Investing in rentals for cash flow or total return
This week I wanted to share a clip from a recent group coaching call where a student and I went over how to determine if a property would make a good rental and how to run the numbers. I thought this would be good to share as it illustrates from a 10,000 ft view the difference between investing in rentals for just cash flow vs overall total return
When buying rentals there are two main strategies of many, many people buy to focus purely on cash flow or you buy knowing that cash flow may not be strong but when you exit (i.e. sell the property) you will have a nice payday in the end. So you forgo the monthly cash flow for what's known as the total return.
In the video, I show you an example of what this looks like briefly. Keep in mind the video illustrates a “pen and napkin” overview it's not meant to be a detailed analysis but it will show you how to look at a deal either way and illustrate a key point that if you are not already aware of you need to be if you are trying to build a portfolio of income properties.
Watch Video Here >>> https://youtu.be/pqSgDKbDh6U
Lets briefly show you what I mean between the two concepts. Say you find a property that you purchase for $200k and you run the numbers and find out that from a cash flow standpoint this property does not produce very much cash flow say maybe just $200 per month or say maybe 4% annually on your cash, because the purchase price is much higher than what you expected. However, if you hold the property say for 5 years two things are happening the value of the property is likely going up as real estate is generally always appreciating even with just inflation alone. The same house today might have been $500 in the 1900s to give you a quick example. Second, the tenant is paying down any mortgage for you or building equity in the property as the months go on. So value up mortgage/equity down. Let's say you decide to sell this property now in 5 years Assume the tenant paid down $5k per year in equity so $25,000 and say the value of this home went up now to $300k So you now have $125,000 in equity in the home. (Not including your $200 a month in cash flow you were taking well ignore that for this illustration) If you divide $125,000 by 5 years that's $25,000! A year you were making. Say you had $50,000 into the home in cash that's 50% cash on cash every year you would have been making. Though you didn't realize it monthly upfront you captured it in the end.
This type of strategy is good when you 1) don't need the immediate monthly cash flow and can wait many investors use 401ks and IRA for this or if you just have cash sitting around you want to deploy and 2) find yourself in a situation to pick up real estate that might be more than what you want to pay at the time.
The second focus for rentals is much more straightforward and its cash flow only play. If you looked at the scenario above in order for that property to make sense for a cash flow only play you may need to have picked it up for say $125k This might give you say a solid 8-12% return on your cash every year. However, you are not always in a position in real estate where you can get properties at a price that makes sense for a pure annual cash flow play. If that's the case look for total return play.
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