Real estate investing has been a game played for generations by many as a reliable pathway to building generational wealth. The basic premise is simple: buy a property, rent it out, and reinvest the rental profits into another property. Repeat this process enough times, and you end up with a large portfolio of homes, each generating positive cash flows. Eventually, this process can snowball into a sizable portfolio of strong, cash-flowing, recession-proof assets.
Clearly buying real estate is a proven method for building wealth. So the question is, why isn’t everyone doing it?
Time, money and complexity.
We realize that investing in real estate can be daunting. Where do you start? What market should you look at? What type of analysis should you do?
These were all questions we had at one point as well. The purpose of this blog is to provide a guide on why and how to get started, and is broken out in the following three sections:
- Why you should invest in real estate
- How to conduct market research
- How to conduct property analysis
Why you should invest in real estate
First of all, real estate in America has been steadily appreciating in value since before the 1980s. Even during recessions, as long as you invested in a property that can maintain a positive cashflow, you can wait out any real estate downturns.
Second, real estate is one of the only asset classes that lets you access leverage at 5 to 1 ratio. When purchasing a property, it’s typical to put 20% of the total price of the home as a downpayment while a bank puts in the other 80%. This allows potential buyers to buy homes at five times the value of the physical cash that they have on hand. With interest rates being as low as they were, you could get loans ranging from $100k — $1M+ only paying 3–4% in yearly interest. While times are changing with interest rates increasing, the leverage available to real estate is still unmatched.
Third, real estate is a tax advantaged asset. When you purchase a property, you have the ability to depreciate certain aspects of your home, meaning that you can write off some of the value of your home which lowers the total amount of taxes you pay on the rental income of your home. In addition, paying interest on the loan for your property allows you to benefit from an interest tax shield. In this case, an interest tax shield refers to the tax savings resulting from the tax-deductibility of the interest expense on debt taken. In addition, when you sell a home, you have the ability to defer capital gains taxes by reinvesting the proceeds into another property via tax advantaged strategies such as the 1031 exchange. This allows you to completely defer all profits that were made when selling a home as long as you quickly reinvest the money into another property within 180 days.
As a final point, real estate markets are very local. Meaning that if you pay enough attention, you can become an expert in your immediate neighborhood, or very nearly so. This gives you a competitive edge and the ability to find good deals. Whether you are buying real estate, as we detail in this article, flipping, developing, prospective land buying, househacking, etc., the advantage of being native to your target market is of great benefit.
Hopefully, the reasons outlined above were enough to convince you of the value of investing in real estate. If that was enough to peak your interest, let’s go ahead and talk about how to conduct market research.
How to conduct market research
When deciding which real estate market to invest in, you want to look at different data points to understand how healthy the market is and whether or not it’s worth investing in it. Some of the data points you want to look into include the following:
- Unemployment data
- Population growth
- Population Age
- Supply and Demand of Homes
- Upcoming Construction
Unemployment Data — you are looking for unemployment figures that are stabilizing and sit between 5–10%.
Population Growth — what you want to see here is either steady numbers over the years, or a steady increase. Some analysts recommend focusing on places with more than 1M inhabitants, or places that have grown 30% or more since the year 2000.
Population Age — population age gives us an overview of what sort of facilities are needed, as it relates to the population age. Places with a lot of employed young people will have demand for studios, and small housing. Places with families will have demand for multi-room units, single family homes. Places with a lot of elderly folks will have a market for senior living or senior care centers.
Supply and Demand of Homes — knowing where rents are and where they are going helps us understand what sort of income is expected. The HUD website is particularly good for preliminary information; but, ultimately you want to ask your agent. You want to look for markets where vacancy rates are low, and rents are steadily increasing.
Upcoming Construction — keeping a pulse on how many homes are available for rent in the market, and how many new apartments are coming online in the upcoming months gives you a pulse on competition. This speaks to the healthiness of the market.
These five attributes are just a few of many different variables that real estate investors look into when assessing the viability of a market. Everyone has their own secret sauce for evaluating a real estate market. In the end, it’s about analyzing many different data points and discovering potential correlations that lead you to believe that the market you choose will continue to experience growth.
How to conduct property analysis
To best showcase how to conduct property analysis, it’d be good to start off with an example. We’ll do that by looking at the financial projections on a property. The goal is to give an example of how a property’s financial picture looks, and in the process we’ll touch on the useful metrics that can be used to decide on whether to invest in the property or not.
Lets look at an example
Purchase Section
This property was bought for $144k, and financed with 25% down. This is pretty typical for investment property, lenders will give more favorable terms with lower loan-to-value. As for whether the purchase price is right, a rule of thumb can be used. It is called the 1% rule. If a property can bring in 1% or more of its purchase price, it likely cash flows.
Income Section
This is the income section of the acquisition estimator. It reflects actual data for this property, which is a triplex.
The monthly rent is $2250, which is above the 1% rule, so we have high hopes that it works. In addition, always calculate with vacancies.
A best practice is to find opportunities that allows you enough cash flow to pay for a property manager. This allows you to limit your involvement to managing the managers and not the day-to-day operations of the property. The benefit of this approach is that you now have the option to scale your business by buying more properties in the future and keep your focus on acquisition instead of dealing with tenants, repairs, or vacancies.
Expenses Section
When calculating expenses, a good rule of thumb is that total expenses are typically ~50% of gross income. This includes property management fees, insurance costs, any HOA, utility costs, and taxes. Property management fees are typically between 6%-10%, if you can manage it yourself (you should do that to save yourself the costs).
Summarized Financials Section
Definitions:
Net operating Income (NOI)= Effective Gross income — Expenses
Gross rent multiplier — number of years of gross income needed to recover property value
Debt Service Coverage Ratio; rule of thumb: lenders like 1.25 or more.
Cap rate: what percentage of its value the property returns in NOI. Use to compare properties, related to property classes.
In this case, we invest $42,000, and bring in $5,255 in yearly cash flow. This amounts to a cash-on-cash return of 12.51%. This would be a profitable investment, and has enough cash flow built in to give you quite a buffer if unexpected expenses occur. Of course there are risks associated with real estate investing that could still sour the deal, but at a high level this investment pencils out to be quite profitable.
If you want to get started, we created a pre-built spreadsheet for you (just make a copy and input your variables into the highlighted cells).
Our Beliefs at Homebase
We created this guide to give individuals new to real estate investing a framework to get started and see firsthand how wealth is built up overtime.
The example showcased in the previous section outlines how real estate investors are able to build generational wealth. You 1) invest in a cash flow positive property, 2) save profits generated over time, and 3) reinvest the profits into another cash flow positive property. Repeat this process enough times and you build a formidable portfolio of cash generating assets.
Unfortunately this pathway to building wealth is becoming increasingly unaffordable over time as real estate prices continue to hit monthly all time highs. Our goal at Homebase is to lower the barrier to entry into real estate investing and give people the ability to invest in fractional shares of a home. We believe that everyone should have the same opportunities of investing in a stable, income generating asset and pursue their own pathway to financial independence.
Domingo, Homebase Co-founder
Disclaimer: Homebase does not act as a real estate broker. The information listed on this page was provided by the property owner/seller/broker. All information is deemed to be reliable, but not guaranteed. It is the responsibility of a prospective buyer to confirm the accuracy of any pro forma, including estimated rent ranges, closing costs, taxes, insurance, appraisals, and third party inspections before purchasing any property. Mortgage interest rates are subject to change and actual rates will vary. It is also recommended that buyers set aside reserves for potential vacancies and/or maintenance costs (typically calculated between 3–6% of rents).
