The Secrets to Building Wealth through Real Estate
0Owning real estate is a great way to build wealth. As a matter of fact, many people today owe their fortunes to good real estate decisions, like purchasing investment properties. Investment properties can be bought with little money down and mortgage payments are covered largely or wholly through tenant rent. What is more, you can substantially increase the original value of the property by maintaining it and making improvements.
In 1997 for example, I purchased an investment property for $195,000 and I put down $25,000 as a down payment and received a mortgage for the balance. Today, this investment is worth $500,000 and the outstanding mortgage is approximately $120,000. In a nut shell, this is a 1,200% return on my capital.
This is not an isolated situation and many people have become millionaires from buying real estate. Compare this to the stock market where the TSX grew by 300% since 1994 and the S&P 500 by 179% not including this year where they have shed 20% of their value.
So why isn’t everyone buying real estate? The simple answer is most people do not understand how to buy, how to evaluate, and most importantly, how to manage this investment.
““Owning real estate is a great way to build wealth.”
When buying an investment property the first basic rule is not to buy a property unless it can positively produce cash flow. In other words, when you calculate the rent and subtract expenses there has to be a little remaining to pay. If you have to add money every month to pay for this investment then stay away!
The second rule for purchasing an investment property is to be wary of listings showing a great rate of return on projected values. Many realtors simply take the information provided by sellers without verifying if it is correct. If you are looking at an investment property ask for the income and expenses for the past 24 months. This includes asking for actual bills to verify that the expenses are real. Also, allow for a reasonable vacancy rate as no property will be 100% occupied all the time. Make sure not to forget about maintenance as many listings do not include this information. The amount of $600 per unit per year on maintenance is reasonable.
Now that you are getting the idea, the next step is to calculate the capitalization rate, otherwise known as the cap rate. This is the rate of return that you would be happy with if you paid 100% cash for the building. Traditionally, cap rates for investment properties were around the 10% range, however, in recent times this rate has been reduced to 6-7.5%. Below that is generally not a great idea for an investment unless the property has some real upside. For example, it has additional land, it has been extensively renovated or the leases are very long term and you can increase the rent when a new tenant comes in.
Another factor to consider is the interest rate you have to pay on the mortgage. Say, for example, you buy an investment property at a 6.5% cap rate, pay a 25% down payment and get a mortgage in the 5% range. On the money invested you will earn 6.5%, but on the money you have borrowed you earn the difference between the cap rate and the interest rate you have to pay. This translates into an increased return on investment (ROI) to well over 11%.
In addition to the above, you need to consider depreciation, as well as appreciation. This is where it gets complicated and the need arises to seek the advice of a seasoned real estate advisor. However, the most important rule is patience. Do not rent your property to anyone unless you have checked them out fully. By this I mean that you have investigated their references and obtained their credit report.
Like all investments, buying and owning real estate poses a form of risk. There are very few investments that are so dependent on your management skills, yet most people do not understand this. As a result, people may end up selling what would be the best investment for them in the long run. If you do not have the time, knowledge, or patience to manage this type of investment you should seriously consider hiring a professional management company that specializes in managing real estate. These companies will screen the tenants, collect the rents, maintain the property and provide you with financial statements helping you to become successful as a real estate investor.
