After growing up with limited resources, Todd Baldwin knew he wanted to achieve financial independence one day. He bought his first property at 23, covering the mortgage by renting the spare bedrooms.
Baldwin’s early experience as a landlord taught him there was serious money to be made in real estate. He now owns six properties, has a net worth of over one million dollars, and brings in $13,000 per month in pure net cash flow.
Baldwin says, “I dropped out of college at 22, and by the time I was 25, I was a millionaire through real estate. If I can do it, anyone can do it.”
U.S. home values have increased 48.55% since 2012, and rent prices have increased an average of 8.86% since 1980, bringing reliable profits to real estate investors like Baldwin. In fact, 77% of millionaires have investments in the real estate industry.
While owning rental properties includes risk, knowing what to look for can mitigate that risk and result in major returns. Before buying an investment property, take the time to learn about:
- How to determine ROI
- Standard guidelines top real estate investors follow
- Tips every investor should know before making a purchase
How to Find ROI
Always start with the numbers when buying an investment property. If the numbers aren’t right, nothing else will be right either. Start by calculating ROI. To do this, you’ll first need to determine the cost of the investment.
The total cost of your investment includes the initial price of the home. However, there will be numerous additional expenses that bring up the total cost of the investment. Those additional expenses vary greatly depending on region, type of home, and lender. The following expenses affect your monthly mortgage payments. Talk with your lender to get an estimate.
- Closing costs
- Interest rate
- Property taxes
After speaking with your lender, you’ll want to consider each of the following expenses.
- Remodels and ongoing repairs: A general contractor can help you estimate how much initial remodel and future repairs may cost.
- HOA fees: Townhouses, condos, and homes in gated communities will often charge HOA fees, which will increase your monthly expenses.
- Property management fees: Unless you live near your investment property and have experience managing rentals, you’ll need to hire a property management company.
Now that you know the cost of your investment, it’s time to find the gain. Your total gains will include appreciation and revenue from incoming rent.
To find the expected gains from rental income, look at the price of rent in your area to determine how much you’ll be able to charge. Don’t forget to consider the direction the rental market is moving in your region. Look up the forecasts for the price of rent and factor in the expected increase or decrease in prices.
Because rental properties are long-term investments, it’s also important to factor inflation into your calculations. Historically, inflation averages around 2% per year. Inflation often favors the landlord because the price of rent increases with inflation, while your mortgage payments stay the same.
Here’s an example of how incoming rent changes over time:
- Income in Year 1: Rent = $1,500/month ($18,000/year)
- Income after 10 years of 2% increases in rent: Rent = ~$1,650/month ($19,800/year)
Appreciation gains will vary depending on the housing market and how long you hold onto your investment. If you purchase a home for $200,000 in a rapidly appreciating market, after 10 years of appreciation, you may be able to sell it for around $300,000. This leaves you with a $100,000 gain.
Follow the 2% Rule
To ensure a positive cash flow and a strong ROI, many investors follow the 2% rule. Scott Trench, CEO of the real estate investment community, Bigger Pockets, explains the 2% rule.
Trench says, “The 2% rule states that for a property to have satisfactory cash flow for a cash flow investor, the gross monthly rents should be equal to 2% of the purchase price.”
In other words, a $100,000 property should bring in $2,000 in rent. This rule ensures you’ll bring in enough to cover mortgage payments, repairs, and short intervals without tenants.
While the 2% rule was standard for years, as home values across the U.S. skyrocketed over the past decade, many markets haven’t seen investment properties on the market that meet the 2% rule in years.
Trench lives and invests in Colorado, a market that he says does not have any properties which meet the 2% rule.
Despite the shortage of homes that meet this standard, many investors have found ways to make profitable investments. To learn how this is possible, read on to find out their strategies.
How to Buy a Profitable Investment Property
1. Invest Out of Market
Trench says, “The 2% rule is a rule of thumb that’s a pretty good one for lower-income areas with lower property values and higher-priced rent rations.”
If you’re living and investing in Los Angeles, Seattle, or other markets with high home values, look to out-of-state markets to get the cash flow benefits of a 2% home. Certain neighborhoods in the Midwest and the Deep South have homes that meet this standard. Keep in mind that many of these areas have lower appreciation rates, so the positive cash flow is a trade-off.
2. Put Your Money Into Short-Term Rentals
If you don’t want to invest out-of-state to find homes that meet the 2% rule, short-term rentals are another good option.
Real estate investment educator, Cody Sperber, explains how short-term rentals allow you to “charge more than a long-term rental agreement and make more money for yourself, especially if you’re in a good area with nice restaurants, an amusement park, or other tourist attractions.”
Short-term rentals are often more profitable because it’s common to pay higher rates for vacation rentals. For example, if the market rate of one-bedroom properties for rent in your area is around $1,000 per month, but nightly rentals go for $100 per day, you could bring in as much as $3,000 per month with a short-term rental. That extra $2,000 a month gives you a solid cash flow.
Be cautious when choosing a short-term rental investment strategy. Some cities do not allow short-term rentals or limit the number of homes allowed to be listed as short-term rentals. Because platforms like Airbnb and VRBO are relatively new, the regulation of short-term rentals is still shifting in many cities, so this strategy comes with an added level of risk.
3. Follow the 1% Rule
Many investors have chosen to abandon the 2% rule entirely, replacing it with the more obtainable 1% rule.
Trench says, “It’s possible to cash flow on properties that don’t meet the 2% rule. You’re just probably not going to cash flow as much in the short- to medium-term as investors who are investing in properties that do meet the 2% rule.”
Because cash flow will be lower when using a 1% rule, avoid properties that will require extensive maintenance. Choose well-maintained properties that will attract the highest quality renters.
Additionally, prioritize the rentability of your rental property to avoid vacancies that further diminish your cash flow. If you’re willing to accept a bit of risk, the 1% rule can lead to strong ROI in the long term.
4. Research Rentability
A rental is only worth as much as tenants are willing to pay for it. You never want to end up stuck with a property that no one is willing to live in. Do your homework in advance to learn about each of the following:
Real estate agent and multi-family investor, Lee Fjord explains how potential tenants’ interests come first in determining the rentability of your property. Fjord says, “You have to look at what your tenant base is really looking for in their future home . . . So you don’t have to go and do every single thing, you just have to do the important things to your tenant.“
Real estate investor Brandon Turner encourages new investors to understand as much as possible about the market they’re interested in. He encourages future landlords to find answers to important questions like, “Where do people like to live? Where are property prices higher? Where are they lower? What about rent? What about crime?”
Most cities allow you to look up the vacancy rate in an area. Neighborhoods with low vacancy rates will be easy to find high-quality tenants because demand is high. Areas with high vacancy rates mean that if you want to find good tenants, your rental property will have to be one of the highest-quality properties in the area.
Smart Investors Remember These Three Things
Buying your first investment property can be intimidating, but once you understand the basics, use them to guide you as you buy your second, third, or even tenth investment property.
However, even the most seasoned real estate investors make mistakes and encounter unexpected turns in the market. It’s important to remember to always do your homework. This isn’t your home—it’s an investment, which is why decisions should be based on numbers and not on emotions.
Buying an investment property could be your ticket to long-term financial stability, but it’s not for the faint of heart. If you have the capital for it, do your research and think critically about your decisions before you invest. You don’t want to lose that capital and end up less financially stable than when you started. With these principles in mind, anyone can make a good investment.
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