What Is A Good Real Estate Investment?

A “good real estate investment” can mean different things to different people. For this article, the definition of a good real estate investment is:

“A real estate ownership interest, whether a personal residence or rental property, that increases one’s net wealth by a fair rate of return on their invested cash equity; for the corresponding amount of risk they are taking by owning a relatively high risk asset.”

What that means is that if you are going to put your invested cash equity into real estate, your net worth should improve by a greater amount than if you invested in a similarly risky asset. And “invested cash equity” isn’t the property price; it is how much cash you took from your bank account to acquire the property, which includes your down payment, plus closing costs, plus rehab costs.

Realize a lot of things can go wrong with real estate ownership, so you had better get a fairly high return on your invested cash equity for it to be a “good deal”. So you ask, how would one figure that out?

For investment properties

Your returns are part cash flows and part appreciation in value. For example, if your property rental income minus expenses produced $250 per month positive ($3,000 per year); and your invested cash equity was $50,000, that’s a cash on cash return of 6.00% ($3,000/$50,000). And that is a pretty darn good deal in real estate.

To add to that, let’s say you project net appreciation in value contributing an extra 1.0% or 2.0% return per year (after subtracting your projected estimated costs of capital repairs and improvements). Summing the cash flows and net appreciation could equal about a 8% to 10%+ projected return per year on a long term basis; and if you achieve those numbers….. that is a good real estate investment!

Some investment properties don’t cut it! Most fancy condos or beach houses, where the net rental income is very low compared to the purchase price, usually have projected negative cash on cash returns. So if you buy a fancy property with negative (4.0%) cash on cash returns, even if it appreciates 2.0% per year, you are typically at a 0.0%, or worse, return on your equity cash investment. And that isn’t a deal most experienced investors would take.

For personal residences

You will also be putting down a large amount of cash equity and the calculations are really a little more complicated and difficult because you need to look at how much you are paying in housing expense versus how much that amount would be if you were just renting someone else’s property. So the overall question again is, “Is your wealth going to improve by owning the property?”

Some general guidance herein. As a general rule, if you are not planning to own it for at least five years you will most likely not be adding to your wealth. Any appreciation in value will not compensate for the 8.0% to 10.0% transaction costs on the buying and selling of your property. And even worse, the monthly ownership expense is usually higher than if you just rented a similar property. Therefore, if you don’t plan to own the property a long time, and the longer the better, you will probably do better renting and leaving the hassles and costs of ownership to a landlord.

So a good real estate investment is really one that will increase your net worth over time. The longer you own it, the better the chances for that appreciation in value and wealth building.

As proof positive on this, find someone who has owned real estate for 20, 30, 40 years and ask them what is a good real estate investment? It is generally easy to find them, they are retired, living comfortably, and usually happy to tell you about the properties they bought decades ago.

The Credibility of "I told you so"...

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     Being a 20+ year real estate veteran, I have seen my share of market swings.  This most recent downturn which started some time in 2007, seems to have finally bottomed out in 2010 and we are now in to a recovery period.  Having been very active in the last 6 months, my feeling about how the market is moving is more than just a hunch, it is an educated guess fortified with street level activity and hard cash being paid at closing tables.
     During the last 6 months we have seen properties at rock bottom prices.  Not just the newsworthy residential home sales, but also the turnaround of income producing properties.  A "market correction" may be a better term to describe what has just happened in the real estate industry.  Finally we are able to make sensible economic real estate investments.  In retrospect, we have seen inflated property prices, fueled by easy lending underwriting which further skewed the public's perception of what was a good real estate deal and what wasn't.  In the world of income producing properties, I threw in the towel many years ago when I would see people purchasing properties with, dare I say it, negative cash flow.  URGGHH, just the mere thought of it makes my blood curdle.  Vacancy, property taxes, unforeseen tragedy, and the like can never truly be avoided.  But purchasing a building from the onset with negative cash flow never did seem like a prudent investment to me.  Making a profit on all four phases of real estate has always been my goal:  acquisition, cash flow, appreciation/depreciation, and disposition.  The best real estate investments stand solid on all four of these proverbial legs.
    So are what shall we do now?  Good news and bad news.  Good news is that the are still many good acquisition deals to be had.  Properties have been adjusted in price to make economic sense again and give the investor opportunity to make a profit on all 4 phases of a real estate investment.  Bad news:  the "Happy Harry" investors who had dropped out of the market will now be looking for an opportunity to get "back in" the market and create competition for great acquisition deals.  The longer term negative effect is that the increased acquisition competition will again over inflate the expectations of sellers and prices will again climb back to levels of low cap rates and longer term investment holding periods.  
     How will we survive?  Well, when the stock is down BUY MORE!   Real Estate is still one of the best investments around.  This recent wave of foreclosures and loan defaults have humbled many banks and lending institutions to consider work out scenarios before foreclosing and taking title to a real estate asset.  BUY, BUY, BUY and make your decisions wisely (preferably with the help of a professional like myself), so that you can ride the wave of prosperity through this current up swing of the real property marketplace.  Financing is at a reasonable level and cash is king.  Lending institutions are opening their doors again if the numbers make sense.
     BUT MY HEAD STILL HURTS!  Many real estate investors are still feeling the pain of the market downturn and have been "beating their heads against the wall" to try and make the best of declining property values, higher than anticipated vacancies, ever rising property taxes and non-renewal of bank notes.  The obsession of the mind from dealing with this multitude of problems thrust upon them has triggered a proverbial tailspin which they are having trouble pulling out of. Mike Ditka had "mental toughness"  but he never had debt like this!  
     Alas, a light shines upon the horizon!  There are many solutions to the problems some investors are still dealing with.  Mostly it is about letting go.  While we cannot hold on to a dwindling stock, likewise we cannot "fall in love" with a property and hold onto it beyond its investment life cycle.  Like a merchant who must painstakingly throw out perfectly new and good merchandise because it is outdated, so too must the savvy real estate investor dispose of non-performing assets.  In doing so, he clears the runway to set off on a new wave of investment acquisitions by applying age old investment analysis.  The mere action of new blood is invigorating.
     Buy low, sell high is the American way, however in light of some investors holdings, it may be prudent to sell low, in order to ride a better wave of economic growth.