Updated: Mar 12, 2019
I recently met with a group of young investors, who asked me to review what they were doing, and give them my opinion. They had steady jobs, had some experience flipping houses, and had achieved a combined portfolio of eighteen (18) rental homes. The problem was that even though they had 18 rental properties, they had little equity. They made 10-20% down payments on each house, and had good 15/30 year fixed rate loans. However, there was little equity and little positive cash flow. Since they had not yet experienced major repairs such as roofs or heat & air systems, I could tell that the cash flow would move in the negative column relatively soon. So, the bottom line was they had several hundred thousand dollars invested and yet to make anything from it.
Were they building a portfolio? No, they were not building a portfolio -- they were building debt. Like many investors, they were counting on the fact that the houses would go up in value, their residents would pay off their loans, and the tax advantages of owning real estate would help their bottom line. And in many respects these things can and do work. However, I don’t think they are enough on their own.
My approach to owning rental property is entirely different. I am much more debt averse. I will not purchase property that doesn’t produce cash flow immediately. We are here to make money and better our lifestyle and waiting 15 or 20 years for a property to cash flow is too long and painful for me. Here is my strategy. I base my decision of whether to purchase a rental house largely on the CAP rate the rental house produces, just as if it were a commercial property. After all, it is a rental house. The cap rate is determined by the ratio between the net operating income produced by the rental property and the price paid to buy the rental property. In order to determine the net operating income, I have to determine the real cost.
To determine the real cost, I first look at the cost of borrowing money to purchase the property. Borrowing money at a rate higher than the CAP rate is a foreclosure waiting to happen. Don’t borrow at 7% to buy something that makes 5%. That problem is less likely with today's low rates, but it was easy to do back in the day when rates were higher. (Ask me how I know!) Don't assume that because it's a nice house it will rent better than others. Always run the numbers. Many houses in nice areas that appear to be good investments and easy to rent actually have low rates of return. Investors get excited because they have 100K in a house worth $120K and it looks nice and rents well. But it has a CAP rate of 4%. Who wants to spend 30 years paying off a mortgage, when the investment only makes 4%?
Next, I consider the fixed expenses and maintenance costs. Some investors are dooped by the low payment and what appears to be positive cash flow. Again, I speak from experience. In addition to the fixed expenses, such as property taxes, insurance and mortgage payments, you must also estimate maintenance costs for the entire life of your investment. One resident turnover can eat up as much as three to four month's rental income. In addition, there will always be ongoing maintenance (leaky plumbing, stopped up sewers, electrical issues, pest control, lawn care, etc.). Finally, if you plan to keep the property for any significant period of time, you will have to plan in the beginning for capital expenditures, such as roof replacements and HVAC repair/replacement. Depending on the age and condition of the house when you purchase it, five to ten years down the road the house may need other major upgrades that will eat up years of cash flow.
The point of investing in rental property is for it to produce cash flow. Equity is nice and later down the road we'll enjoy that. However, I have to work to survive. If I can own enough income producing properties/assets to pay for my family’s lifestyle, then I am free from having to work. It’s just that simple. If I buy a rental property with no cash flow and a 30 year loan, I am saying I am willing to work for 30 more years.
Doug Betty has been a real estate investor in Middle and East Tennessee for over thirty years, and he is an instructor/mentor teaching investors the at Tennessee REIA.