Factors Causing Real Estate Prices to Rise
The real estate market remains highly competitive and many buyers are finding it hard to afford a home. These high prices are due to a limited supply of properties, historically low mortgage rates and increased competition from private equity firms which are aggressively buying single family properties. Real estate markets are also evolving due to labor trends. Businesses and employees are leaving expensive, highly taxed and regulated states like California. They are moving to more business friendly states like Texas, Tennessee and Idaho where real estate was traditionally less expensive. That has now changed, this influx of high income buyers willing to pay more for homes has pushed real estate prices higher in these states.
A Potential Real Estate Investment
These trends are also making it harder on small scale real estate investors. For example, I recently toured a $650,000 single family property with 2 bedrooms and 2 baths located in one of these business friendly markets. Purchasing this property as an investment with 20% down would require a down payment of $130,000. The total monthly expenses would be $3,350, but the property would only rent for $2,300. This leads to a monthly loss of $1,050 and an annual loss of $12,600 if the property is self managed. These estimates include set asides for future repairs, capital improvements and vacancies each at 5% of rents collected.
Losses Over the Year
An investor who buys this property would build up equity each month from paying down the mortgage and the depreciation taken at tax time will narrow the out of pocket loss for the year to about $7,875. As it stands this investment will be generating losses for the first few years. The property may appreciate in value, but that will also bring higher property taxes and will not necessarily help with the negative cash flow.
Short-Term Losses May Not Matter
There are high income investors who are fine with such losses in the short-term. They will carry the losses against other income as they wait for rents to increase or for appreciation to improve the returns on this investment. This is the long game approach to real estate investing where one's existing net worth allows them to sustain losses for a few years with the hope of much higher returns in the decades to come.
But, this approach can be risky in the short-term. If the economy sours real estate prices could decline along with rents leading to wider losses. But, investors only really lose money in real estate when they have to sell, if the investor can continue to successfully ride out a downturn they will likely profit in the years to come. If they are able to continue purchasing real estate as prices decline, they will do even better.
Counter Losses by Lowering Risk or Increasing Rents
However, most real estate investors, particularly those who are new, do not have the ability to sustain these monthly losses. They also may not have the $130,000 for the down payment. If you are feeling priced out of real estate it is not a sign to give up. The key is to hustle to find ways to invest with the resources available. You could bring in a partner on this deal to reduce your down payment to $65,000 and cut your monthly losses in half. You are still facing a period of losses, but at a much lower rate.
On the income side, you could divide the property into two separate units each with one bedroom and one bath. Renting them separately may yield a higher total monthly rent. If the property cannot be easily divided, renting out each bedroom separately may command a higher price than the entire property. Depending on local laws you may be able to rent the property on Airbnb or as a vacation rental to earn higher rents than traditional monthly rates.
There may be traveling professionals such as professors or nurses who would be willing to pay higher rent for a shorter lease. It may also be possible to earn significantly more if you furnish the property as a corporate rental. If one of these strategies is able to generate $650 more in monthly rent this investment will break even while still building equity each month from paying down the mortgage.
Consider Other Real Estate Investments
There are alternatives to owning properties directly. These include investing in in Real Estate Investment Trusts (REITs) or real estate index funds such as Vanguard's (symbol VNQ). These investments pay a dividend derived from rents but do not offer the tax advantages of owning real estate directly. Similarly, you can invest in real estate companies that focus on a particular real estate sector such as Public Storage (symbol PSA) a leader in storage units or in private equity firms that are purchasing single family homes such as Invitation Homes (symbol INVH).
If you are concerned that the current real estate market is becoming overheated consider when to not invest in real estate and learn to identify the signs of a real estate bubble. If you are new to real estate investing learn the basics and the fundamentals of real estate negotiations. If you are looking to invest out of state start with these key factors and then build a successful team out of state.