The purpose of any investment is to obviously make as much money as possible. However, in real estate there are two types of “money making” investments: price appreciation and cash flow.
Often, there is an inverse relationship between these two investment objectives, meaning a good cash-flowing property may command a much lower price than a non-cash flowing asset that might be located in a more desirable area. Basically, you should expect greater cash flow/return for investing your money in a less desirable neighborhood/property. The way to do that is to pay a much lower price for one property versus the other.
Price Appreciation: You buy a house for $500,000 and sell it after a period of time for $600,000, for a profit of $100,000. In this simple example, your profit is the difference between purchase price and sales price.
Cash Flow: You buy a 4-unit building for $500,000 and your mortgage payment is $2,000. Let’s say you have another $1,000 in expenses (taxes, insurance, repairs, etc.), for a total expense of $3,000. Now, let’s say you rent each unit for $1,000 for a total rental income of $4,000. In this case, you have a positive cash flow of $1,000 per month, or $12,000 per year.
The Difference
Obviously, it’s best to have both cash flow and profit. Also, you may intuitively think that the more cash flow you make, the higher the price you can command for your property relative to other properties. However, unless you’re very lucky, there is usually an inverse relationship between cash flow and price appreciation.
For instance, in the two examples above, it’s not unusual to sell the $500,000 single family house (or condo) after only one-year for a profit of $100,000. However, it is also not unusual to sell the cash-flowing fourplex for a much lower price, say $525,000, or a profit of only $25,000.
How can an income producing property with more units and cash flow sell for a lesser profit than a single family home or condominium?
Well on average, single family homes, especially ones in established neighborhoods, appreciate much faster than other residential properties. Why? because many families like to live in neighborhoods with an abundance of other single family homes, safe areas and good schools for many years.
On the other hand, rental properties imply a more transitory living arrangement (i.e. turnover) for people who can’t necessarily afford to buy a house. This may not always be true, but rental properties are usually much cheaper on a per unit basis than single family homes or condos. Also, the more rental units you have, the higher your probability of dealing with evictions, expensive repairs, etc.
Therefore, before investing in real estate, it’s important to determine what you’re chasing: profit or cash flow.
There are a few other things to consider when determining which type of investment objective you’re trying to accomplish. For instance, it’s typically easier to get a loan for a single family home than it is for a multi-unit property. Also, loans for single family homes typically require a lower down-payment and come with a lower interest rate than multifamily investments.
Criteria for Appreciation
1.) Location, Location, Location: An established neighborhood with a high-concentration of single family family homes in an excellent school district with low crime rates is the blue chip investment for those aiming for price appreciation. There are exceptions in some areas with declining populations, but generally this is the case.
2.) Functional Property: Increasingly, Americans prefer homes with at least 3-bedrooms and at least 1.5 baths, a modern kitchen, a garage and a backyard or outside patio. Older homes with only 1-bath, an outdated kitchen or no garage will typically appreciate less than other properties in the same area.
3.) Convenience: Neighborhoods that are fairly close to employment centers also do well. Also, the more transportation options or other commuting alternatives the better. Nearby quality shopping, dining and entertainment options are also a plus.
Criteria for Cash Flow:
1.) Building Condition: Repairs and maintenance can drain your budget. The more deferred maintenance, the less cash flow you’ll be able to realize. Therefore, if you buy an old investment property, be prepared to spend some money to rehabilitate it.
2.) Rental Rates per Unit: Obviously, the higher the going rental rates the better. However, don’t compare rental rates in one area to another.
3.) Economic & Population Growth: Growth prospects, or lack thereof, is something to keep in mind. Many parts of the rust belt have experienced population declines, while many areas in the West have experienced strong growth over the past years, thus pushing rents much higher.
4.) Number of Units: If you’re cash flowing on each unit, the more units you have the better.
5.) Debt Service: This is determined by the price you pay for the property, as well as the interest rate on the loan and how much of a down payment you made.
6.) Utilities Costs: Who pays utilities, the tenant or landlord? It is common in some localities for the landlords to pay all utilities, especially if the property is not separately metered. This adds a lot of expenses and can be an incentive for tenants to abuse their use of utilities. Therefore, whether or not the property is separately metered is very important.
7.) Other Expenses: Taxes, Insurance (flood insurance?), business licenses, etc. All these expenses vary by state, city, etc. Also, some properties are located in flood zones, which can add a significant expense for flood insurance.
8.) Property Manager: Absentee landlords will probably need to hire a property manager to collect rents, process repair requests, issue eviction notices, etc. Typically, a property manager will charge a percentage of rents collected. Some property managers charge a minimum (i.e. they will collect a fee even for vacant units). It is critical for investors to consider the cost and quality of the property manager they’re hiring, because property managers can make or brake an investment.