Success in real estate doesn’t require getting a “great deal.” It requires good fundamentals: a location, a solid tenant base, and a property that attracts those tenants.
personal case study
Let me share my own experience. In 2016, my partner and I purchased a three-bedroom, two-bathroom, one-story townhouse. We paid the asking price of $180,000, which was fair market value at the time.
The initial cash flow was about $50 per month, which our clients would not have considered at the time. However, we believe in the potential of the Las Vegas market, so we don’t mind the initial minimum cash flow.
Four years later, the property’s monthly cash flow exceeded $400 and its value increased to $280,000. We refinanced the townhouse, took out $60,000, and used cash to purchase another townhouse for $265,000. Again we paid market value for the second townhouse, which had an initial cash flow of about $50 per month.
Today, the first townhouse is worth $380,000 and the second townhouse is worth $350,000. The total cash we invested in the two properties was $45,000, 25% down on the first townhouse, $10,000 to renovate the first townhouse, and $15,000 to renovate the second townhouse, which equals $70,000. Today, the combined cash flow from the two properties is $1,000 per month. Total assets are over $360,000, which is not bad for $70,000.
Be sure to take inflation into account when calculating
If you invest in a good location, all but the most serious mistakes will be corrected through property appreciation and rising rents. I define a good location as one where rents exceed inflation. If you invest in any location where rents don’t exceed inflation, your only option is to sell the property and buy again in a good location.
Assume you are investing in a location where rents are either fixed or slowly rising (like most cities). For this example, I’m assuming rent increases at 2% per year and the inflation rate is 5% per year.
Below are the rents and purchasing power in years 5, 10 and 15.
- today: Rent: $1,000. Purchasing power: $1,000
- fifth year: Rent: $1,000 x (1 + 2%)^5? $1,104. Purchasing power: $1,000 x (1 + 2%)^5 / (1 + 5%)^5 ? $865.
- Grade 10: Rent: $1,000 x (1 + 2%)^10 ? $1,219. Purchasing power: $1,000 x (1 + 2%)^10 / (1 + 5%)^10 ? $748
- Grade 15: $1,000 x (1 + 2%)^15? $1,346. Purchasing power: $1,000 x (1 + 2%)^15 / (1 + 5%)^15 ? $647
So while rent is rising every year, the amount of goods and services you can buy decreases because it’s not rising faster than inflation. It doesn’t matter if you bought the property at a “great deal”; after inflation, your monthly cash flow will decrease every year, and so will your equity.
Let’s say the rent in the location you invest in increases by 8% per year and the inflation rate is 5% per year. This is the rent and purchasing power (in today’s dollars) in years five, ten, and fifteen. I’m assuming the starting rent is $1,000 per month.
- today: Rent: $1,000. Purchasing power: $1,000
- fifth year: Rent: $1,000 x (1 + 8%)^5 ? $1,469. Purchasing power: $1,000 x (1 + 8%)^5 / (1 + 5%)^5 ? $1,151.
- Grade 10: Rent: $1,000 x (1 + 8%)^10 ? $2,159. Purchasing power: $1,000 x (1 + 8%)^10 / (1 + 5%)^10 ? $1,325.
- Grade 15: $1,000 x (1 + 8%)^15? $3,172. Purchasing power: $1,000 x (1 + 8%)^15 / (1 + 5%)^15 ? $1,526.
So even if you buy a property in an area where rents are rising faster than inflation, it’s only a matter of time before your investment performs well and continues to improve.
If you buy a home where rents are rising slower than inflation, your purchasing power and the amount of goods and services you can buy will continue to decrease no matter how good the deal is.
bottom line
When buying property in a place where rents are rising faster than inflation, it’s far less important how good a deal you get. You will most likely own the property for the rest of your life, so how the property performs during the holding period is much more important than when you originally purchased it.
Achieve financial freedom through renting
If you are considering using rental properties to build wealth, this book is a must-read. Nearly 400 pages of in-depth advice on building wealth through rental property, Rental Property Investment Books Teach practical and exciting strategies investors can use to build cash flow and wealth.
Notes on BiggerPockets: These are the opinions written by the author and do not necessarily represent the views of BiggerPockets.
