What is the most important factor when investing in real estate? For nearly a century, we have been told its location, location, location. The word location is repeated three times for emphasis, but this could not be further from the truth. While the location of a property is often the most important attribute, it’s rarely a crucial factor in determining profitability. I am a small real estate investor with about 70 properties, and I’ve been doing this for over 15 years. If it’s not location, what are the 3 most important things in real estate?
The 3 most important factors for success in real estate investing are price, price, and price. Everything else is a distant runner-up. For completeness, we can say that real estate’s 3 most important things are price, cash flow, and discipline.
The location of a single-family rental property is undoubtedly the number one factor in determining its selling price, but real estate investing is about earning a profit and not about paying the highest commission to an agent. As investors, we don’t care what a property sells for. Our return is driven by the acquisition cost and revenues generated by the property. These revenues can be rental income or a property sale, but the return rate is primarily dictated by the price we pay for the property.
Why Location is Irrelevant
Location is indeed the primary factor in determining the appreciation rate of real estate. In the academic paper, Rental Yields and HPA: The Returns to Single Family Rentals, the author finds an appreciation rate of about 6% per year in the top-tier cities, compared to just 3.3% in the lower-tier cities. Within a city, the appreciation rate can be even more remarkable given the proper location, so it’s easy to see why people think the location is crucial.
As a real estate investor, property appreciation should be the gravy on top of a great return. It’s our job to find undervalued properties and manage them at full market value. This may mean buying at a discount and selling at market value. It could also mean starting with an undervalued acquisition price and collecting market rents for the long term. Either way, our rate of return is driven by the purchase price, with property appreciation being a bonus.
The paper mentioned above finds an appreciation rate of 6% and a rental yield of 6.8% in the best markets, which doesn’t beat the stock market’s long-term return. The combination of rental profit and appreciation may make this an attractive investment, but property appreciation is speculative. We can’t be sure the overall market will appreciate within our investment horizon. Trends can change, stifling appreciation for decades.
No wonder real estate agents still push location, location, location. Location-driven appreciation drives properties to higher values, giving agents a higher sale commission. As investors, we all like higher selling prices, but buying significantly below market value works for every location and economic environment. If it doesn’t, you’ve incorrectly calculated market value. Location is not even on the list of the 3 most important things in real estate.
Why Price is the Winner
Price, Price, Price …
What are the 3 most important things in real estate? It all starts with price. Location may drive the appreciation of our real estate assets, but the acquisition cost of the property will drive our rate of return.
For example, assume you have a property valued at $200,000, providing a net profit of $13,600 per year, the 6.8% return predicted in the study above. If you can purchase that property for $180,000, you will still get the same $13,600 net profit, but your return will now be 7.56%. The table below shows your return based on different acquisition prices.
|Acquisition Price||Rental Yield|
If you can purchase the property at just a 10% discount to market value ($180,000), you are already beating the average appreciation rate by nearly one percentage point. However, our goal is to purchase at about 70% of market value, and often we will do much better than that. I have always paid less than 50 times the monthly rent for my rental portfolio, which is about half the market value. This price point would give you a return of approximately 13.6% for the rent collected. In this article, I’ll show you precisely what you should pay for a single-family rental property.
While a great location is favorable, it’s often harder to buy below market value in these areas. When we buy at the right price, we get the best returns in all markets and locations; if the property happens to have a great location, it may benefit from significant appreciation, but we can’t rely on it. If we have a poor site with no appreciation, our rate of return still beats the average appreciation. By far, the first factor for success in retail estate investing is the price you pay for the property.
Cash Flow Keeps You Going
Price, Price, Price, and cash flow, …
Your purchase price for the property is the first factor of success and the primary driver of your return on investment (ROI). However, your cash flow drives your ability to maintain the investment and realize your true ROI. Your cash flow is the money left over after paying all your obligations, such as expenses, taxes, insurance, and mortgages. It’s possible, and often true that you will have a high net profit and a small or negative cash flow.
If the free cash flow from your investment does not cover all expenses, you will need to inject capital from outside the business. Put another way; you will need to use your personal money to pay for the investment upkeep. This can be unsustainable in the long run, forcing you to sell the property quickly before realizing the actual return on your investment.
Cash flow is essential for keeping your investment going. When the property earns enough to cover all its costs, it’s just a matter of collecting the outsized gain you’ve achieved by buying below market value. On top of that, having a healthy cash flow can allow you to make more investments and amplify your growth. To increase your cash flow, check out my article on how to beat the average profit on a rental house.
Importance of Discipline
Price, Price, Price, cash flow, and discipline.
Discipline, the ability to overcome one’s weakness, is essential when investing in single-family rental properties because it helps ensure that the investment is managed effectively and efficiently. This attribute will allow you, as an investor, to maximize your return on investment2 over the long term.
As a disciplined investor, you must understand the numbers and always use them to your advantage. You should never buy a property just because you need a deal; only buy properties with numbers that work. When you don’t follow the formulas, you end up with properties that eventually fail to cash flow, and your overall return will suffer. Once you have a property, set the correct rent to keep vacancies at a minimum and profit at a maximum. You should stay on top of repairs and maintenance and allow your investment to throw off profit for years.
As of today, I have 69 properties, but I would prefer to have a lot more, and I could have if I had altered my criteria. However, I don’t want 100 additional properties that are speculative and may not produce a cash flow or the right ROI. By staying disciplined, I now have a mid-sized portfolio that runs itself with very little stress or personal involvement.
Overall, discipline is essential for long-term success in rental house investing. By being disciplined in budgeting, maintenance, tenant screening, and rent collection, you will maximize your return on investment and build a successful rental property portfolio. Run the numbers, stick to the number, and your wealth will grow. If you don’t know how to run the numbers, I’ll show you in my guide to running the numbers on a rental house.
To Sum Up
The 3 most important things in real estate investing are price, cash flow, and discipline. The location isn’t even on the list. Location benefits are speculative and can easily be outperformed by the purchase price.
If you are a giant hedge fund with billions to invest in real estate, you may not be able to find enough below-market deals to keep your portfolio invested. In that case, you may need to invest at market rates and let appreciation drive your returns. On that assumption, it may be location, location, location, but for the small to medium investor, the driver is undoubtedly price, price, price. The Oracle of Omaha, Warren Buffet, once said, “I think I could make you 50% a year on $1 million. No, I know I could. I guarantee it.” It’s the same with real estate investing; there are enough below-market opportunities for all but the largest portfolio sizes.
The number one rule for investing in rental houses is never to pay too much for a rental property. The 3 main things for real estate investing are price, cash flow, and discipline. Purchase properties at a significant discount to market value, manage the properties for maximum cash flow and be disciplined to keep this going for years while you grow wealthy. This is how fortunes are made.
What are the 3 most important things in real estate?