The ultimate goal of real estate investing is financial freedom. It’s not just about making a deal.
To achieve financial freedom, you need an income that meets the following requirements:
- Rents are rising faster than inflation. Unless rents rise faster than inflation, you won’t have the extra dollars to pay for the increased prices.
- Your rental income must last a lifetime.
These income requirements cannot be met by purchasing a property in any market. This is why market analysis is crucial.
The following are the steps for market analysis.
Site selection is the first and most important step as it defines all long-term revenue characteristics.
Compare location financial performance
What is the difference between buying in a low appreciation market and a high appreciation market?
People often choose a location based on cost, cash flow or return on investment. However, cash flow and ROI metrics can only predict how a property will perform under ideal conditions on the first day of long-term ownership. You need to look beyond the first day.
To illustrate this, I will compare a property in an area with high appreciation and rent growth, such as Las Vegas, to a property in a typical city with low appreciation and rent growth.
Let’s say you buy an investment property in Las Vegas for $400,000 and the monthly rent is $2,200. You also purchased two $200,000 properties in a low-priced city, each renting for $1,100 per month.
The real estate market we are targeting in Las Vegas has seen rent growth average over 8% per year between 2013 and 2023, so I will use 8% rent growth in the example. For cities with slow rent growth, I assume rent increases of 3% per year, which is high for most low-cost cities.
If we assume an annual inflation rate of 4%, what will the inflation-adjusted monthly property income be in five, ten and fifteen years if the same inflation and rental growth continues?
Cities with high rent growth
- Year 0: $2,200 = Purchasing Power: $2,200
- Year 5: $2,200 x (1 + 8%)^5 / (1 + 4%)^5 = Purchasing Power: $2,657
- Grade 10: $2,200 x (1 + 8%)^10 / (1 + 4%)^10 = Purchasing Power: $3,209
- Grade 15: $2,200 x (1 + 8%)^15 / (1 + 4%)^15 = Purchasing Power: $3,875
Because rents grow faster than inflation, your purchasing power, and the amount of goods and services you can buy, increases every year.
low rent growth city
Side note: For simplicity, I combined the income from both properties ($1,100/month x 2 = $2,200/month).
- Year 0: $2,200 = Purchasing Power: $2,200
- Year 5: $2,200 x (1 + 3%)^5 / (1 + 4%)^5 = Purchasing Power: $2,096
- Grade 10: $2,200 x (1 + 3%)^10 / (1 + 4%)^10 = Purchasing Power: $1,997
- Grade 15: $2,200 x (1 + 3%)^15 / (1 + 4%)^15 = Purchasing Power: $1,903
Because rents don’t keep up with inflation, your purchasing power (i.e., the amount of goods and services you can buy) decreases every year.
If you buy a property in an area where rents don’t exceed inflation, you’ll never achieve financial independence.
How much money do you need to achieve your goals
Another problem with low appreciation and low rent growth cities is that most people need to purchase multiple properties to achieve their financial goals. One disadvantage of low-cost areas is that acquiring multiple properties requires more capital than in high-growth/high-cost areas.
I’ll illustrate why this happens by comparing the properties of the two locations. I would start by estimating how much property you need to purchase.
For example, if you need $5,000 per month to maintain your standard of living and each property generates $350 per month, you would need to purchase 15 properties ($5,000/$350).
Let’s say I assume the cost of each property in a low-cost, low-appreciation location is $200,000, and your only purchase cost is a 25% down payment. How much money do you need from savings to buy 15 properties?
15 x $200,000 x 25% = $750,000, a lot of after-tax dollars.
What if you invest in a higher-cost, higher-appreciation location instead of a lower-appreciation location?
I assume each property is worth $400,000 and appreciates at 10% per year. (Note: Between 2013 and 2023, the average appreciation rate in our target real estate segment in Las Vegas is over 15% annually.) Also, as in the previous example, I’m assuming the only acquisition cost is the 25% down payment.
Cash savings to buy your first home:
$400,000 x 25% = $100,000
Due to the rapid appreciation, we were able to use a cash-out refinance to cover the down payment on all additional properties. How does this work? You can refinance the property and take cash out. The amount of cash you can withdraw depends on the value of your property relative to your outstanding loan balance.
Generally speaking, you can withdraw 75% of the market value minus the remaining balance of your existing mortgage loan. Assuming the property appreciates at 10% per year, how long do you have to wait before you can withdraw $100,000 for a down payment on your next property? (Note: For simplicity, I assume there are no principal repayments.)
- the first year: $400,000 x (1+10%)^1 x 75% – $300,000 (existing loan) = $30,000
- the second year: $400,000 x (1+10%)^2 x 75% – $300,000 = $63,000
- The third year: $400,000 x (1+10%)^3 x 75% – $300,000 = $99,300
- fourth year: $400,000 x (1+10%)^4 x 75% – $300,000 = $139,230
So, after three years, a 75% cash-out refinance will provide a down payment on your next home.
The property you refinance and the property you purchase will continue to increase in value, allowing you to repeat the process every few years. This allows you to continue growing your portfolio with limited additional capital in your savings, as shown here.
Although properties in high-appreciation cities are generally more expensive, the capital required to purchase multiple properties is much less than in lower-cost areas. That’s because you can use accumulated equity to expand your investment portfolio through a cash-out refinance.
You need less property in a high-value location
Another benefit of investing in high-appreciation cities is rapid rental growth. When rents rise faster than inflation, your inflation-adjusted income rises as well. So as each property’s inflation-adjusted cash flow continues to grow, you may need to purchase fewer properties.
final thoughts
In order to achieve and maintain financial freedom, you must choose the right market before considering any property. Use the tips listed here to guide you.
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Notes on BiggerPockets: These are the opinions written by the author and do not necessarily represent the views of BiggerPockets.
