Where should you invest your money? There are thousands of options: company stocks, exchange-traded funds (ETFs), hedge funds, bonds, banks and private business. Is property investing a viable strategy to increase your long-term wealth and put you on a path towards financial freedom?
As with everything, it depends on your circumstances, but there are several key variables you should consider before deciding for yourself.
Note: This article is not intended as financial or investment advice. It is merely a guide to encourage you to think about the core components of good real estate investing.
1. How much risk are you willing to take?
Investing in real estate is risky. Before we even look at the financials, we need to ask ourselves: “Is this for me?”. Fires, floods, tenants and the housing market can all affect the returns on your investment. “Wait a minute” you’re thinking, “I can get insurance for fires and floods!”, and you’re right.
Of course, there is a cost involved, but you can insure yourself against all kinds of risk. The more risk averse you are, the more you need to consider the financials of limiting your risk. It is more difficult to insure against the housing market or bad tenants, but it is not impossible.
As a potential real estate investor, you need to consider your risk tolerance and decide which risks you are willing to take, what steps you can take to mitigate risk and how you will react when a disaster strikes (it will, eventually).
2. Rental income over capital gains
Now that you have decided that you can handle the many and unpredictable risks of real estate investing, let’s look at how to think about key issues. There are essentially two different value-creating processes at work in real estate.
Firstly, there is rental income, the monthly contribution tenants make to the property owner. Secondly, there is capital gains (or losses); the amount by which a property increases (or decreases) in price over time. Of course, it is attractive to imagine buying a property for R1 million this year and selling it for R2 million next year.
This does happen, but it is unpredictable and risky. Real estate investing is not about luck, its about playing the odds in the long-term. You may disagree with my philosophy, and that is fine, but then you are not an investor, you are a speculator.
Predicting whether housing prices will go up or down in the medium-term is impossible to do consistently, and I wouldn’t put my eggs in that basket. Think of capital gains as a bonus, but don’t count on it.
3. Location, cash flow and negotiation
Rental is driven by wages; higher income = higher rent. The logical conclusion? You guessed it; Location is important! Some real estate investors grade areas on a scale from A-F, and you can do the same, in order to get an idea of how much people in a given area are earning,
Look for areas near economic hubs; think Sandton or Cape Town city centre if you want to maximise rent (of course if you are buying cheaper property you can afford to generate less rent, this is just an example).
A better area is usually associated with better tenants, who will occupy a property for longer, pay rents sooner and take better care of your property. Next, think Cash Flow. Cash flow = Income – Expenses. Since rental income is somewhat inflexible, we need to minimise our costs.
If we have a home loan, we need to minimise it. This means paying as little for a property as possible. Negotiate like your life depends on it; do the maths and don’t pay a cent more than you planned to, this is investing, remember, not speculation.
4. Remember all the costs
This was an introductory guide, and we can’t delve into the details I would like to, but I will leave you with some rules of thumb.
Most people fail in property investing because they overestimate how often their property will be occupied (or overestimate how much rent a tenant will pay), and because they forget to calculate all the costs.
Firstly, when making calculations, don’t assume that your property will be full all the time. On the cost side, remember these costs:
- Property tax (usually around 1% of the home, find out from your local property tax office)
- Maintenance costs (on average, budget for 1% of the property value per year)
- Home loan repayments
- Property management fees (if you won’t be managing the property)
- Marketing costs (to get tenants in your property)
- Selling and buying costs (realtor fees, registration and transfer fees)
- The Opportunity Cost. If you invested your money elsewhere, say at a bank, you could earn a return. Will the return on a particular property beat this return? By how much?
- The cost of your time
Nobody said property investing was easy, but it can be worth it. Will you be investing in real estate? How do you think about these issues? Let me know in the comments.