What are the 3most important things for 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 for determining value, it’s rarely a crucial factor in determining profitability for a property purchased for an investment purpose. I am a small real estate investor with a single-family home portfolio. I have been investing in real estate for over 15 years, with an emphasis on residential property, and I’ll show you the 3most important things to pay attention to.
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 leverage.
The location of a single-family rental property is undoubtedly the number one factor in determining its selling price. Still, real estate investing is about earning a profit and not 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
Appreciation is Driven by Location
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.
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 housing market will appreciate within our investment horizon. Trends can change, stifling appreciation for decades.
Acquisition Cost Drives Profits
As a real estate investor, property appreciation should be the gravy on top of a great return. The best way to build wealth in real estate is by finding undervalued properties and managing them at full market value; that’s our job as real estate investors. 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.
No wonder real estate agents still push location, location, location. Location-driven appreciation drives higher home values, giving agents a higher sale commission. As real estate professionals, 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.
1. Price Sets the Rate of Return
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.
Purchase Price Amplifies Returns
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, 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 invest in a poor location with no appreciation, our rate of return still beats the average appreciation.
A Bargain Price Mitigates Risk
A great way to avoid risks with real estate investing is to purchase property at a bargain price. A lower price range will offset an increase in interest rates, a drop in property values, and even renovations that take a significant amount of time.
A good investment is a profitable investment. Buying below market value goes a long way to making and investing profitable, regardless of the local market conditions. By far, the price paid for the property is the most critical factor of a successful real estate investment.
2. 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 maintenance costs, 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 a key factor 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.
In real estate investing, leverage uses borrowed funds, typically a mortgage, to finance the real estate transaction. Leverage allows investors to amplify their purchasing power and increase their potential returns by using borrowed money to supplement their own capital.
With leverage, investors can acquire a property with a smaller down payment, enabling them to control a larger asset and potentially benefit from asset appreciation. Using borrowed funds, investors can use leverage to potentially generate higher returns on their invested capital, as they use other people’s money to finance their investments.
Real Estate is Uniquely Suited to Benefit from Leverage
Real estate is a physical asset that can be used as loan collateral. Lenders typically find real estate collateral more reliable than other assets, such as stocks, bonds, or intellectual property. Real estate properties can be assessed for their value, and lenders can secure their loans with the property, reducing the risk of default.
Real estate properties are generally easier to value than other asset types. Property valuation methods, such as appraisals or comparative market analyses, are widely used and accepted in the real estate industry. This makes it easier for lenders to determine the value of the collateral and assess the risk associated with the loan.
Local Community Bank Focus on Real Estate Loans
Community banks typically have a deep understanding of the local real estate market, including local property values, trends, and demand. This knowledge allows them to assess the risks associated with real estate investments more accurately and make informed lending decisions.
Lending to real estate investors can allow community banks to diversify their loan portfolios. This diversification can help spread risk across different types of borrowers and investment projects, which can be beneficial for managing risk and maintaining a healthy loan portfolio.
For these reasons, local community banks are the primary mortgage lender for many real estate deals. This makes it easier to borrow against a real estate business than most other business types. Getting a loan for a brick-and-mortar business is much more difficult, and the borrower often needs to put up real estate as collateral.
Leverage Amplifys Gains
Leverage can amplify real estate gains by using borrowed funds to purchase an investment property. When an investor uses a mortgage loan, they are using a small of the property value (the down payment) to control a larger asset (the property) with the help of borrowed funds.
Using leverage, investors can acquire a larger property or more properties than they can afford with their funds alone. This allows them to diversify their portfolio, take advantage of different real estate markets, and potentially increase their overall returns.
While using a loan comes with a monthly payment that reduces cash flow. This is a detriment to a single investment but allows investors to scale their portfolios. In order to amplify the gain, it’s a good idea to spread available cash around as a down payment on multiple properties. This will increase the overall return on investment (ROI) on each real estate property, and it’s a technique used by most successful real estate investors.
If the property appreciates, the investor’s equity increases proportionally, resulting in a higher ROI than the initial down payment. For example, if an investor puts down a 20% down payment on a property and the property appreciates by 5%, their ROI would be 25%. That is a 5% appreciation on the total property value but a 25% appreciation on their original down payment.
The Importance of Self Discipline
Price, Price, Price, cash flow, and self-discipline.
Self-discipline, the ability to control one’s thoughts, actions, and behaviors to achieve a desired goal, is essential when investing in single-family rental properties. It helps ensure that the investment is managed effectively and efficiently. As an investor, this attribute will allow you to maximize your return on investment 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.
Real estate is a long-term investment. Once you have properties, set the proper monthly rents 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 70 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 positive 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 numbers, and your wealth will grow. If you don’t know how to run the numbers, I will show you in my guide to running the numbers on a rental house.
The 3 most important things in real estate investing are price, cash flow, and leverage. 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. A real estate investment rarely performs well when the investor buys advertised properties for the listing price. Remember, the asking price is only an ask, not the selling price.
The 3 main things for real estate investing are price, cash flow, and leverage. To become a successful real estate investor, purchase properties at a significant discount to market value using leverage and manage the properties for maximum cash flow.
Be disciplined and stick to the process. Keep this going for years while you grow wealthy. This is how fortunes are made.