My father has said on more than one occasion, “It’s not how much money you make, it’s what you do with the money you make that will give you financial freedom.” My friend and real estate colleague Larry Kendall refers to this concept as having “wake-up money” — waking up every morning and having the money you need to fulfill your dreams.
Let’s talk about investing in single-family homes as rental investment properties. Investing in real estate is not for everybody. It could take a larger equity investment than you’re comfortable with. It’s not a “liquid” investment like a stock portfolio, in that when you decide to sell you can’t have your money the next day. You could have to feed your investment in lean times. So if I haven’t scared you away yet, let me share with you all of the reasons you should invest in residential rental properties.
Investing in rental properties can give investors a great hedge against inflation and greater returns than other types of investments. If bought right, financed right and managed right, returns can approach 10 percent to 15 percent on an annual basis. Your investment return can come from any combination of four potential sources: annual cash flow from the property (net income), principle reduction (reducing your mortgage with rent payments), depreciation (legal expense deductions provided by tax laws) and appreciation (how much your property increases in value). Another good reason is that you can see it, touch it and manage it yourself (if you wish). Lastly, since everyone needs to live somewhere and not everyone will choose to buy for themselves, rental property remains a desired commodity.
So why invest in Mesa County? While many sophisticated investors buy rental homes all around the country, there’s more comfort for most investors in knowing their investments are local and they’re able to drive by them every day if they wish. Typically, you know the market you live in and feel more in control of a local investment rather than being an absentee owner. Relatively speaking, our rental rates in the Grand Valley have remained strong and vacancy rates are dropping. Lastly, even though we have all felt the effects of the recession, Mesa County is well positioned going forward as a great place to work and live.
Probably the most frequently asked questions I hear are: “Why now?” What makes this the right time?” Simply put, in my 38 years in the business I’ve never seen a better time to invest in rental properties. I’ve experienced low home prices and low interest rates, but never at the same time. Home prices have been at their lowest levels in four to five years. We are now starting to see median prices edging up, which points to a recovery in our housing market.
Now, let’s talk about the pros and cons of borrowing money to buy rental properties. Simple example: If you paid cash for a $100,000 investment property and have a net income of $7,000 a year, that’s a 7 percent return on your equity investment (cash on cash). If you borrowed $50,000 at 6 percent and put $50,000 of your own money (equity) in, your return would be 8 percent. If you borrowed $75,000 at 6 percent, your return would be 1 percent. And if you could borrow $90,000 at the same rate, your return would be a whopping 16 percent. So why not borrow as much as possible to get that higher return?
My economics professor in college always reminded us that reward and risk are commensurate — meaning the higher the reward (return), the higher the risk. That’s why savings deposits insured by the federal government offer a lower return than a well-placed stock portfolio or real estate investment. Leveraging (borrowing) your investment in real estate certainly does influence the return, but the risk can be greater if the market softens and you find your rental income less than your mortgage payment. My counsel would be to stay in the 60 percent to 75 percent range of loan to purchase price. It’s wise to give up a little return to minimize risk. And it would be wise to put aside at least three months of rental expense for the lean times. So if it costs you $1,500 a month for your mortgage, taxes, insurance and utilities, always have at least $4,500 set aside to cover you through lean times. People can get into trouble with rental properties if they borrow too much or don’t have enough money set aside.
So when is the right time to sell? Simply put, it’s when you begin to see the returns (cash on cash) diminish. Many get caught up in increasing values (betting on the come) and ignore the current return. Many smart investors try to be out of the market before values (prices) peak and get back in the market just before prices hit bottom. Others might choose to hold through the peak and the corresponding down cycle if their strategy is for the long term.
There’s a popular and logical premise that says: “The best investment you make in real estate is the day you buy it — buying it right minimizes the downside risk and increases the upside potential.” Here’s one parting thing to consider: Even though many investors are capable of managing their own properties, hiring a professional manager can enhance your income stream, save on operational costs and give you peace of mind.