If you are an aspiring real estate investor, you may be anxious to get started. Traditionally, real estate can be a path to building wealth, although there are no guarantees, and even real estate can decline in value.
Start with a plan
If you own the home you live in, that may provide a way to start. You may be able to use the equity you have gained in your current home as a down payment on your first investment property. Alternatively, if you purchase a second home, you can live in one and rent one. Now you are a landlord and a real estate investor.
If you do not yet own property, there are some steps you should consider taking to prepare for your first purchase:
- Reduce or eliminate any debt. If you have credit cards, student loans, medical bills, or other debt hanging over your head, consider working on getting rid of it. You don't want to be in a position where you are over-leveraged and can't get affordable financing.
- Establish reserves. This action serves two purposes. First, it may help you qualify for a lower interest rate, and second, it may come in very handy if the property is ever vacant for a while or needs a repair. You can use some of your reserves as a down payment, but it's best not to exhaust the savings entirely.
- Look into lending options. The first two steps will help expand your options for lending and open the door to better terms. If you have a "day job," then the tenure with your employer can help qualify you for a favorable loan, as will lower debt amounts. Check your credit score and ensure that your reports are error-free.
- Be prepared for the application process by collecting your tax returns and other financial documents. If you are missing critical pieces of information, get the work done before your heart is set on a property. You don't want to miss out on an opportunity because you haven't filed something on time.
Research before you commit
Don’t buy real estate based on emotions. Make sure the asset appears to be worthwhile. There are several methods of valuing property:
- Cap rate compares the net property income to the market value:
Cap rate = NOI/market value
A property with a net operating income (NOI) of $100,000 for which you paid $1 million has a cap rate of 10%. The net operating income is the rent minus expenses (not including the mortgage, if there is one.) Expenses include the utilities, insurance, maintenance, and costs to obtain and retain the tenants. Cap rates will be lower (higher valuation) for properties viewed as lower risk. Typically, a cap rate between four and ten percent is favorable, depending on asset class, location, and age.
- ROI, which measures the potential profit on an investment, compared to the cost:
Gain on investment/cost of investment = ROI
For example, an investment with a cost of $100,000 that produces $6,500 of net cash flow has an ROI of 6.5%. A cash purchase will have a lower ROI initially than a financed property since the cost of ownership is spread out in the mortgage payments rather than paid in one large upfront amount.
Suppose your prospective property acquisition has an attractive cap rate and ROI. In that case, these will support your bid for financing, so knowing how to calculate the ratios will be helpful as you launch your entry into real estate investments.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants.
There is no guarantee that the investment objectives of any particular program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.