Investing in real estate is a popular, time tested way to diversify your assets and start earning a passive income. Any investment decision should be well considered and assessed carefully as there will always be complications - real estate is no different.
In this short but comprehensive guide, we'll give you our two cents on one particular challenge you may run up against: the cost of investment in expensive markets.
This guide will help you get your feet wet with the complicated world of high-cost real estate investments. We will analyze:
- Expensive markets
- The types of investment opportunities they offer
- Who they are for, and
- The steps to take if you're an aspiring landlord
High net-worth individuals sometimes choose to invest in expensive markets for long-term appreciation. Buying assets like investment homes or condos in expensive markets is not ideal if you are just starting your investing career. It's hard to be cash flow positive from the get-go in expensive markets. This leaves you with less or no extra money from this investment to buy more properties.
It's difficult to be cash flow positive in expensive locations
For aspiring landlords who want to build their wealth through real estate, it's better to start with smaller properties in less expensive areas and then increase your assets as you gain experience and wealth. However, if you already live in an expensive market, and if you want to keep your investments within your sight, local investments are your best bet.
This article focuses on aspiring landlords who want to invest in expensive cities. Do you want to get started? Let's go and make your investments count!
Expensive Markets: Friend or foe?##
First things first, let's identify expensive markets and analyze why the properties command the prices they do.
Broadly speaking big cities like New York, Vancouver, London, Shanghai, Singapore, Hong Kong, and San Francisco are home to some of the most expensive properties in the world. Even within expensive cities, different locations have different values - some more prime than others. While some areas may be 'cheaper', it's still a relative term as properties in these cities are not cheap by any means.
Different neighborhoods within the city have different property values
Statistical analysis of such markets clearly shows that there is a direct correlation between the population of the city and the property prices.
There is a very simple supply and demand economics at play here.
With so many people needing a place to live, the available properties are in high demand - especially for landlords like yourself looking to buy one for rental income. What does this mean? High demand + Low supply = $1400 per sq ft for a New York City apartment, while the national average is $123 per sq ft.
So what's the upside? Well, the biggest one is the fact that rent prices are much higher in these cities. More rent means more passive income for you.
Given that larger cities generally have more employment opportunities, it will be easier to find tenants who can afford an expensive rental home and are looking to raise their standard of living. Such tenants also reduce your chances of ending up with a broken wall to repair when they leave.
Another benefit is how well your asset appreciates. Property prices in dense cities tend to appreciate or hold well over the years. Long-term hold and sell likely will result in a higher price than what you paid. When buying real estate in expensive markets, appreciation plays a bigger role than the cash flow from rent. For example, San Francisco property values appreciated by 88% in the last 10 years, New York City by 42.6%.
To put this in context, property values in Dallas, Texas went up by 71.63% and Waco, Texas by 54.16%, Raleigh by 41.49%. While such locations produce impressive returns, if they are far from where you live and if you want to keep your investments closer, they may not be an option for you.
Liquidity is heavily dependent on the economy, the location, and the condition of the house. Cities typically continue to grow and attract more migrants, increasing both the property value and the need for rental properties, increasing rental income.
Now that we understand the benefits of expensive markets, let's proceed to our next steps.
1. Determine your budget##
This is the most obvious one.
You need a large chunk of cash as down payment (or do you? Refer to 3.) for investments in expensive locations. While the exact down payment varies based on the economy, your financial situation, and the bank, 20 to 25% is not uncommon. For a million-dollar condo, that's about $250,000 just for down payment. That's more than the value of an entire home in many parts of the US and the world!
Down payment in expensive locations is more than the cost of an entire home (or a few homes) in other locations
The standard financial advice in the real estate investment industry - recommending investing in assets with money you already have as opposed to taking out a loan or a mortgage - will not work for most people in expensive markets. Leveraging with mortgage is your best bet in these locations. You just have to be careful about how much you overextend yourself with a mortgage, which is very easy to do in these markets.
Real estate gurus tend to focus on immediate cash flow so that you can continue to build your portfolio by buying more assets. If most of your new rental income goes towards paying off loans or mortgage payments, then it's not a good trade-off according to traditional real estate investing guidelines. Your rental income has to cover your operating expenses, property taxes, mortgage with enough left over to save towards your next property purchase. What makes expensive markets worse is that you may have to put in more money every month to cover your total expenses, leaving you with even less to save towards your next purchase.
Positive cash flow may or may not happen immediately in expensive locations. You may have to do a trade-off between immediate cash flow vs. long-term appreciation and positive cash flow. You can address this by either putting down more money upfront or taking a negative cash flow for the first few years until the rent catches up.
In expensive neighborhoods, investors usually own fewer homes - less doors to collect rent from. But the rental income is high. For example, a 2-bedroom apartment in San Francisco rents for $4000 to $7000 while a similar unit in Dallas costs $2000 approximately.
On the bright side, rents tend to be mostly sticky and they go up over time. Therefore, even if you don't break-even immediately with your $4000 rental income, you'll be able to do so in a few years. That coupled with appreciation in property value will make up for the temporarily negative cash flow.
2. Decide what type of property to buy##
There are a myriad of properties available for investing and the choice can seem very daunting.
If you're just starting or your pockets aren't super deep, residential properties are usually the way to go. They are familiar, the choices are vast, and the barrier of entry may be a lot lower than other property types. Condos, townhomes, and single-family homes each have their advantages and disadvantages. In residential investing, the landlord is responsible for both the interior and the exterior.
For seasoned investors with deep pockets, commercial properties could be an option. The rent opportunity is much higher and if the property is in a good location the value will only continue to rise as advancements take place. Commercial contracts usually run for about 10 years, giving you a long-term tenant. While the landlord is responsible for the exterior, the tenant is usually responsible for the interior of the property. This implies lesser headache for the landlord.
3. Research, Research, Research##
The importance of this step cannot be understated. You have to do extensive research into the area and property you are looking to invest in.
There are so many online resources to help with this. The advantage of local investing is that you can see the different locations for yourself. Don't just rely on your realtor to educate you. Visit the locations at different times of the day and on different days to observe the neighborhood and people. An educated buyer makes good decisions and you have to make sure you know exactly what you're getting into and the repercussions.
A big part of your research phase should be spent trying to find good deals on properties to help alleviate the high cost of entry. Many markets we previously mentioned will usually share one common characteristic: the further you go from the city center the cheaper the properties get. This means that city outskirts and up and coming pockets are a great place to look for affordable property.
Besides cost, you also want to look at the location of your property. Good schools and amenities nearby make a residential property attractive for renters. On the other hand, for a commercial property, check the surrounding buildings and the general business landscape. You don't want any unpleasant surprises after spending your savings.
Buy in the best location you can afford. Location matters the most in real estate.
Other options that might work to your advantage could be buying bank foreclosed property, being the first bidder, buying disheveled properties for cheap, and then renovating, the list goes on and on.
Bottom line: You can reduce your chances of making a bad investment by being well informed and knowing your market inside out.
4. Final Steps##
Now that you're a knowledgeable consumer, it's time to take action. You'll have to put 'down' (pun intended) a down-payment for the property and spend on closing as well.
It's important to have the property you've chosen assessed and inspected by professionals. Carefully review everything in your agreement before signing.
You should also look into insurance options available to you in case of damage to the property as renter's insurance only accounts for a tenant's belongings and does not usually account for the actual building itself.
Finally, get your taxes in order. Like everything else, you still have to pay taxes - property taxes and rental income taxes.
Putting it together##
Real Estate investment is a tricky exercise. There are many complications and pitfalls to look out for, not to mention dealing with lawyers and brokers. But if you make it through to the other side, you'll gain an asset that will help you diversify your portfolio, ultimately help gain a steady passive income and increase your net worth.
Following these guidelines, any investment decision you make will be deliberate and well informed, regardless of how expensive the market is. Many before you have increased their net worth by focusing on expensive markets. You can do it too!
As you start your investment journey, it's important to manage it wisely. Store all property-related documents in one place. Finding the right tenants, performing move-in move-out inspections, collecting rent, renewing insurance, etc can be time-consuming. HomeKasa offers the best property management software that makes your life easy. It's free to start. Give it a try now and improve your productivity.