One of my most popular posts was discussing my real estate holdings in the post How I Became A Millionaire…In Debt. I’m bullish on real estate for both appreciation and all the tax benefits it provides. Rents double every twenty years, the average rent in Hawaii is around $2,000. In 20 years the rent will double to $4,000, buying a home locks your rental costs in. If you don’t lock in your housing costs in the end you may end up paying too much of your income to rent.
When purchasing real estate the two most important factors is location and valuation. Since I don’t know your markets you’ll have to do your evaluation for your local market.The property types are as follows:
Property A: Located in prime locations often in down town or near high paying job centers. It could also be very affluent neighborhoods that are highly desirable. (Honolulu, Toronto, SF) The ideal area has anti growth or development policies that restrict building, thus causing supply constraints. In a bust these properties hold up well, declining the least. If you have a property A you can be extremely picky with your tenants as you’ll have your pick of the applicants as long as your unit is in decent shape. These properties however are the worst cash flow and command premium prices. On Oahu these neighborhoods are Kahala,Waikiki, Kaimuki, Manoa,Makiki, certain parts of Kailua and Hawaii Kai.
Property B: Located still in desirable areas but right outside the most desired. Usually within 20-30 minutes of the best neighborhoods they provide better value. You can still be picky with your tenants as a lot of people would like in this area. However depends on the property you might need to look at some people with blemishes. This could also mean a totally crappy 100 year old 500 square foot house but is located in the Property A neighborhood. On Oahu it’s Kaneohe, Millilani, rest of Kailua and Hawaii Kai.
Property C: This could be nice neighborhoods however the commute or traffic is atrocious. Properties in this area should cash flow as it is much cheaper. On Oahu if you live in Ewa Beach during peak traffic hours it will take you 2 hours to go 8 miles.
Property D: Located in ghetto or inner cities. Cash flow is the highest however your quality of tenants drop dramatically. Expect Section 8 tenants and dealing with a host of issues. These will make you the most cash, but not recommended for novice investors.
When it comes to valuing real estate there are several metrics:
The 1% Rule: During the housing bust in a lot of the country you could find properties that fall under this. The 1% rule is the rent equaling 1% of the purchase price. ex: $120,000 house renting for $1200. Most often these can still be found in Property D, however if you can find this deal in property B or better I would snatch these up all day. However with the rise in prices these deals are extremely rare.
The CAP Rate: A CAP rate is the rate of return on your money after your mortgage and all of your expenses. If someone is looking for a 10% CAP Rate it means that they want 10% annual returns after expenses. Let’s say you have a $150,000 house with the mortgage, insurance, maintenance, vacancies and repairs runs around $1100 and you rent it for $1200. The gross rent is $14400 while your expe nses is $13,200. Your CAP Rate is: ($13,200/$14,400)=9.1%. Some areas can go as high as 15%! If you’re borrowing at 4.5% (the mortgage cost) and earning 10+% that’s a great deal.
Buying in an expensive area. In 80% of the country you can use the above metrics, however where real estate is expensive you won’t find properties with those kind of numbers. In SF, NY, Hawaii and other expensive area rents don’t match the purchase price. Instead I use my 10 and 20 rule. If it’s cheaper to buy with 20% down than it’s not a bad deal. If you can find a Property A or B with 10% down and it cash flows, than it’s a great deal.
Why cash flow and valuation matters. I’m a long term investor and not a flip guy. If you’re in an expensive area and use my 10% rule then you’ll be fine even if prices drop 20%. While prices may drop 20% rents do not follow that pattern. During the recession some of my properties dropped between 10-20%, essentially wiping out hundreds of thousands in equity. I only had to lower the rent by 5%, the rent covered all my expenses.
If you follow my rules and buy a Property A or B if there is a housing bust you can still ride it out as your renters will cover your expenses. You need to ensure the valuation matches up also. If you buy a property C and D you run the risk of 30-50% price drops as those are always the first to go in a housing bust.
The reason why people lost so many homes to foreclosures is that they didn’t look at location and valuation. In Vegas people were buying $500,000 homes that would cost $4000 to maintain and yet rented for $2000. If your carrying cost is $1500 then it’s irrelevant what home prices do if you’re a long term investor.
Over time real estate goes up due to inflation. If you buy right, even if the price drops for a few years if you have a renter your home will eventually be paid off. My net worth increases over $30,000 extra per year thanks to my tenants paying down the properties.
If you’re starting out and live in a cheap area buy a house,live in it for a year. After one year you can move out and buy another and turn that home into a rental. ( A primary home purchase requirement is 1 year for the mortgage.) If you live in an expensive area I would recommend paying it down for a few years, see how the rental market is before deciding on a rental.
Readers do you want me to post additional information in regards to financing and additional real estate strategies? Comment below if you want it and I’ll do a follow up post.
Do you own any real estate and rental properties? How do you value them? Is there any method I’m missing?