Second homes and investment properties fascinate investors, who turn to Inman’s weekly Property Portfolio email newsletter as well as agents who work with this special class of client. This month, we’ll go deeper on everything from the latest at Airbnb and Vrbo to the changes investors are making to their portfolios in a shifting real estate market.
Investing in real estate can be a lucrative way to achieve financial freedom. In fact, it’s considered the best long-term investment strategy, according to a poll of 1,000 Americans. But it can be tricky to get started if you don’t know the basics.
If you’re exploring the idea of adding real estate to your investment portfolio, there are many far-ranging benefits, such as:
- Monthly cash flow that can be used for personal expenses
- Value that grows over time
- Tax breaks
- Dividends that are taxed at lower rates — if you invest in a real estate partnership fund
- Direct control over your financial future
- The opportunity to build equity for future investments
- The potential to build generational wealth
To get started, you’ll first need to determine how much money you should invest in real estate.
How much money do you need to start investing in real estate?
Real estate investing puts your money to work in the form of an income-producing property that can then be used to help finance your next property. The biggest barrier is also the simplest one: money. You need capital to get that first property going.
It’s impossible to put an exact price on how much money you need to start investing in real estate, but it can help to consider four types of expenses.
1. Purchase price
The purchase price is how much the real estate costs, not necessarily the amount of money you need in hand. Many first-time investors make the mistake of purchasing real estate in a place they’d like to live.
But real estate investing is more about finding properties that offer the best return on investment and are affordable for you and your tenants. In fact, 44 percent of Americans say they’d consider moving for more affordable housing.
2. Down payment and closing costs
You’ll need to have the money for your down payment and closing costs in hand when it’s time to close. The amount of your down payment also influences whether you’ll need private mortgage insurance, an extra monthly expense that you may not be able to pass on to a tenant.
If you make a down payment under 20 percent, you’ll end up paying between 0.19 percent and 1.86 percent of your loan amount in PMI each year.
3. Repairs and maintenance
If the property you invest in is not move-in ready, you’ll need to factor in repairs and maintenance necessary to bring it up to code and make it livable. The amount can vary widely and depends on the condition of the property.
4. Reserves
Experts advise having six months of reserve cash on hand to cover gaps between tenants, unexpected damages and other expenses that arise. This cash helps pay the mortgage when tenants are unable to do so.
Evaluating a property’s potential
There are a variety of ways to evaluate a property’s potential as a real estate investment. The simplest of these strategies is to apply the 1 percent rule.
This rule states that an investment property should rent for 1 percent or more of its costs. This includes not only the price of the property but also closing costs and any necessary repairs to make it ready to rent.
For example, if you purchase a property for $100,000 and spend $50,000 to get it ready to rent, your monthly rent expectation should be $1,500 or more. If you are in a rental market that won’t support that, keep looking.
When you find a property that meets the 1 percent rule, you can then consider the capitalization rate.
This is a calculation that helps you determine if the property offers a good return on investment:
- Estimate rental income: Estimate the average monthly rent you’ll charge, and multiply that by 11.5 to gauge the annual rent. This calculation takes a two-week-per-year vacancy into account.
- Estimate operating expenses: Consider monthly operating expenses, such as utilities, taxes and maintenance. Do not include the monthly mortgage payment. Subtract the estimated operating expenses from the estimated rental income to get net income.
- Calculate the capitalization rate: Divide net income by the purchase price, and multiply by 100 to find the potential rate of return.
The best investments yield a high number, and a solid capitalization rate of 4 percent to 10 percent is considered acceptable. Keeping the purchase price low and renting at the upper end of the area’s price spectrum can push that number even higher.
It’s important to note that investment properties can be snapped up quickly. In 2021 to 2022, 33 percent of homebuyers made an offer on a house sight unseen, and a hot market can increase competition for properties with a high capitalization rate.
Deeper dive into investing
After considering the benefits of real estate investing and examining the value of certain properties, it’s time to consider how much money you should invest in real estate.
The percentage of your portfolio will vary depending on how much you have to spend and your comfort level with risk.
In general, holding between 25 percent and 40 percent of real estate as your net worth provides all the benefits of real estate investing without focusing on one specific investment strategy. This percentage includes your own home, as well as your investment properties.
This percentage does not indicate the level of risk associated with the real estate you invest in. For example, investing in an unfinished development is much riskier than purchasing a fully rented retail property in a prime location.
It’s also critical to focus on the type of real estate investments you own. Although residential rental properties and industrial locations are thriving as the world emerges from the pandemic, retail locations are still struggling to recover.
Likewise, owning several small properties instead of one large property is a good way to protect yourself. If one property performs poorly while the others thrive, you can cover costs without taking a hit. Taking all of these factors into consideration is the best way to determine how much money you should invest in real estate.
Luke Babich is the CSO of Clever Real Estate in St. Louis. Connect with him on Facebook or Twitter.
