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Monopoly was one of my favorite board games growing up. I especially enjoyed seeing the expression on my little brother’s face when he landed on my hotel on Boardwalk or on one of my railroads. That was my earliest taste of real estate investing.
Today, there are four things I look critically at in every rental property I invest in: cash flow, appreciation potential, risk and effort. Most new investors make one of two mistakes: Either they focus only on only one of these four factors, which leads to poor results, or else they try to find the perfect property — which often leads to not investing at all.
I’ve learned over the years that it’s important to strike the right balance. When I bought my first investment property, I was only thinking about cash flow. Unfortunately, that place was a nightmare to manage, and it barely appreciated over a span of several years. Another property I bought had very low risk and great appreciation potential. But condo fees increased! Soon, I found myself in the red every month.
When I start coaching new investors, determining what that balance looks like is one of the first things we focus on.
High Cash Flow
Cash flow is the cash that is left over after covering all expenses, mortgage payments and property taxes. I love cash flow and would never buy a property with a negative one. Knowing that I would always be able to cover my payments, whatever happens to my other sources of income, has allowed me to sleep soundly over the years. The value of a rental property might go up and down, but as long as it cash flows, as an investor, you’ll know you can be in it for the long term and weather any market corrections.
Tip: Carefully consider the revenue, but also all the expenses and how those expenses might increase in the future. Also consider both the current cash flow of a property as well as its potential cash flow.
High Appreciation Potential
Many investors consider only cash flow and forget to think about appreciation. Appreciation is how the value of real estate increases over time. It is extremely important for three reasons:
1. Rental prices are often correlated to the value of a property. If the value goes up, usually rent follows.
2. As the value of an asset increases, it is often straightforward to borrow against that extra value to finance the purchase of another property.
3. When the time is right to cash out, you’ll be glad to see a hefty gain on your property.
Tip: Getting a great deal when buying a property is key. Pay attention to opportunities in up-and-coming areas to maximize appreciation potential.
Low Risk
It should be no surprise that properties with the highest return are often those with the highest level of risk. A rooming house may have great cash flow potential — when full occupancy is achieved and assuming everyone pays. I’m not a gambler, and I don’t like to take large risks with my investments. If you can relate, try to stay away from properties that:
• May result in unexpected high maintenance expenses.
• Are difficult to rent out.
• Are difficult to sell, in case you need to get out of an investment.
• Are far away from you.
• Don’t cash flow (here, don’t rely only on speculation).
Tip: Be honest about your risk tolerance and the risk profile of your investment portfolio.
Low Effort
An investment property can range from being a completely passive investment to an Airbnb that you manage and clean yourself. For most investors, the most comfortable amount of effort lies somewhere in between. Hiring a property management company may significantly reduce headaches, but also take a chunk out of cash flow.
Again, consider the balance. Time gone is never going to come back. You likely started investing in real estate in the first place to create passive income, enjoy life more and have more time to spend with loved ones — not to add stress and headaches.
Tip: No matter what effort level you are comfortable with, create a system to use your time effectively. Make sure you are clear about why you want to start investing in real estate and what your end goals are.
Every new property you invest in should have the right balance of cash flow, appreciation potential, risk and effort. Having it all is impossible, so understanding that balance and what is important to you is critical. For me, it was a journey to achieve financial independence to focus on my family.