Hello Money talkers! This is the third installment of my top four ways to invest in real estate. This blog post is all about buy and hold real estate. Buy and hold real estate is a long term investment strategy where you purchase a property, hold on to it for an extended period of time, and rent it out for a profit. It sounds simple enough, however, it can get very complex. But if you are willing to do your homework and put in the work buy and hold real estate can be very lucrative. Owning a piece of real estate that generates continuous cash flow can add diversity to your portfolio as well as an income stream that could see you through to retirement and beyond. There’s also the potential for more stability versus short-term, fix-and-flip property investments.
The first step to investing in buy and hold real estate is to figure out financing. Obviously, if you have the cash to do so you can purchase the property all cash and that’s that. The upside to purchasing all cash is that you have a leg up on people who are using a loan so you may be able to purchase properties at a discount. But if you are like most people, and don’t just have hundreds of thousands of dollars at your disposal then you will need to finance this endeavor.
Since you will not be living in the property and it will not be your personal residence this will require an investor loan. Investor loans typically require at least 20% down. So once you know your budget and stack up 20% for the downpayment and then 2-5% for closing costs, for a total of about 25% of the purchase price you are ready to shop around for loans. Once you choose who to secure your loan through and you have a pre approval letter you are ready to start house hunting.
The key to making money with buy and hold real estate is finding the right property to purchase. You should be looking for properties you can purchase at a discount while also considering location. You want to buy a house under market value, possibly a little distressed, in a neighborhood that is growing and is projected to continue to grow.
Also, as with any investment, it’s important to crunch the numbers before pursuing a real estate investment to generate cash flow. So how do you even know what numbers to crunch to begin to analyze whether or not a property that is priced well in a good location is a good investment?
The first formula you need to know when sifting through potential properties to make an offer on is The One Percent Rule: Does the monthly rent equal one percent of the purchase price or more?
A $100,000 property should rent for at least $1,000 per month
A $200,000 property should rent for at least $2,000 per month
A $300,000 property should rent for at least $3,000 per month
To figure out how much rent you could get, simply get online and look up rentals in your desired area that look similar to how your property will look. This will give you a general idea. If the property meets (or almost meets) the One Percent Rule, it merits further consideration. Otherwise, ignore the property and move on.
If a house does pass the One Percent Rule Test, I then look at a measure called the Capitalization rate, or “Cap Rate.” The cap rate measures your cash flow, relative to property value. The simple formula for cap rate is:
Capitalization Rate = Net Operating Income / Current Market Value
The more detailed formula for calculating the cap rate of a rental property is:
-Potential Gross Rent - Vacancies (5%) = Effective Gross Rent
-Effective Gross Rent + Other Income (Pet fee’s, etc.) = Gross Operating Income
-Gross Operating income - Operating Overhead = Net Operating Income (NOI)
-NOI ÷ Total Acquisition Price x 100 to convert to % = Cap Rate
But what does this random cap rate percentage mean? This number is basically your return on investment. According to the FDIC, the national average interest rate on savings accounts currently stands at 0.04%. The national average on a 2 year CD is .22%. The average rate of inflation is 3%, so you have to make at least 3% to keep up with the market. The average rate of interest on passively managed index funds is about 7%. Then we get into stock investing which varies drastically, but with high risk comes high return. So how does your cap rate stack up against these traditional forms of investing?
Well, that depends on your neighborhood class. Class A neighborhoods (super nice and new, luxury living) should generate a 6% cap rate. Because properties in Class A neighborhoods are typically new and more expensive, they will lure in tenants that make more money that will typically take better care of them, so they will require less maintenance. Class B neighborhoods (a little older in semi nice neighborhoods) should be at 6-8%. You will need to make a higher rate of return on these properties for them to be considered a good investment because since they are a little older you will need to do a little more maintenance and repairs. And Class C neighborhoods (which are distressed homes in bad neighborhoods) should bring in 8-10% cap rates. Obviously, these homes will need more maintenance and repairs as they will be in lower income neighborhoods and may not attract the best of tenants.
If the specific property you're looking at meets both of these formulas then it should be profitable. So make an offer on it and purchase it! Keep in mind that you can, and should, always negotiate the price down. If your offer does not get accepted then just dust yourself off and try again.
Building Your Team
One of the biggest mistakes I’ve witnessed is investors not using professionals at every turn of the buying or selling process. You could be setting yourself up for failure if you don’t have the right people in the right corners when making a long-term investment in rental property. That includes having a real estate agent or broker, general contractor, and a real estate attorney at hand. Your financial advisor can also play a part in helping to guide your property investment decisions. Bottom line, there are too many moving parts involved in buying property. Having a team behind you can help ensure your long-term investment success.
When exploring your options for renting out the property after you purchase it, you have three main options. The first rental option is to offer a traditional annual lease for sure and steady income. These are good so that you can clean and repair the property every year or so to make sure it is being well maintained and you can raise the rent when appropriate to adjust for inflation every couple of years as well.
You can also do long term leases of two or more years for consistency. This is a good option if you have a really good tenant that you know will take care of your property and pays the rent on time so that you can lock them in.
You can even do short term rentals, like month to month, AirBNB, or VRBO. Short term rentals are a lot more work because your turnover rate is so high and you are constantly looking for tenants and cleaning and resetting the property in between them. However, even though it may be more work, you can charge more for short term rentals. So if you are willing to put the work in, you may be able to make more money doing short term rentals.
A lot of new investors forget about maintenance. When you own a property things can, and probably will go wrong. You will need to perform regular maintenance and even replace some items to keep it up to standard. If the roof starts leaking, it is your responsibility to fix it. You should have an emergency fund of at least 3-6 months rent to cover any preventive maintenance or replacements that will arise.
Landlording v Property Management
So now that you vetted your property, crunched the numbers, purchased it, rented it out, and have your emergency fund in place for a rainy day you have one more task to complete. Do you want to be a landlord or hire a property manager to take over the day to day operations of your rental property? If you manage the property yourself, you will be responsible for collecting rent, answering calls and complaints from tenants, handling any maintenance issues, etc. If you hire a property manager they will handle all of that for you for a fee of usually 10% of the rent. So that’s up to you to save some cash and handle it yourself, or to pay someone else to manage it for you.
Growing Your Portfolio
If after all of this, you really love being a buy and hold real estate investor then you will want to think of how to grow your business. A lot of successful rental investors use the BRRR method and I think it's the way to go to grow your business exponentially and use leverage to your benefit.
The acronym BRRR stands for: Buy, Renovate, Rent, and Refinance. You buy a rental, renovate it to get the maximum rent out of it, you rent it out, and then you refinance it. When you refinance it and pull out the equity you put into it you then use that capital to do it all over again. Thus, building your real estate empire!
Basically, buy and hold real estate can be a great tool to generate cashflow and create passive income. Once these properties are paid off in full you will really see some serious cash flow that can act as a retirement plan and can really create generational wealth for your family for years to come.
Financial freedom is on the horizon!