Long-term rentals can disappoint if you don’t consider three key factors: long-term rental growth, appreciation, and the pool of tenants the property attracts. In this article, I will describe two ways long-term buy-and-hold can fail.
Select properties based on initial return metrics
Many people base their purchasing decisions on return on investment and cash flow. However, these metrics can only predict day one performance under ideal conditions. They don’t show how the property will perform in the future. Considering you’re likely to hold onto the property for the rest of your life, what happens on day one isn’t that important, especially in a world where inflation continues to erode the value of the dollar.
I will compare two properties to demonstrate why a property with excellent ROI and cash flow can still be a poor investment.
Property A:
- rent: $1,500/month
- Initial investment return: 4%
- Rental growth rate: 1 year
Property B:
- rent: $1,500/month
- Initial investment return: 0%
- Rental growth rate: 7 years
I assume the average inflation rate over 10 years is 3.75%.
Next, I’ll calculate the inflation-adjusted purchasing power of rent relative to its initial purchasing power over a 10-year period. The formula for calculating future purchasing power is as follows:
- FV = PV x (1 + growth rate percentage)^years/(1 + inflation rate percentage)^years
For example, to calculate future purchasing power 5 years from now relative to an initial rent of $1,500, an annual rent increase of 1%, and an inflation rate of 3.75%, do the following:
- FV = $1,500 x (1 + 1%)^5 / (1 + 3.75%)^5 ? $1,311
Below, I calculated the annual purchasing power of both properties over the first 10 years relative to an initial rent of $1,500 per month.
Property A
Inflation-adjusted rent (by year):
| year of purchase | $1,500 |
| 1 | $1,460 |
| 2 | $1,422 |
| 3 | $1,384 |
| 4 | $1,347 |
| 5 | $1,311 |
| 6 | $1,277 |
| 7 | $1,243 |
| 8 | $1,210 |
| 9 | $1,178 |
| 10 | $1,147 |
Although rents are increasing by 1% per year, they are still not keeping up with inflation. Therefore, the amount of goods and services you can buy in the future is less than the amount you can buy today. So if you’re making a purchasing decision based on day one ROI and cash flow, you’re making a huge financial mistake.
Property B
Inflation-adjusted rent (by year):
| year of purchase | $1,500 |
| 1 | $1,547 |
| 2 | $1,595 |
| 3 | $1,645 |
| 4 | $1,697 |
| 5 | $1,750 |
| 6 | $1,805 |
| 7 | $1,861 |
| 8 | $1,920 |
| 9 | $1,980 |
| 10 | $2,042 USD |
Although the return on investment for Property B starts out at 0%, purchasing power increases over time as rental growth outpaces inflation.
Real estate is a long-term investment, and making long-term decisions based on day one performance is almost guaranteed to fail.
Buy a property before choosing your target tenant base
A common mistake is to buy a property just because it looks like a good deal. The reality is that the property never pays rent. The tenant occupying the property pays rent. Therefore, the tenants occupying the property are far more important than the actual property.
Financial independence requires reliable income. The surest way to ensure reliable income is to keep your property occupied by reliable tenants. Reliable tenants stay for several years and always pay their rent on time. Reliable tenants are the exception, not the rule.
To increase the likelihood that your property will always have reliable tenants, start by identifying tenant groups with a high concentration of reliable people (via property manager interviews). Once you identify this niche, determine the types and locations of homes they currently rent and purchase similar properties.
The focus is on selecting a segment with desirable payment behavior and focusing on what they are willing and able to rent. Rather than guessing which attributes will perform well, find a segment that performs well and let them define:
- Property Type
- Property configuration
- Rent range
- that place
Bottom line, focus on the people paying the rent, not what you or the guru thinks is a good property.
final thoughts
Real estate investing is the easiest type of investment to learn and is a proven path to financial freedom for the average person. However, people still fail because they make decisions based on the wrong factors:
- Choose a city where rents consistently outpace inflation. This will be a city with significant and continuing population growth. I recommend not considering cities with a metro area population of less than 1 million.
- Purchase a property that meets the housing requirements of a tenant base with a high concentration of reliable individuals. Don’t base your property selection decisions on opinions or experts.
If you don’t adhere to these two investing principles, your chances of long-term success are greatly reduced.
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Notes on BiggerPockets: These are the opinions written by the author and do not necessarily represent the views of BiggerPockets.
