Purchasing rental properties provides benefits for investors and wealth building for many reasons.
First, it provides diversification from other assets like stocks so that when the market goes down, you can still generate cash flow through rental income.
You can build equity through rental payments as well as property value appreciation. Additionally, you can earn passive income through recurring rental income (rent minus expense).
It protects you from inflation as the home value and the rent price appreciates more than annual inflation while keeping your fixed loan amount the same.
Lastly, there are tax benefits with tax deductions such as management fees, property tax and insurance, maintenance and repairs, mortgage interest, and related owners' expense (travel, continuing education).
However not all investment property is equal. Some generate more income than others. Additionally, investment properties come with some drawbacks such as requiring greater capital, being time-consuming, less liquid, and have greater risks.
We currently own two rental properties in the city of Chicago (Location) because we are familiar with the area and our demographic is the young workforce (Demographic). Both properties are high-rise condominiums (Types of Home) giving us less cash flow return, but in exchange, many of the repairs are covered by the association and the on-site maintenance crew (ROI).
Four things to consider when picking an investment property: Location, Demographic, Types of Home, and ROI. Below I will explain more about the four categories that I consider when purchasing a rental property.
Location
Picking cities or areas that you're familiar with will help understand the local culture, demographics, and other general ideas. But if you're open to other markets, finding cities, where corporations are moving, can be a good start. Corporations drive a young workforce, and growing wages, which will help find tenants more easily. Other factors can include cities with good school districts that attract growing families who want to send their kids to a certain school district.
Demographic
Once you find an ideal city, you have to find a property that your target demographic is looking for. Is it an urban city where the young workforce is moving into, a growing family who is simply moving to send their kids to a certain school, or a college town with students looking to live in off-campus housing?
Types of Home
Finding a home that your ideal demographic is looking for would be a good next step. Buying an expensive single home in a city with a young workforce may not be an efficient use of capital, while purchasing a small condo in a city with a growing family may not attract enough demographics.
There are many types of residential you can purchase from. Purchasing a high-rise condominium may provide amenities and maintenance on-site but you will be paying for higher homeowner association fees. Vice versa, purchasing a single home may provide more cash flow and fewer fees, but you will be responsible for finding your own repair.
ROI
Investors want to maximize their return on investment. Two ways of their return are through home appreciation or cash flow. If you invest in a mature market where the home may not appreciate as much, you want to compensate for it by looking for a property with higher cash flow (rent minus expense). However, if you find an area that has the potential to appreciate in value with a developing market, you can forego the cash flow amount temporarily to benefit from an appreciated property.
The general rule of thumb is to target property where your rent charge is at least 1% of the home price. So if the market rate for your condo is $2,000/month, you should look for a condo priced under $200,000 in order to receive enough cash flow to pay down the debt.
ROI should be at least 10%. If you invested $200,000 on a property, you should try to receive $20,000 in cash flow return annually which comes out to $1,600 per month. If your property tax and other expense come out to $400/month, you should try to charge $2,000 per month (Rent minus expense = ROI). If you put a $50,000 down payment only, a 10% annual ROI should be $5,000 (Total rent $20,000 minus Expense $15,000 [property tax/Interest] = $5,000 annual ROI).
Because investors have a longer time frame, holding cash reserve and creating a checklist of your desired home, and purchasing during a market downturn to purchase at 10-20% below fair market value should be considered.
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