The ultimate goal of real estate investing is financial freedom. It is not just to do a deal.
To get financial freedom, you need an income that meets these requirements:
- Rents rise faster than inflation. Unless rents rise faster than inflation, you will not have the additional dollars to pay inflated prices.
- Your rental income must last throughout your life.
Purchasing a property in just any market cannot satisfy these income requirements. This is why market analysis is critical.
Here are the steps in market analysis.
Location selection is the first and most important step because it defines all long-term income characteristics.
Comparing Location Financial Performance
What would be the difference between buying in low-appreciating versus high-appreciating markets?
People often choose a location based on cost, cash flow, or ROI. However, cash flow and ROI metrics only predict a property’s performance under ideal conditions on the first day of a long-term hold. You need to take a much longer view than just the first day.
To illustrate this point, I will compare one property in a high appreciation and rent growth location like Las Vegas to a typical low appreciation and rent growth city.
Suppose you buy an investment property in Las Vegas for $400,000 with a rent of $2,200 per month. You also buy two $200,000 properties in a low-priced city that rent for $1,100 per month each.
Rents for the property segment we target in Las Vegas increased on average by over 8% a year between 2013 and 2023, so I will use 8% rent growth in the example. For the slow rent growth city, I will assume rents increase by 3% a year, which is high for most low-cost cities.
If we assume an inflation rate of 4% a year, what will be the inflation-adjusted monthly income from the properties after five, 10, and 15 years if the same inflation and rent growth continue?
High rent growth city
- Year 0: $2,200 = Buying power: $2,200
- Year 5: $2,200 x (1 + 8%)^5 / (1 + 4%)^5 = Buying power: $2,657
- Year 10: $2,200 x (1 + 8%)^10 / (1 + 4%)^10 = Buying power: $3,209
- Year 15: $2,200 x (1 + 8%)^15 / (1 + 4%)^15 = Buying power: $3,875
Because rents increased faster than inflation, your buying power and the amount of goods and services you can buy increased yearly.
Low-rent growth city
Note: For simplicity, I combined the income from the two properties ($1,100/month x 2 = $2,200/month).
- Year 0: $2,200 = Buying power: $2,200
- Year 5: $2,200 x (1 + 3%)^5 / (1 + 4%)^5 = Buying power: $2,096
- Year 10: $2,200 x (1 + 3%)^10 / (1 + 4%)^10 = Buying power: $1,997
- Year 15: $2,200 x (1 + 3%)^15 / (1 + 4%)^15 = Buying power: $1,903
Because rent didn’t keep pace with inflation, your purchasing power, which is the quantity of goods and services you can buy, decreased annually.
You can never be financially independent if you buy properties in locations where rents do not outpace inflation.
How Much Capital You Need to Reach Your Goal
Another problem with low appreciation and rent growth cities is that most people will need to purchase multiple properties to meet their financial goals. A drawback of low-cost locations is that acquiring multiple properties requires much more capital than in high-growth/higher-cost locations.
I will show why this is the case by comparing properties in two locations. I will start by estimating how many properties you will need to purchase.
For example, if you need $5,000 per month to maintain your standard of living and each property generates $350 per month, you will need to buy 15 properties ($5,000 / $350).
Suppose I assume that each property in a low-cost, low-appreciation location costs $200,000, and your only acquisition cost is a 25% down payment. How much capital from your savings will you need to purchase 15 properties?
15 x $200,000 x 25% = $750,000, a lot of after-tax dollars.
What if you invested in a higher-cost, higher-appreciation location instead of a low-appreciation location?
I assume each property costs $400,000, and the appreciation rate is 10% annually. (Note: The average appreciation rate in Las Vegas for the property segment we’ve targeted was greater than 15% annually between 2013 and 2023.) Also, like the previous example, I will assume that the only acquisition cost is the 25% down payment.
The cash from savings to acquire the first property:
$400,000 x 25% = $100,000
Due to rapid appreciation, we can use cash-out refinancing for the down payment for all additional properties. How does this work? You can refinance a property and withdraw cash. The amount of cash you can withdraw depends on your property’s value relative to the outstanding loan balance.
Generally, you can withdraw 75% of the market value minus the payoff balance of the existing mortgage. Assuming the property appreciates at 10% annually, how long must you wait to withdraw $100,000 for the down payment on your next property? (Note: To simplify things, I assume there is no principal paydown.)
- Year 1: $400,000 x (1+10%)^1 x 75% – $300,000 (existing loan) = $30,000
- Year 2: $400,000 x (1+10%)^2 x 75% – $300,000 = $63,000
- Year 3: $400,000 x (1+10%)^3 x 75% – $300,000 = $99,300
- Year 4: $400,000 x (1+10%)^4 x 75% – $300,000 = $139,230
So, after three years, a 75% cash-out refinance provides the down payment for your next property.
The property you refinanced and the property you acquired will continue to increase in value, enabling you to repeat the process every few years. This lets you continue growing your portfolio with limited additional capital from your savings, as illustrated here.
Although properties in high-appreciation cities are typically more expensive, acquiring multiple properties requires significantly less capital than in low-cost locations. This is because you can expand your portfolio using accumulated equity via cash-out refinancing.
You Need Fewer Properties in High-Appreciation Locations
Another benefit of investing in high-appreciation cities is rapid rent growth. When rents rise faster than inflation, so does your inflation-adjusted income. As a result, you may need to acquire fewer properties as the inflation-adjusted cash flow from each property is growing.
Final Thoughts
To achieve and maintain financial freedom, you must choose the right market(s) before considering any properties. Use the tips outlined here to guide you.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
