Real estate has made more people independently wealthy than any other type of investment, but it is not a venture to be taken lightly. There are many things that anyone starting a rental business should know before they purchase their first investment property. Specifically, one needs to know Landlord/Tenant, tax, discrimination, and accounting laws – to name a few. An investor should also know what makes a property a good investment. Despite what most people think it is not all about how much the rent is. There are many factors involved in figuring out what to invest in and where to invest.
First, you need to decide what type of property you want to invest in (e.g. land, commercial, residential, etc). The focus of this article is residential investments. Residential properties are defined as single family homes, duplexes, and multi-plexes (even though structures with over four units are considered commercial property).
Second, you will need to figure out the location you want to invest in. This can be as simple as staying close to home or having a property you can manage at a place you vacation or visit. By investing at a location you vacation or visit, you can thereby make it possible to deduct your travel expenses from taxes. One might also look for locations which are in high demand, growing communities, developing areas, and places speculated to appreciate (keep in mind this could be a risky way to invest).
Now you need to decide how you want to invest. Do you want to buy properties below market value, fix them up, and flip them for a profit, or do you want to buy rental property and build a real estate investment portfolio? With the number of foreclosures on the market this may seem like a no-brainer; but there is still a lot speculation. Property flipping is riskier and there are additional expenses involved such as a higher rate of capital gains referred to as short term capital gains and there is no way to defer this tax or avoid it. This type of real estate investing could be compared to day trading. It has the potential to make a lot of money quick, but it also has the potential to lose a lot of money quick. This is not for the inexperienced investor. It is not a good, initial secure base to build your investment business on.
After considering all of the above, let’s say you’ve decided to invest in rental property. You’ve determined the rental property will be residential and close to home. You need to decide which property will give you the best wealth building potential. This will depend on what and where you currently invest your investment dollar, what your current income is, how you want to build your real estate portfolio, your age and/ or time left in which you want invest, and what your future plans and needs are. You will also need to determine if you want to have a cash flow income or build wealth.
Looking for the Right Investment Property
Look for property with a good rate of return. A good rate of return can be figured in many different ways. Most experienced investors do a quick calculation, called a Gross Rent Multiplier (GRM), or capitalization Rate (Cap Rate).
- The GRM is figured by dividing the purchase price by the monthly rent. A good GRM should be less than 150 (the lower the better). This is not the most efficient way to base your decision.
- The Cap Rate is another quick way to determine rate of return. This is figured by taking the net property income and dividing it by the purchase property. A good Cap Rate is 8%. The Cap Rate can be compared to the interest rate you earn on money in a savings account. If the Cap rate were only 4%, you would probably be better off putting your money in a CD at your bank (or something similar). Using the Cap Rate is a slightly better way to base your investment decision because you are taking into account what the expenses are.
These two ways of figuring a good rate of return are helpful in narrowing the field of available properties. When you are ready to decide which property would be best to buy, a complete investment analysis is recommended. A complete investment analysis will figure out your cash flow, estimate your tax savings, estimate a holding period (to maximize your rate of return on your cash invested), and it will take everything into account (even a conservative appreciation rate).
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