The times are good for investors. That was the conclusion from my last column regarding the latest mortgage industry problems and their affects on landlords and tenants.
The current credit crunch has stifled some potential home owners from purchasing their dream home, forcing many to stay in the rental market. This has been an encouragement to landlords who have suffered under stagnant rents and fewer prospective tenants over the last few years.
At this time, there are many opportunities for investors in the real estate market. According to the Federal Reserve Bank, foreclosures are at an all time high in the national market. In addition, the housing sales slowdown affords investors a chance to pick up properties on short sales or directly from a distressed buyer.
Because of these opportunities, it's important for investors to better understand their place in the real estate market. I've had the opportunity to teach several courses on investment real estate. From my experience in this arena, I place most investors in one of two categories: net worth investors or cash flow investors
Many investors initially gravitate to single family homes. This is an easy category to understand for most people and they are comfortable with the lingo of single family homes. Whether they know it or not, this category of investor is generally a net worth investor. A net worth investor is one that makes money over a long slow period of time, and very little on a month to month basis. They build "net worth" slowly while the property appreciates in value.
The single family home simply isn't going to produce a large return except in the long run. The reasons are many, but the simplest is that the average home will produce about .75 percent per month in rent of its value. This is my personal rule of thumb and it fluctuates according to market cycles. Based on this rule of thumb, a home valued at $150,000 will produce a monthly rent generally around $1,125. Given a down payment of 10 percent, a 7 percent, 30-year mortgage, property taxes, and insurance costs, that home will produce anywhere from $6 to $73 per month, depending upon the county location, in net cash flow before repairs and vacancies.
So, the net worth investor is banking on the fact that single family homes in the past have appreciated in value and hopes to someday capitalize on that trend.
The second type of investor, the cash flow investor, looks to real estate investments that produce more cash flow on a monthly basis than in the long run. In other words, they may give up future appreciation for money in their pocket today. Multiple family units, such as duplexes, quads, or apartments, generally fit this bill. The main reason is that the unit can be bought cheaper than a single family home due to lower land and development costs per unit. Because of this, that lease rate ratio comes closer to 1 percent.
So, a multi family unit that is purchased for $75,000 might produce a rent of $750 per month. Using the same parameters from the single family home example, this unit will produce cash flow of $170 to $205 per month, depending upon the county location. As you can see, this small deviation in the lease rate ratio produces a sizeable difference in monthly cash flow; thus, making the multifamily investor primarily a cash flow investor.
Another factor for the investor to consider is the exit strategy, which is how to dispose of the investment when they are ready.
The net worth investor who is buying single family homes will be selling his investment to a retail buyer. A retail buyer is someone looking to purchase the home to live in. This buyer market is generally fairly stable since there are a lot of them in the market place. Thus, it provides a little more liquidity for the net worth investor since the property is easier to sell. Additionally, this buyer may buy on emotion and doesn't care how well the house produced as a rental or what the investor paid for it. So, the investor, in a good market, can ask top dollar for the property no matter how well he managed it as a rental.
On the other hand, the cash flow investor is almost always selling to another investor. This may be an investor who bases his entire decision on the income of the property. The cash flow investor won't have the luxury of stretching the fair market value. The purchaser will only pay what the rents dictate.
So, while there are many opportunities in this new market cycle, potential investors must decide which route they want to take. Do they go with the direction of slow and steady and hope for a big pay day, or do they look to cash in the pocket today with less excitement in the end? These are questions that every investor, whether big or small, eventually must answer for themselves.
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