Real Estate Investing. Every bull market brings a new boon of people telling us how to make a ton of cash with their real estate system. But where does the value come from?
Fundamentally, there are three different business models for real estate investing. Most strategies are a sub-variation that explores a niche of one particular strategy. These models are: Buy & Flip, Hold for Appreciation, and Rent for Cash Flow.
Buy & Flip Value
Anybody who has tuned-in to the TLC or DIY television networks have seen fix & flip television shows. The glitz of Television makes many people develop big dreams of transforming a house from ‘drab to fab.’ And this is where a nugget of truth is hidden. That truth is that the value of fixing & flipping comes from creating value.
In order to succeed as a buy & flip investor, you will need to do something to the property that creates value. Further, this value must exceed the cost of executing the improvements. (Including the value of your time) This is no small consideration since the market is competitive and time is limited.
The way that many people succeed in this space is to seek out “ugly” houses that are offered for sale below their intrinsic value. People tend to over-emphasize what they can see, so astute investors can swoop in and purchase inexpensive houses that can be rapidly rehabilitated and sold for a profit.
Bottom-Line: Buy & Flip requires a significant value-add to be feasible
Hold for Appreciation Value
Appreciation is the part of real estate investing that gets the headlines. Whenever you buy a property with 80% borrowed money, it leverages your gains. Doing the math:
Let’s say you put 20% down and the property value appreciates 10%. In this case, the return on your investment isn’t 10%, it’s actually 50%! (10% gain / 20% down = 50% return) This is how people get rich fast with real estate.
Of course, leverage cuts both ways. If the property goes down by 10%, now you have a 50% loss. Ouch
So the critical thing to consider with appreciation is how to keep paying your mortgage. This is especially important since most high appreciation markets also have high property values. Many people rent out their properties in these markets to tenants. This does not always cover the full mortgage, but it helps to reduce the monthly net cost.
Note that holding for appreciation is a speculative play. Nobody knows what the future will hold. It’s the proverbial casino of real estate. You may hit a big run-up in values and clean-up. Conversely, you could hit a collapse and get cleaned out.
Bottom-Line: Holding for Appreciation is all about figuring out how to pay the mortgage.
Rent for Cash Flow Value
The third avenue of value for real estate investment is renting for cash flow. Many people consider this to be a bit ‘boring’ when compared to leveraged appreciation. The reason for this is because the markets with the best cash flow usually have the most modest price appreciation. (And the markets with the best price appreciation tend to have the worst cash flow)
The way that most people produce cash flow from their property is to find a long-term tenant. This tenant rents the property for a pre-dermined period of time. (Usually 12 months) The owner uses the rent revenue to pay the expenses. Typical expenses are property management (If you are outsourcing), insurance, the taxes, any maintenance and the mortgage.
The amount left over after all these expenses is the ‘cash flow’ value for the property. Many owners set aside this monthly amount in a reserve fund to cover future major maintenance items like roof or siding repairs.
Another key value of rental real estate is the mortgage pay-down. If you finance the property with a fixed-rate mortgage, part of that monthly payment will go to reducing the principal balance. Over time, the mortgage will pay off naturally and eventually you will own the property free and clear.
This makes rental real estate the safest long-term wealth building strategy. If you cover your overall expenses, it’s hard not to win in the long-run. Even if the market lags the major markets, it is likely to appreciate in line with inflation. This will result in repeating leveraged appreciation. Further, the monthly cash flow and mortgage pay down will steadily increase your equity position.
Some people have even started using short-term rental sites like AirBnB to enhance the returns of their rental real estate. (As you have probably guessed, this is a separate series of lessons)
Bottom-Line: Renting for cash flow is a long-term play for high confidence wealth creation.
Ultimately, the strategy you choose is up to you. There is no “best” way to create value with real estate. There are many people who do both well and poorly with all three strategies. The tactics and tools will be different for each, but success is always a matter of becoming educated and taking action.