Buying Investment Properties

When buying investment properties it's always best to begin with the end in mind. What is your main objective? When consulting with our clients we want to know if your goal is to build up your balance sheet, by investing for capital gains, or is the reason for buying investment properties to generate cash flow? What we also want to know is the time frame to reach your objective.

Buying investment properties offers the ability to generate both capital gains and cash flow. However, they are on two different time lines. Let's first discuss capital gains.

Capital Gains

A capital gain, when buying investment properties, is when the asset's selling price exceeds the initial purchase price. For example, if you purchase a property for $100,000, and sell the asset five years later for $125,000, you made a capital gain of $25,000. Assuming you paid cash, the return on the capital gain would be 25%. If you want to know the annual return divide the 25% by the number of years held and you get a 5% annual return.

We believe buying investment properties has a distinct advantage in a market where you can purchase assets below market value. For example, an asset may appraise for $100,000, however, due to circumstances surrounding the property like, death, divorce, deferred maintenance, etc., you can purchase the property for $75,000. This gives you an unrealized capital gain of $25,000 when you purchase the property. To realize the gain you have to sell the property. Let's assume you hold the property for five years, and during this holding period the property appreciates in value to $125,000 (5% annual appreciation on a compounded basis). When you sell the asset the capital gain is $50,000. This equals a 67% return on capital gain or an average 13.3% annually.

Leverage

Another advantage when buying investment properties is leverage. Let's go back to the example where you purchased the property for $75,000, except this time you secured a mortgage on the property for $55,000 and also spent $10,000 in repairs to get the property in rentable shape. You now have a total of $30,000 invested in the property.

What does this do to the return? You still have a capital gain of $50,000, however, you only invested $30,000. Your return on this hypothetical example would be 166%! Yes, you read that correctly. Because of the use of leverage your return went from 67% to 166%. Over the five-year holding period that would average a 33.2% annual return.

How much faster do you think you could build wealth for you and your family buying investment properties?

Cash Flow

Buying investment properties also gives the investor the ability to make cash flow. This type of investment is overlooked by most investors. The main reason is the lack of financial education when buying investment properties. It is more difficult to accurately predict cash flow than to predict the capital gain. However, once you know how to analyze these types of assets, the investor achieves a huge advantage over someone who is only looking for capital gains. Let's look at how buying investment properties can also make you money from cash flow.

After analyzing the market you determine that the house may rent for $1,000 per month. Going back to our example of applying leverage, let's assume principal, interest, taxes, insurance, and any other expenses associated with the property cost you $700 per month. This would generate a positive cash flow of $300 per month or $3,600 per year.

When buying investment properties the return on your cash flow is called the cash-on-cash return. Simply take the annual cash flow and divide it by the amount invested of $30,000. In this example the cash-on-cash return is 12% annually.

Tying it All Together

It is important for an investor to know their investing objectives when buying investment properties. Although investors can attain both capital gains and cash flow from real estate investing, most deals are tailored to maximize the capital gain or maximize the cash flow. The reason being, when buying investment properties, is that the purchase price is based off of how much income the property is producing. If the property is producing high cash flow it will tend to be more expensive and limit the amount the property can be purchased below fair market value. If you cannot purchase below market your ability to achieve the high capital gain is dramatically lowered. Conversely, if you are able to purchase a property below market value it's usually because there is little to no cash flow.

This is why it is so important to focus on investor's objectives when buying investment properties. The investor needs to be aligned with the type of investment that makes the most sense for them.

What's really interesting about buying investment properties is that, within a few months of purchase, there is potential to take a property with little to no cash flow and turn it around. When this happens you just achieved the best of both worlds. You gain the benefits of capital gains AND the benefits of the cash flow. Going back to our hypothetical example, let's say the asset didn't produce any cash flow the first year of operations. However, in years 2 - 5 the property is producing the 12% annual cash-on-cash return. Over the four years the total cash-on-cash return would be 48%.

Add this to the potential 166% return on capital gain and the return could be 214%. To determine the average annual return on investment simply take the 214% and divide it by the holding period of 5 years and you get a 42.8% annual return on investment.

As you can see by buying investment properties, and using the power of leverage, you can increase you return on investment much higher than most traditional forms of investing.

If you would like more information on how you can get involved in investment properties, please sign up for one of our introductory seminars. Just click the register me button at the top of the page.

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