General Overview of Investment Properties
Real estate makes good investments for the owners by providing one or more of the following criteria:
- Positive cash flow
- Appreciation—market increase
- Appreciation—improved use
- Tax shelter
For investment properties, the tax shelter advantages are considered to be “part of the deal,” as nearly every investment property will provide tax benefits. Market prices for single family homes are primarily based on the price of comparable owner-occupied homes; market prices for multi-units are based on cash-flow projections.
An investment property will have strengths in one or more of the first three categories. The desirability of a cash flow property is how much income will it generate for the owner? Market increase appreciation is gained by the upward trend of the area, based on economic conditions beyond the control of the owner. In other words, will there continue to be a growing demand for the property? Improved use appreciation is based on acquiring a property and doing something to it that makes it worth more. Improvements, remodeling, adding features such as landscaping, eliminating problem conditions, and so on are what cause the increase in value. This is also known as “sweat equity.” What can be done to the property to make it more desirable, to make it worth more?
Examples
House 1 is a bit worn out. It’s 20 years old and has never been remodeled. It’s been painted once or twice, but the current owners are older and no longer have the energy or interest to improve the property. Houses in the neighborhood are sound, have good curb appeal, and fairly well maintained. The subject house is structurally sound but landscaping is ragged and some paint is feeling from the exterior trim and the inside could use a new coat of paint and carpet. Compared to other houses, it’s $20,000 under the average price of $200,000.
How is this a good investment? A buyer can purchase the property, put $5,000 in paint, some tile, new carpet, countertops in the kitchen and bath, new fixtures, do the work himself, and increase the value from $180,000 to $200,000. This is a profit of $15,000. To sell the property, a real estate commission of 6% plus closing costs of 2% come to $16,000, so there’s not enough profit to “flip” the property.
However, there are two ways to make this property a continued good investment. First is by renting the property at a positive cash flow. The amount of positive cash flow determines how good an investment it is.
Second, market increase appreciation can result in profit. If the area is increasing in value, and that trend is expected to continue, an owner can rent the property at a slightly negative cash flow or break-even after repairs are completed, knowing that in the future rents will rise as property values rise, but the real profit is in the appreciation. From the “improved” value of $200,000, a 10% appreciation brings the profit to $35,000, $20,000 plus $15,000. After costs of sale, there is still a nice profit for the owner.
Analysis: Property is a good candidate as an investment property. Modest cash flow and appreciation potential make this a sound investment.
Example 2
Property is in the high-rent district. It’s just been renovated and is one of the nicest houses on the block. Purchase price is $500,000. Absolutely nothing needs to be done.
Monthly mortgage will cost $2,700, taxes and insurance are another $700. Average maintenance per month is $100, for a total of $3,500 per month. The house will rent for $2,500 per month, for a negative cash flow of $1,000 every month.
Analysis: Is this a good investment? For the average investor, no. For the well-healed investor who can afford $12,000 out of pocket, it will be a good investment ONLY if market prices are sky-rocketing upward. 10% for the first year will only break even on the purchase price, not covering the $12,000 out-of-pocket. Thus properties must be increasing at least 20% per year to consider it (many areas in Clearwater have been increasing 20% or more in the last few years –you will need to know the areas VERY well). But there will be better opportunities available.
Example 3
House is in a lower income area and needs improvement. Appreciation is modest in the area. Many rentals in the neighborhood. Area is clean, but not super-pretty. House is $10,000 under average price and needs paint badly. Will cost about $3,000 plus some sweat to fix it up.
As it is, house will only break even on cash flow, as it won’t attract the rent a nice property would. With paint and cosmetic improvements, house will rent for $300 MORE than the monthly expenses.
Analysis: A good investment candidate. Cash flow more than makes up for the soft appreciation.
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