, many companies and individuals make a business out of buying/selling/renting/financing them. Real estate investing for cash flow is very similar.
Now real estate investing is particularly favored because of its tax advantages. Real estate also has a track record for creating generational wealth time and time again. We like to keep Warren Buffet’s investing advice top of mind.
Rule #1: Don’t lose money
Rule #2: Remember Rule #1.
Remember: real estate investing can get oversold if solid fundamentals are not put into play.
It is critical that would-be investors not be intimidated by what may appear to be a crowded market with lots of competition and low-quality players. While it is true that “we buy houses cash” signs litter street corners and property owners can be bombarded by robo-calls and texts going out by the millions – not to mention the social media gurus – at it’s core, real estate investing just works.
The truth is that when properly executed, real estate investing is one of the definite paths to wealth and freedom that exists. And, for those that desire to create longevity and generational wealth, you will be hard-pressed to find another, profitable asset class with similar staying power.
What makes income-producing real estate a solid investment?
Real Estate is a multifaceted asset class. Income producing real estate is unique because it actually helps the investor get to their end destination faster. It puts the investor on the financial fast track. Here’s why:
Real estate keeps an investor financially disciplined
It takes financial maturity to successfully execute and manage a real estate investment. Meaning that one has to be disciplined enough to use the rental income towards the property’s fixed costs, put reserves aside for “rainy days”, etc.
If the property has a mortgage, those payments and maturity dates are fixed. That fixed date for payments keeps you motivated to arrange for the funds on time and prevent any late payment penalty fees. Moreover, one needs to keep up the holding costs as well keeping in mind the tax and rental income factors as well. All of this makes you more aware and urges you to have monetary dexterity.
Real estate keeps on growing
Real Estate assets never stop growing. Once you buy it, the ROI tends to increase because the purchase price and initial equity are fixed but the currency used to pay it back is not.
Put simply, if you have a mortgage on property, it is denominated in dollars that are stronger than the dollars used to pay it back. So, while you anticipated paying back your original $50,000 investment with $800/month rent, the rent will keep pace with inflation and eventually be $1000/mo or more.
When prices rise for goods and services, home prices tend to rise as well. Landlords can charge higher rent and homeowners can sell at a profit. If your primary objective is to build a nest egg for a comfortable retirement then you can collect that rental income until you decide to retire. You can even sell it for a lump sum amount to buy another property.
Benefits from other’s investment also
A rising tide lifts all ships. In real estate, the property values increase whenever there is an improvement on an individual property as well as to any infrastructure development. Newly upgraded community amenities like new hospital, school, shopping complexes and the like cause the overall neighborhood value to increase. Furthermore, new employment opportunities also boost housing demand because those new workers will need a place to live. If the property is in a suburb, improvements in accessibility can raise the property values as well as housing demand.
Little Stock Market Correlation
Real estate is a completely separate asset class and has little correlation with the stock market. This means that when the stock market is dropping, the real estate market will not necessarily be affected in the same way. The reverse is also true. Because of this, investing in real estate provides good diversification for your portfolio.
Leave a legacy for the next generation
It’s said that only what you can leave to your family is truly yours and of value. It doesn’t matter how much you enjoy your career, working a day job only benefits you – not your family. Real estate is an asset class that you can pass on to your children and generations to come. Expanding on the two points above, as time passes and inflation rises, the income able to be derived from income producing real estate will also increase. The beauty of a long-term investment is that the length of time doesn’t necessarily have to end with your lifetime. You can pass this to your children and if well-positioned, property will continue to grow and produce dividends for them as well. No other asset class can offer the generational wealth building capacity that real estate can.
Real estate is a tax advantaged asset class. That means that the property owner receives a tax rebate of sorts called depreciation every year they own the property. Not to mention that any expenses associated with owning the property (utilities, renovations, etc) are tax-deductible expenses.
You don’t need all the equity up front
Real estate investing is one sector where you’re not expected to have all the money you need up front or by yourself. Being able to leverage other people’s money in the form of loans can help you amass a portfolio far beyond what you can reasonably do in the stock market.
There are many areas that make income property valuable today and in the future. Oftentimes, the benefits simply get better with time. Beyond thay, real estate is thought of as a safe haven because the fundamental business model is simple to understand and the investments themselves are tangible. The fact that you can drive by and literally touch a property makes its intrinsic value far more than any share or stock. You can see the property for yourself and know whether or not the location is desirable and likely to make money in the future. Compared to stocks which may become worthless overnight, land will always retain some value. In most cases, the value actually appreciates over time.
How to determine if a property is a good real estate investment
Now that we’ve covered real estate as an asset class, and extolled the benefits from being an on-going income source to fueling a financial legacy, the question becomes how to make a good investment decision. Many people ask “How do I know if a property is a good investment?”. In truth, if you have to ask that question, it means that you do not have a solid investment thesis in place to leverage for your due diligence.
Due diligence is the vetting and underwriting of any investment to verify the financials and certify that the investment is suitable and appropriate for your financial goals. Would-be investors go wrong by looking at property too soon. They focus on the property and not the process of setting the intention and course for the investment from the beginning.
This is why buyers remorse is a real thing.
Anybody can go out and buy a house, only a confident professional can tell you why they purchased that house in that location for that price and the particular strategy they plan to employ after purchase.
Afterall, investing in real estate is a financial commitment and it would be silly to enter into such an arrangement haphazardly – yet so many do.
What are the best ways to evaluate real estate investment property?
Real estate can be valued in three primary ways:
1) comparable sales
2) income approach
3) cost approach.
The sales approach to valuation simply means comparing recent sales of similar properties in the surrounding area. This is what realtors refer to as “comps” or comparable sales. This is the most common approach to valuing residential real estate because values are typically based on property amenities. The comparable sales approach is not appropriate for commercial real estate properties because they are often uniquely built out to suit a particular business or industry. Finding similar commercial properties with recent sales can often be difficult.
The income approach values the property based on potential income it can generate. The income estimate is then reconciled against recent comparable sales for purposes of determining the appropriate cap rate. The income approach is by far the most appropriate approach when it comes to investment property as the purpose of the investment is to generate income.
The cost approach evaluates the property based on the cost burden for maintaining the property. It is closely related to the income approach but more focused on maintaining a certain profit margin.
Regardless of how you value a property, if you are going to obtain a loan to finance it, the income from the property must support the debt or the investment is unsustainable.
Here are some key areas to keep in mind when completing due diligence on investment property:
Plan Out All of Your Expenses Before You Buy the Property
The biggest risk in investing in real estate is understanding the difference between revenue and profit. Many would-be investors get caught up in the lure of income but don’t complete the property diligence to understand what expenses they should allocate for in their reserves. Expenses such as repairs, taxes and shared utilities can eat into precious profit. This is why some property owners are left empty-handed when it comes to having fund for repairs and the like. When you are the landlord or property owner, anything that goes wrong with the function of the property is your responsibility.
It is imperative that the rental rate covers repairs and other expenses easily. Additionally, you will need proper property reserves set aside to cover the cost of any repairs that are required before the property is self-sustaining.
Source Robust Insurances
You will want to carry good insurance on the property, your liability and require your renters to do the same. Insurance is a critical component of your risk mitigation strategy – the major risks are of damage, injury, non-payment and/or tenant negligence. A good insurance program will equip you to be prepared to deal with additional costs and other situations as they arise.
Research the Property Carefully
Legal aspects are some of the most confusing to new investors. A best practice is to use a title company to complete title searches on the property to uncover any encumbrances you may not already be aware of. You want to be sure that you can gain clean title upon purchase, that the property taxes are paid up and the property is clear of any other undesirable liens.
Do your due diligence, look at a lot of deals to familiarize yourself with your buying power in a particular locale. Do not buy the first deal that you see.
The key ingredient to making real estate investing successful is to stick to sound investing principles of investing with strong fundamentals. Have an investment thesis and business plan, plan for downturns by learning how to identify value. Income producing real estate is boring, mostly stable…you can think of them as brick ATMs.
The key to successful investing, in any asset class, is to Invest in what you understand, and develop a plan in place to learn what you don’t know.
Successfully investing without getting in over your head
Let’s be honest. There is a lot of fear getting started with real estate. Everyone has heard about it, many have thought about it, but only a select few ever take any action.
All investments carry a risk of financial loss. The name of the game is to reduce it.
The truth is you cannot completely eliminate fear of real estate investing, but you can decide to take a logical approach to mitigate as much risk as possible. Here is what we suggest:
Crystalize your goals in a business plan
Having a vague idea is not going to cut it when there are hundreds of thousands of dollars on the line. It is so surprising that people will make a business plan to sell homemade candles on Etsy for $12 but are hesitant to create a business plan to successfully deploy $150,000.
Olympic athletes have coaches but financially ignorant people think they can figure it out on their own…just saying.
Have a clear investment strategy
Perhaps the biggest risk to real estate investing is that almost any moron can run out and buy a house, if they are willing to put their money and/or credit on the line.
Of course there are many ways to invest, flipping, wholesaling, buy and hold, tax liens, etc. Any investment can be greatly profitable or provide solid returns or incur a loss depending on various factors. A real estate investment typically provides investment returns in 2 forms:
- Rental income
- Capital appreciation
Buy and hold is perhaps the simplest to understand and the most proven path to success. Rental income provides you monthly earning from your property, if it is leased out. The risk here is property staying vacant when you are unable to find any tenant. Commercial properties can provide a higher yield (in general), but residential ones are easier to find a renter for. How much income you will get depends on the demand and supply of properties similar to yours.
Capital appreciation depends on a host of market forces not in our control. However, if you are able to acquire a good property at a price below market rate, your investment is profitable from day 1. Some would argue that buy and hold is about the only true way to invest. And it makes sense. The business model is very simple and proven. You buy a property and then rent it out. Usually, the goal is to maximize cash flow—the difference between your payments and the renter’s payments. However, sometimes the owner wants to pay off the loan as quickly as possible and sacrifice short-term cash flow. They then have a free-and-clear property with a large monthly cash flow.
The validity of an investment is not in the asset itself – it is in the timing, market research, buying price, and other due diligence aspects. This applies whatever you invest in – stocks, real estate, debt, etc. Just as with any investment, you want to be prudent before deploying capital.
The major factors of consideration – beyond the property are:
- Long-term investment goals
- Your current financial and time situation
- How much capital you have available to invest
- Risk tolerance
- Willingness to manage the asset or outsource to a vendor
- If you have sufficient knowledge to execute the investment or are you willing to acquire that knowledge
Regardless of the strategy you ultimately employ, you need rubric that combines economic and performance indicators on the state, city and neighborhood level.
To solve this, the Housing Joint Venture team developed our own definition and framework for evaluating investment areas: Growth Value NeighborhoodsTM.
The GVN system uses economic indicators and key performance indiciators to predict the future performance of an investment property.
What is an Economic Indicator?
An economic indicator is a statistic about an economic activity. Economic indicators allow analysis of economic performance and predictions of future performance. One application of economic indicators is the study of business cycles. – Wikipedia
What is a KPI and why is it important to real estate?
A performance indicator or key performance indicator is a type of performance measurement. KPIs evaluate the success of an organization or of a particular activity in which it engages. Wikipedia KPIs help businesses make decisions about where to invest time and resources. Similarly, having a well defined list of investing KPIs helps investors stay focused on the metrics that matter for streamlined decision-making.
The right KPIs for your business should follow these KPI best practices:
- Aligned – Make sure the KPIs your are choosing align with the strategic goals and objectives of your organization.
- Attainable – The KPIs you choose to measure should have data that can be easily obtained.
- Acute – KPIs should keep everyone on the same page and moving in the same direction.
- Accurate – The data flowing into the KPI should be reliable and accurate.
- Actionable – Does the KPI give you insight into the business that is actionable?
- Alive – Your business is always growing and changing. Your KPIs should evolve as well.
The GVN framework entails key performance indicators that can be separated into three categories: economic analysis, market analysis and property analysis.
What are Growth Value Neighborhoods ™?
GVN’s are areas of untapped potential with ample opportunities for workforce housing. The term ‘workforce housing’ typically sparks images of firefighters, teachers, law enforcement professionals, and others who are overqualified for affordable housing yet can’t afford the average market-rate home. These are working blue and gray collar professionals that are often overlooked in the context of residential development.
The components of a GVN are what makes a great neighborhood…great! The buildings tend to be set close together with shops and other activities within walking distance. Homes in desirable neighborhoods should ideally accommodate a variety of lifestyles and income levels. Of course the quality of the housing stock is imperative. The best neighborhoods have building designs that preserve historical styles and reflect cultural traditions. They tend to offer a variety of designs while conforming to a general, uniform theme.
In general, a GVN should:
- be geographically confined between two more stable and established neighborhoods.
- Have a significant trigger or catalyst for the direction of the neighborhood.
- Have residents with pride in the neighborhood. People love the community and identity derived from a sense of place.
- See property values increase as the neighborhood value increases
- Population: Rising or Falling
- Crime Rate: Increasing, Stagnate or Declining
- Proximity to Amenities (Work and Play)
- Quality of Housing Stock: Age, overall condition
- Home Values: Increasing, Stagnate or Declining
- Access to Public Transportation
- Access Greenspace
- Vacancy Rates: Stagnate or Declining
- Public Investment in Infrastructure
- Housing Availability
Growth Value Neighborhoods Explained with Detailed KPIs
- How is the overall economy doing? With particular focus on:
- Income levels
- Consumer confidence
- Money supply and monetary policy
- How is the region doing?
- Are things getting better or worse in the region?
- How is the county doing?
- Are there any pieces of pending legislation in the local municipality that will affect your venture?
- How are the major employers? How are they doing?
- How diversified are the industries represented by the businesses and corporations?
Property Market Economic Indicators
Before you get started investing in buy-and-hold real estate you have to determine which market you want to focus on. Like the old adage says, investing in real estate is about location, location, location. It is imperative that you select a location that meets your investment return criteria.
This is one of the most significant decisions when it comes to investing and it is imperative that you take proper diligence prior to making a purchase. You have to know what you’re doing. Do your research to learn about the strengths and weaknesses of the markets you are considering and develop a rubric to determine which market fits your criteria.
- How is the overall property market doing?
- Are prices increasing, decreasing or stalled?
- What are vacancy rates in the area?
- Development – is more competition coming online?
- What are the average days on market for buy/sell?
- What are the local business journals and newspapers saying about real estate investment?
- What are the Homeownership Rates?
- Total Population: increasing, decreasing or stalled?
- Population Demographics segmented by:
- Most used transportation method to work
- Average Travel Time to Work
- Median Family Income
- Household Type
- Education Level
It’s important to keep abreast of what the economists, pundits and other smart people are thinking and saying. While no one can predict the future, they often have access to unique data and can synthesize in a way that smaller investors do not have the time or resources to.
Asset Level Economic Indicators
Once you identify a potential property to invest in, it is imperative to perform a thorough due diligence. You will want to learn as much as you can about the property and compare it to similar investments in the local market. You will want to make sure it meets your own investment criteria and, if the deal is under performing, why.
- What is the Housing Type
- How many units are in the structure?
- What Year Structure Built?
- What is the purchase price?
- What is the home fair market value?
- What is the price per square foot?
- What is the property tax rate as a % of the property value?
- What is the occupancy status/rate?
- What is the vacancy rate? True & economic?
- How could you improve the vacancy rate?
- What is the average gross rental rate?
- Rental rate by number of bedrooms
- Can we raise current rents?
- Does the property offer any other income?
- Can we add other income with amenities?
- What are the operating expenses?
- Can you lower expenses?
- Is the property under developed?
- What is the lease renewal rate?
- What do the tenants think of the building? Where can it be improved?
- What is the condition of the roof?
- What is the condition of the structure?
- How many parking spaces?
- Is there anything awkward or functionally obsolete about the property?
- Is the building secure? Secure buildings feel safer and command more rent.
- Remember there are reasons to own besides just making money each month: Rentals that create a loss, while increasing in value, can reduce your taxable income, and your income taxes, while increasing your equity.
- Crime Rate: Increasing, Decreasing or stagnate?
- School District: The school district rating will determine the popularity with homebuyers.
- Accessible Public Transportation.
- Walkability: Walking access to amenities such as restaurants, nightlife, and grocery stores is an attractive feature.
Once you gather all the data, you are looking for properties where you can add value to increase revenue and subsequently value. Your overall due diligence is how to tell if an investment is good or bad.
Do keep in mind that is a very basic summary of the analysis we conduct. There are a lot more aspects of real estate that can be analyzed. You can do very well in real estate without this level of scrutiny but the probability of consistent success diminishes as time moves forward.
If you found this helpful and would like to learn how to apply these topics, visit this page to learn more about the Housing Joint Venture flagship 8-week online Real Estate Investing Bootcamp.