Alternative investments are picking up steam in 2021. There are reasons for that. Interest rates are at all times low, yields on many income paying assets cannot pay enough to battle inflation, challenges in fixed income securities with expectations that rates will eventually rise. One of the most popular alternative assets is real estate. At the moment, there is no shortage of capital flowing from one asset class into another.
However, this is not all positive, with many places like Canada, New Zealand, Australia, and some places in the U.S facing a housing affordability crisis.
Here is an example of the average MLS price in Toronto, Canada.
If you are a real estate investor and you look at that chart, you think that is the answer. That is how you make money in real estate. You buy it, hold it and then sell it. In other words, enjoy the appreciation. Also, thanks to leverage through mortgages, you will get a very sizeable return.
But we want you to view appreciation differently as it is not always sustainable and isn’t the only way to make money in real estate investing. In fact, we can argue that you don’t need appreciation at all.
Improve the asset value
How to make money in real estate through price increases? The best way is to control the price increase, which means instead of relying on Mr.Market to push the prices upward, we rely on ourselves.
What can we do to improve underlying asset value?
It is pretty simple. Renovate to improve:
1) Make structural changes by adding a value-adding feature like a bathroom or an extra room, and so on.
2) Renovate aesthetically by putting in higher quality floors or higher quality countertops and so on.
The cost to renovate is typically less than the appreciation you will enjoy.
What should I renovate to increase the house value?
This might require additional research on your end for your local market, but we can rely on the National Association of Home Builders for some insights.
“According to NAHB’s survey, 86% of home buyers prefer their kitchen and dining room to be completely or partially open. Top finishes include stainless steel appliances (67%), granite or natural stone kitchen countertops (57%) and white kitchen cabinetry (32%).
Nino Sitchinava, principal economist at Houzz, shared similar findings from its consumer research for kitchens and master bathrooms.
“White upon white is the new style that is emerging,” she stated — both for the kitchen and bathroom — in terms of cabinets and countertops, as well as gray on white.”
Every year NAHB releases an analysis of the most wanted features in a house in America. As investors, by implementing those changes, we can significantly appreciate the home’s value by ourselves.
Why we should not rely only on natural price appreciation.
Because there is nobody that can confidently pinpoint precisely when said price increase will stop, and it may very well be tomorrow. Even people who knew that the U.S housing market would collapse in 2008 didn’t know exactly when. Michael Burry posted losses for almost two years before realizing his massive return.
If we look at the Toronto price chat again, 2008 was but a blip, but if you were an investor back then trying to sell your property because you needed the money, you had to realize a loss. Suddenly never-ending appreciation on paper ended.
This brings us to the second point on how to make money in real estate, which is income.
How to make money in real estate with positive cash flow?
As an investor in physical real estate, you own a generally appreciating asset. By utilizing that asset to provide a service to the community in rental housing, this asset starts generating income. If the income is higher than all the costs it takes to maintain your asset, you have positive cash flow. As a result, you are earning money every month.
This is how you actually make money regardless if the market crashes tomorrow. If you secure your own income and hopefully your renter’s income does not take a hit during a recession, you can survive any downturn.
How to ensure you can have positive cash flow from the start?
Predicting whether you will have positive cash flow can be tricky. First, you must understand your potential income and all your expenses. Your income will be your rent received, so it is a little easier to estimate by doing a rental search in your neighborhood. Your costs, however, are trickier. There are mortgage costs, taxes, repairs, maintenance costs on top of the simple fact that there will be times when you will not receive any income at all.
We have put together an easy-to-follow calculator to help you roughly estimate if the property you want to invest in will be cash flow positive and its potential return.
Cash flow is far more important than appreciation. It sounds gloomy that if you invest in real estate, it potentially might not increase in value. And looking at history, it is implausible. The market will always demand housing, and the way the system is structured and overall economic and population growth, appreciation is a reality. However, it is best not to rely on it 100%—people who did in the past paid the price.
How to make money in real estate with leverage?
To invest in real estate on your own, not through a trust or a crowdfunding platform, requires a relatively large amount of money. Thankfully banks are there to help us with mortgages. This results in what is called a leveraged investment. You use other people’s money to purchase an investment for yourself. The upside is that gains are vastly increased but so are the losses. Renters don’t have that risk. With cash flow positive rental properties, you are being compensated for that risk when rental income covers your mortgage costs.
Therefore as your mortgage principal gets paid down every month, that is how you make money. As a result, you owe the bank less and less every month, and the principal becomes yours to keep.
As an example, we purchase a house for $500,000 with $400,000 borrowed from the bank. After five years, if the mortgage is paid down to $350,000, you made $50,000. On top of that, if the house generates $500 every month on top of all expenses, you would have an additional $500*12*5= $30,000.
Thus without any price appreciation, you made $80,000. This is how you can build wealth with a stable income without relying on the market and government policies pushing the prices of real estate upward.
So when looking into how to make money in real estate, focus on cash flows, and you will be in a financially sound position. Appreciation will happen as well, and it will be a nice bonus, but don’t make it your primary source. If you do use leverage, remember that your risks increase but with that also the rewards. As your mortgage gets paid down by rental income, your wealth grows without house prices going up.
If you think rental property investing is something that interests you, check out our first steps article.