Many young people have been told that investing in properties can help them retire early, be their own boss, and create passive cash flow. While the right investment property can help achieve these things, I’ve seen just as many people in compromising financial positions because of a poor investment property purchase. This is a discussion of financial considerations for people who want to add an investment property to their portfolio.
Know Your Goal
Before you hire a realtor or begin browsing online, it’s vital to understand your financial goal of purchasing a property. When we’re talking about investment properties, there are only two major categories of investment goals:
- You expect the property value to increase, and you’d like to eventually sell for a profit or pass it to the next generation.
- You expect for the property to generate an income for you.
If your goal is neither of these, it is not really an investment property you seek. It would be a second home.
Do Your Research
Once you know your investment goal for this purchase, you’ll want to begin the research process. If your goal is price appreciation, you’ll want historical price data, along with all current factors impacting future price appreciation. Let’s say an area is on the rise because a major corporation plans to move their facilities there, creating a plethora of new jobs, and promising to develop further infrastructure. That alone could be a positive sign for future price appreciation.
But going further, you’ll want to know if there is a contract in place, how long the corporation has committed to staying, and if there are any potential factors you haven’t considered, like if the addition of the new company will create a waste problem or pollute the water supply, causing a downward price strain on your potential property.
If your goal is income, you’ll want to understand rental trends in the area, laws surrounding long-term and short-term rentals, and understand where your income source will come from. For example, if you’re purchasing in a college town, your income source will likely be college students and your occupants will likely turn over annually. If you’re looking at short-term rentals in a beach town, you’ll probably have vacationers as your source of income, and you may have months on end without the property producing any cash flow.
I also would urge that you get your own research from an uninterested third party. Lending companies, property management companies, and realtors would all have a monetary interest in you purchasing a particular property, making their data and research potentially biased.
Know How Much Work You’re Committing To
Being a landlord can be a lot of work, particularly for older buildings that require a lot of maintenance. If you decide to take on the burden of property management yourself, your investment property can easily become a full-time job. Even if you are not renting the property out, you will need to put work into maintaining it.
I occasionally have a client mention that one of their friends says there’s a great investment property opportunity in another state, far away from where my client lives. If you are not easy driving distance from your investment property, you will need to be prepared to have to expend money to hire a property manager, ask local friends for help, or spend the time and resources traveling yourself.
Understand Income and Costs
Too often, I see people just think about the potential rental income from an investment property in a vacuum. Let’s say you purchase a property where a $300,000 home can produce $30,000 per year in rental income. At its surface, that looks like a 10% annual cash flow.
Unfortunately, even if you purchase a property outright, there are still associated costs, between maintenance, insurance, and property taxes. And oftentimes, if this is your first investment property, you’re probably financing the purchase instead of purchasing outright.
Let’s say you’re looking at an investment property in Austin, TX. If you purchased a $300,000 home, put 20% of the purchase price down, received a mortgage interest rate of 7.027%, paid property taxes of 1.77%, and held the Austin average cost for homeowner’s insurance, your annual cost breakdown would be as follows:
So, even without additional expenses for hiring a property manager or paying any applicable homeowner’s association dues, the positive cash flow in this case would be $3,233.04 per year, which is closer to 1%. If this investor’s goal is cash flow, this would be a poor investment.
Follow Through
I have clients who have bought investment properties with the goal of generating cash flow only to sit on the property for years on end. If you set a goal and did your research, you’ve got to do the work and follow through to make the investment worth it.
Know When To Walk Away
If based on your research and cash flow analysis, the investment doesn’t meet your goals, it may be time to walk away or consider a different investment to meet those goals. Just because you have the funds set aside and can purchase an investment property today doesn’t mean it’s the right decision for your financial picture today.
Conclusion
Under optimal conditions, investment properties can provide generous cash flow and immense investment growth. However, they can easily become a financial burden if these optimal conditions are not met. Investors looking to purchase an investment property should first delineate their financial goals, then do their research using reputable sources, understand how much work they will need to put in, assess all costs and benefits, follow through on their commitments, and know when to walk away if an investment isn’t right for them.
This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or real estate services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-6775426.1 (07/24)(exp. 07/26)
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