Investing in real estate takes a lot of financial planning related to all aspects of your portfolio of investment real estate properties. It is simply not looking for properties that incur higher rent than your mortgage payments as there are many factors that can change this: property taxes, insurance, changing home values, repairs or even changes in your home loan. Financial planning is a crucial step, and can make your investments succeed or fail.
Planning your mortgage:
First time and early real estate investors typically rely on a mortgage to help them finance a property purchase. Utilizing a mortgage means that as a purchaser, you will need a higher down payment – at least 20% of the purchase price. Furthermore, financial planning of your investment properties should also include mortgage payments, property taxes (as some mortgagors may add this to your monthly payment) and any related closing costs / loan costs that will hurt your ROI on year one.
Financed properties will have associated loan fees – from origination fees to appraisal, and some others. Though financing a property can leverage your cash on hand, investors should plan for how long a property takes to break even. In cash flow positive properties, your initial investment divided by profits will indicate your break even period. Having a property break quicker, allow you to utilize funds as a down payment towards another property purchase. Your exit period, typically is a lot longer and refers to when a properties’ profit has fully paid off an investment.
Cash flow properties (the monthly or annual income after accounting for related expenses, including mortage, taxes, repairs and vacancies) allow property investors to either reach a break even period quicker, or invest in other properties or investments, such as stocks.
Getting your real estate property to be cash flow positive is a priority as an investor but may not always be possible. One method is to rehab a property to raise the potential rent. However understanding what the rental ranges are for the area will allow you to make an informed decision as it is easy to either be at the top of the rental price range for your area, or even just out price the market which could lead to extended vacancies.
High demand will also increase potential rental values, although this is harder to control, especially in urban areas where new developments and other rental properties can become competitive on the market.
Where your return on investment (ROI) assesses your rental income over your initial costs, the capitalization rate (cap rate) analyzes the rental income over the property purchase price or asset value. The cap rate helps us understand the exit period for an investment, and the potential risk and value of the property. High cap rates are preferential for buyers as they indicate a purchase price for a property is low, whereas lower cap rates are indicative or higher property prices. Cap rates are also influenced by market trends and risk. Areas of slower appreciation and high risk typically have higher cap rates, and areas with higher appreciation and lower risk have lower cap rates.
Having a real estate broker and a financial planner can help you plan for which investments suit your risk profile, resources and both your long and short term goals.
When planning your property investments, it’s also important to understand related costs as these are sometimes easily overlooked or underestimated.
Some of the potential costs that should be taken into account are:
- Property taxes
- Mortgage payments
- Utilities (electric, gas, water)
- Repairs and maintenance
- Property services (property management, broker rental services, scavenger, lawn care, snow removal, HOA fees).
- Potential vacancy rates
Appreciation should be taken into account when planning your investment portfolio, and should be revisited as the market conditions change to continue to understand your risk profile, cash flow and property value.
Though appreciation is a predictive factor, continually understand year over year metrics, or changes in factors over a short time period will help you take preemptive actions before drastic changes on the market.
Once you understand all these related factors, you will begin to understand investments potential break even period, exit period, cap rate, and return on investment. From there it is crucial to then understand the market, and areas of investment that interest you, potential risk and costs.
Sherwin L. Sucaldito, REALTOR®, GREEN, ABR, CRPM
The Institute of Luxury Home Marketing
Green REsource Council, GREEN
Accredited Buyer’s Representative , ABR
Certified Residential Property Manager, CRPM