I see a lot of emphasis on ROI in real estate investment forums and want to add my thoughts on why ROI alone can be misleading. Most investors hold properties for many years: 10, 15, 20+ but ROI is a snapshot of the property as it is at this moment in time, not what it's likely to be in 5 or 10 years. If your goal is to achieve financial freedom through real estate, you need to consider more than just the current ROI. You should measure each property by at least the following criteria:
- Located in an area likely to appreciate over time
- Sustained profitability
- Real estate investor friendly taxes and legislation
The old adage that the three most important things in real estate are location, location, location is still true but areas change. Areas that are good today can decline and sometimes areas that were once bad get better. Is it possible to accurately predict what an area will be like in 15 or 20 years? No, but you can make a reasonable guess what an area will be like in 5 years and extrapolate from there. Three indicators I think you should watch are population, crime and job stability.
If people are moving out of the area, the housing prices and rental rates are likely to fall. If people are moving into an area, then there is likely to be appreciation and rising rents. Here is a website that shows population shift by area. Also, many areas have populations that are getting older. As people age they tend to want smaller properties and lower rents. If you are considering a home targeted towards families and the area is aging, you will likely find demand decreasing. So, also check the population demographics.
Stable or increasing property values and rents rarely occur in areas with high crime. People with sufficient income move from areas with high crime to areas with lower crime. The people who cannot afford to move remain in the area with increasing crime but they tend to have lower incomes thus resulting in falling rents and property values. What you need to consider is the types and frequency of crimes in the area and how it is changing. Where can you find such data? One site is crimemapping.com. There is also good data on homefacts.com. Depending on your city/area you may have such data available from the local police department or the sheriff's department. Remember that it is not just crime in the specific neighborhood that matters, you also have to consider areas near the property where people will shop and such. For example, I was evaluating a property in an area that I did not personally know so I was using Google Street View to check the drive path to the property. I noticed a strip mall near the property where I anticipated tenants would shop. When I checked that location on one of the crime sites I discovered that robberies and assaults occur frequently at the strip mall and that the situation appears to have been the same for the past few years. I rejected the property based on these findings. So, be sure to check the shopping areas that tenants would use. You should also check the sex offender database. See familywatchdog.us but there are likely many others. Some states/counties/cities have their own sex offender/crime websites.
Job Quantity and Quality
In many parts of the US, manufacturing and similar jobs are going away and what remains are service sector jobs. Service sector jobs tend to pay less than manufacturing and similar jobs so the families of these workers have less disposable income. Less disposable income means that they cannot afford to pay the rents that they did in the past. Look at the major employers, what industries they are in and their future prospects. Another key indicator is inflation adjusted per capita income over the past few years. If you see a declining job market or dropping per capita income adjusted for inflation, you need to carefully consider the long term value of the property. On inflation adjusted numbers, "official" inflation during 2014 is at 1.7%. However, “official” inflation numbers do not include energy or food. Personally, I use energy and eat so the inflation I experience at the gas station and the grocery store is much higher than the “official” number. Depending on whose numbers you use, actual inflation is between 6% and 10% per year. Keep in mind that unless the per capita adjusted income is rising at or greater than the rate of actual inflation, your potential tenants disposable income is eroding. What this means is that if you buy a property that rents at the upper end of the rent range, you will likely have increasing time-to-rent and declining rents over time.
Real Estate Investor Friendly Taxes and Legislation
Legislation concerning tenants vary by state, county or city and can have a huge impact on your return. An example is evictions. Clients have told me that in California, if the tenant knows what they are doing, it can take up to 1 year to evict and cost thousands. In Las Vegas, the time to evict is typically less than 30 days and usually costs less than $500. The best source of this sort of information would be local property managers.
State taxes and property taxes are another big factor to consider. For example, suppose you are considering two identical properties that rent for the same amount (yes, this is an over simplified and contrived example!). And, one is located in Austin, Texas and one is located in Indianapolis. Which one is better? Below is a table showing approximate state personal income tax (I will assume a person filing separately with a $50,000 income) and property tax rates for both cities. (Note, please forgive me if I am off on the values. My goal is to communicate a concept, not accurate math.) Note: Property taxes source and state income tax source.
In order to have some numbers to work with I will use the following.
- Purchase price $150,000
- Rent: $1,000/Mo.
- Financing: 20% down, 4.5% interest, 30 year term.
- Down Amount: $30,000
- Debt Service (PI): $600/Mo
Below is a (oversimplified) formula for estimating cashflow assuming 100% occupancy, no maintenance, etc. in order to keep the numbers simple:
Cash Flow = Rent x 12 - DebtService x 12 - PropertyTaxRate x PurchasePrice
And, to take into account state taxes:
Annual Cash Flow = (Rent x 12 - DebtService x 12 - PropertyTaxRate x PurchasePrice) x (1 - StateTaxRate)
For Austin: ($1,000 x 12 - $600 x 12 - 1.9% x $150,000)x (1 - 0%) = $1,950/Yr
For Indianapolis: ($1,000 x 12 - $600 x 12 - 1.07% x $150,000)x (1 - 3.4%) = $3,086/Yr
The lesson is that while ROI is a good tool to compare properties with the same property tax rates, income tax rates and real estate legislation, it is not a good tool for comparing properties in areas with different property or income taxes or different real estate legislation.
In summary, while the current ROI is important, you need to take a long term view of the areas in which you are considering buying properties as well as considering other factors. So, if you have three locations with similar ROI numbers, long term considerations may make your selection much easier.
Your feedback is appreciated.