Buying a rental property is a big financial decision. While there is no bulletproof way to make sure that you never fail, you can verify the following 4 numbers prior to purchasing to reduce your risk.
Return on your money
Let’s go over one by one.
1. Cash Flow
Many people buy rental properties because of cash flow. It’s nice to receive cash month after month. The best way to have the biggest cash flow is to buy in cash. If you buy a $100,000 property with cash, and the rent is $1,000, you will have $1,000 to pay all the expenses and keep the balance. However, if you only put $20,000 for the same property with a 30-year fixed mortgage with 4.5% interest, about $405 of the $1,000 rent will go toward paying the mortgage. That means you only have $595 to pay for all the expenses, instead of $1,000. So clearly paying with cash to buy a rental property is better than using a mortgage, correct? Not so fast.
2. Return on your money
One of the best benefits of buying a rental property comes with using leverage. The fact that you have to pay mortgage monthly is a GOOD thing. How can it be? That’s because by using leverage, you’ll be able to buy more properties with the same amount of money and will have BETTER total cash flow than just buying one house with cash. Also, by buying multiple properties, you’ll enjoy the appreciation of multiple properties, not just one, and that is the next number you want to look at.
It’s not easy to predict future appreciation, plus even if the house appreciates, you can’t easily touch spend it. That’s why a lot of buy-&-hold investors call this “an icing on the cake.” But can we ignore it like that? Here is how much impact it’ll have on your bottom line. If you are getting $1,000 rent right now on a $100,000 house, and it goes up by 5%, your rent goes up by $50 per month or $600 per year. Not bad, especially if you have multiple properties. But what if the property appreciates by 5%? Now you get $5,000 per property per year! That’s a lot more than meager $600.
4. So you found a rental property that cash flows well, return on your money is good, and the future appreciation seems to be good to the best of your knowledge. One last thing you need to add to this is how much you think it’ll cost to own the property. High turn around means potential vacancy (no rent) and/or repairs to get the property ready to put it back on the market. What is your expected expense in terms of the repairs? For example, you can assume that a brand new property with a warranty will cost a lot less than a 100-year old property that didn’t get proper maintenance over the years. Generally speaking, a larger property will cost more to maintain it.
Once you analyze the above 4 numbers, and you are still comfortable to purchase a rental property, you should have reduced the risk quite a bit, if not to zero. That said, you do NOT have to have a perfect score on all the 4 numbers though. You may end up missing a lot of opportunities if you try to look for a “perfect” rental property. Just know ahead of time where you may miss out. You might sacrifice some cash flow but may get some decent appreciation. You may get cash flow, but the area might be a bit rougher than your liking, and you are willing to pay some extra expense while owning it.
Owning rental properties, just like any other business, has its pros and cons. Try to reduce the cons by analyzing the above 4 numbers prior to purchasing it.