How to Know Which Property Investments Will Pay Off
By: Jeff Brown

NEW YORK (MainStreet) – As an investment, real estate has an allure unmatched by stocks, bonds or mutual funds: it’s big, there’s nothing abstract about it, and you might use it yourself if renters are sparse. And as the old saying goes, they don’t make any more real estate, so supply is sure to fall short of demand someday, driving up prices.

Of course, there’s plenty of evidence that real estate can be a bad investment, too. More than 25% of homeowners with mortgages owe more than their homes are worth, thanks to the housing bubble burst.

How, then, do you figure whether investment property such as a rental is worth the risk? The simple answer is by comparing its return with that of alternatives, though calculating the return can be tricky.

In his blog on Zillow.com, San Diego State University lecturer Leonard Baron points out that real restate returns come in two parts: cash flow exceeding expenses, and property appreciation.

“In today’s world, even though it will eventually come, we cannot count upon and should not consider long-term appreciation,” he advises. “That leaves positive operating cash flows as our primary source of investment return. Let’s call this: ‘Earning money the old fashioned way.’”

While calculating cash flow return is fairly straightforward, many people fail to do it properly, resulting in poor investment decisions, he says. Many investors, for example, focus on the property’s purchase price rather than the more relevant figure of “cash equity,” or the amount of cash invested in the property.

He offers the example of a rental property purchased for $200,000. The buyer gets a $150,000 mortgage, puts $50,000 down and spends another $10,000 on closing costs and improvements. Cash equity is therefore $60,000. In other words, that’s the cash that could have been invested in stocks, bonds, sowbellies, or something else.

If the property rented for $1,800 a month, while the mortgage and other expenses totaled $1,500, the investor would earn $300 in net monthly income. That annual income of $3,600 would be a 6% return on the $60,000 invested.

Over time, the monthly rent might grow faster than the expenses, improving the return. (But the monthly expenses should include building a fund for occasional expenses like a new water heater, furnace or roof.)

Also, returns may gradually improve as the mortgage debt is paid down, giving the owner more equity in the property. And if things work out really well, the property will appreciate in value.

Still, this is something of an ideal example. In many cases, cash return may be negative for a number of years, meaning expenses exceed the rent. Baron advises against such investments.

“As a final note, buyers will find prize properties, like at the beach of fancy condos, generally have very low or negative returns,” he says. “Skip those! It is the moderately priced units that have decent cash-on-cash returns. Hence, ‘prize’ properties are no prize. Moderately priced cash-flowing properties are the real prizes!”

Investors should also note that real estate has two negative features compared to alternatives like stocks, bonds and mutual funds: First, it is “illiquid,” or difficult to sell, and second, it represents a “concentrated” investment, or lots of eggs in one basket.

Those factors add to the investor’s risk. A 6% return may look very attractive compared to bank savings below 1%, but bank savings are insured against loss. A real estate investment is much more like a stock. Because a real estate investment is concentrated and illiquid, it doesn’t pay unless the return beats what you think you can earn in stocks, bonds or other investments that allow you to spread your money around and get it out on short notice.

If that property you’re considering is a second home, there are certain other criteria you need to think about. Check out MainStreet’s look at what to ask before signing on the dotted line!

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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