I was asked the other day by a new investor about buying some property. The investor identified himself as a new investor and had recently taken an online course on real estate investing and was eager to get started. So I did the typical investor / buyer questions to find out what his investment style was:
Q: So do you consider yourself to be an active investor or a passive investor?
A: what is the difference?
Q: Are you interested in buy and hold real estate or fix and flips or what is most interesting to you?
A: whatever makes the most amount of money
Q:What kinds or returns are you realistically expecting to get on your investment?
A: 20 percent or better
OK, based on this dialogue, I knew we had a lot of work to do. While these responses may sound funny to you, these are very common responses I hear everyday. It is very common that people just want to make a lot of money and have not put much thought into what they want or how they plan on getting it.
It is the response of 20% plus in returns that raises my eyebrows the most. I have found having worked with hundreds of investors that expectations are always much higher than reality. It makes me think of the show American Greed. If you have ever seen an episode it usually starts with promises of higher than average returns and ends with disappointed investors who lose their money.
Of Course, the reason on the show is due to shenanigans, but the moral of the story is do not trust the inflated or unrealistic returns as they are rarely ever sustainable.
Real estate is no different, while there are always investments that may outperform another, the sustainable investments will make you more wealth over time than any non-sustainable high ROI will provide.
The key of course to a good investment is the sustainability of the ROI (return on investment). The key to any sustainable investment is to buy in markets that are considered affordable. Not necessarily affordable to you or your bank account but to the general public as a whole.
You all know the expression, “you make your money going in.” The translation, of course, is the ability to buy today with some sort of forecastable appreciation and cash flow. Cash flow is easy to forecast as it is simple mathematics. A market rent minus expenses equals positive cash flow.
Sustainability of this cash flow is the most overlooked piece of diligence within an investment and is best obtained in affordable markets.
Appreciation is always speculative in nature; however there are ways to increase the probability of appreciation by buying in affordable markets. With affordability of a market being so important let’s dig deeper.
3 ways to know if you are buying in an affordable market
1. Income to price ratio:
A number of factors are looked at to see if a market is affordable, interest rates, median income and median home price. The simple equation is (median income x 3 = affordable).Think of the last time you went to get a home loan, the lenders typically want you to buy a home that you can pay for using 1/3 (33%) of your income. This is where the best loan terms are. Why? Because it is lower risk to a lender. In their eyes it is affordable.
They do this because this amount is what a lender has proven through their actuary calculations to be a safe and sustainable amount you can as a borrower to comfortably repay without going into financial distress. If the national lending system uses this as an affordability measure, then it would make great sense as an investor to make sure we are buying properties with this same affordability measure.
As investors most of us qualify a tenant based on the same criteria. We want the tenant to make 3 times rent so we know they can afford to pay each month.
2. Median home price matches median income:
In the above example it may be possible to buy any priced property and find someone that can afford to pay rent based on a salary of 3 times rent. To invest in the safest, most sustainable property, you want to invest in property that has the largest number of people who can afford to rent your property.
To do this you want to invest in property that represents the area’s median priced home. Further, you want to insure that the median priced home can indeed be bought and rented based on the area’s median income.
This gives you the largest pool of renters and when you go to sell will give you the largest pool of buyers who are willing to pay retail prices for a home they can move their families into (this is often referred to as the sweet spot). My past experiences has been that I often actually sell the property to the tenant which further benefits my bottom line as I save the cost of listing the property through a conventional Realtor transaction.
The only thing better than an affordable market is an undervalued market. If an affordable market represents a purchase where you can pay for the median home with 33% of your income, then a market where you can buy the median priced home for less than 33% is of course considered an undervalued market.
So where are the affordable markets:
Affordable markets are always a moving target. Like everything real estate markets are also cyclical. There are markets at any point in time that are considered undervalued based on this criteria.
To you as an investor it represents great sustainability. When doing your diligence on affordable markets, you also want to insure the market has upward growth potential. Job growth and population growth will provide you the upward growth you desire. Markets such as Atlanta Georgia, Philadelphia, Birmingham, Memphis, and Kansas City just to name a few represent these great markets.
Ride the wave
As you invest in great affordable and undervalued markets and watch for the market shifts (typically a 5 to 8 year cycle), you can be rewarded with both great cash flow and equity growth. The nice thing is these markets always exist. Like everything in life they are moving targets but fortunately in real estate the movement is much slower than typical investments making them safer and more lucrative. To keep on top of all these moving targets join the Equity Builders Group Investment Group and receive insights to these in your inbox weekly.