I think one of the best ways to increase wealth and add versatility to any financial portfolio is with real estate. In my experience, one of the simplest real estate investments to manage and understand is the single-family rental; town homes fall under this description as well. There are multiple approaches to this type of investment, and you can begin this portfolio at any point in your financial life, but in my opinion, the sooner you start the better off you are. There are two models I think lend themselves best to the young investor.
Let’s say you’re a single 20 something and have managed to save enough money to cover the down payment and closing costs for a small single family or town home. I usually recommend keeping your budget low enough to be able to tolerate a 15 year mortgage so you can build equity faster, but that is not always the best option if you plan to hold the property for a long period or have limited cash reserves. There are two approaches that I have found work well for the first time, younger investor. Scenario 1 is to get a roommate with whom to split the rent and the carrying costs OR in scenario #2, have a roommate or live alone but make a plan to improve it and sell it within five years and buy another one or more rental properties. Doing either scenario under a 1031 exchange can help defer taxes. This is of course a topic to discuss with your tax advisor.
How will investing like this make money you ask. Financial discipline is the key to success in either model. Instead of spending all that rental income or counting on it to pay the rent, save it. This simply will not work well if you need that roommate rental income to cover your PITI. Let’s look at this from both examples.
Scenario number ONE:
This is basically a long-term rental. The idea here is to save some or most of the rental income to purchase another home and KEEP the initial purchase as a long-term rental.
Ideally, you will have a long-term income generating property, and you will be on your way to building a portfolio while investing in yourself with your own home. You may even want to follow the same model when purchasing the second home and get a roommate or buy a duplex and live in half while renting out the other side.
Either way, there are some snake pits you need to avoid or at the very least be prepared to address. First and foremost, in any real estate consideration is location. You will need to know the historic trends for this area. What has pricing done over time? Have there been any events that might stigmatize the area or put your property at risk (AKA flooding, earthquakes, mudslides, hurricanes, plant explosions, high speed rail to be developed nearby, etc.)? Have there been significant jumps in taxes? Any of these can kill your return on investment and ultimately make your investment a poor one.
Be careful about investing in properties older than 30 years that have not had extensive mechanical and structural updates. Older properties have older property issues such as galvanized pipe problems, roof issues, foundation problems, asbestos and lead. One or two of these may be addressable but could cost you and will requiring a greater holding time to recoup that investment and is something you will need to factor into your offer price. MAKE CERTAIN you get a thorough inspection and, in my opinion, it is worth the extra time and money to get additional inspections for roof, mecahnicals and WDI (wood destroying insect). For investment purposes, I love homes that have been structurally and mechanically updated but are stuck in their time period. Cosmetic updates can be done over time and as part of an income producing property may be deductible. Score!
Keep in mind, you will also be making this your home even if only temporarily so the location and layout need to work for you as well, and you will also need to factor in the cost of HOA fees and any potential assessment fees. Those amenities may be worth the extra cost as not only will you get enjoyment from them, but your future tenants will as well making the property easier to rent in the future.
Scenario number 2:
The same cautions apply here as with #1 but with less room for error because of the time frame. This is basically your hold and flip model. It’s often used by more experienced home buyers and investors, but even a novice can do it as long as he or she has some capital. This requires more market knowledge and a bit more luck. Since the plan here is to basically hold until you have maxed out the tax value, you need to be sure that the area is appreciating in value and the location is very desirable. You also do not have as much time to recoup large investments in items the consumer will not appreciate such as re-pipes, new windows, or foundation repair. Most consumers do appreciate new roofs, new mechanicals and new appliances so those will likely be worth the investment, but like with any RE purchase, any needed improvements should play a factor in your offer price.
With this property, the rental rate carries a much more significant weight as you only have a limited amount of time to profit from that … I tend to think of these more like a flip property. Can I make a significant profit between rental income applied to the PITI (principle, interest, taxes, and insurance) and resale value after improvement costs? On these, it’s not unusual to take a contractor along with you during a preview or in Texas during the option period to see what your “all in” cost will be and make adjustments to your offer price accordingly. Once you sell, you can roll the proceeds into another income producing property or maybe even two properties, or a duplex/triplex as mentioned in Scenario #1.
Real estate investing like any investment carries a certain level of risk. And there are other factors to consider. Can you tolerate the fluctuations of the housing market? Do you have a back-up plan if the market turns and you need to hold longer than expected? Do you have the personality to be a landlord? As with any investment, it is always best to seek out advise from an accountant, financial advisor and/or an attorney. And always consult a licensed Realtor who is knowledgeable about the area in which you are considering.