With the current low interest rates, investors need to deviate from the “classical” wealth creation methods and find new ways to really make the money work for them. In addition to buying shares in companies via individual shares or ETFs, real estate in particular offers a unique opportunity to build sustainable assets because of the cheap money.
What is a real estate investment?
First, we need to clarify what a real estate investment is and what not. Many people associate with a real estate investment namely the construction of their own cottage outside the city. This is often referred to as old-age provision and thus justified that they do not want to throw the money in the throat of their landlord. It is disregarded, however, that although actually no landlord gets more money, but usually at that point the bank holds up the hand.
In general, an investment is defined as using capital with a specific purpose. In general, we see the term in a different context. According to the actual definition, buying a car would be an investment. However, as long as you are not a salesperson looking for “customer catch” from this car, no one really expects a positive return from this investment.
We consider investments as a use of capital to achieve a positive return flow. If we look at the term in this way, it quickly becomes clear why building a home is not an investment. On the one hand, we do not receive any direct return from the investment and, on the other hand, we also have to retain a lot of money for maintenance and repairs that would otherwise be stomached by the landlord.
According to the “Petersschen” formula, 80 years of real estate use will cost the homeowner 1.5 times the cost of construction. Also, the costs of the land transfer tax and the fee for the notary must be added. This is often overlooked in the comparison of rental payments and loan installments. Who builds his own home in a promising location, could of course say that the property increases in value.
However, those who have settled into community for much of their lives, seeing their children grow up in their own homes and found friends in the neighborhood, will seldom sell their homes to turn tied capital into liquid assets and thus again to make new investments. The home is therefore usually not an investment, but a luxury that you have to be able to afford.
What is the alternative?
The alternative is to live for rent yourself and take advantage of tenant life while investing in residential real estate and using rental income and value to build your wealth. Let’s assume a mortgage rate of 5% and assume that you want to buy a property for $150,000. At the typical repayment rate of 2% you would have a monthly charge of $250 ($150,000 * 2% / 12 months).
However, it should not be forgotten that these $250 are not a cost in the classical sense but pay off the loan for your property. The money is not gone but is bound in your property. In addition, however, the loan interest of $625 are added. Overall, you would need to pay a monthly loan of $875 on your property.
In addition to these costs, the bank will set certain costs and lump sums to determine if you can afford the mortgage. For example, if you had rental expenses of $600, a living cost of $500, a $200 car allowance, a $100 installment credit, and a $100 bailout, you would need to have to earn at least $2,375 net and you need to carefully select the right bank for your real estate financing deal.
Only with this income would the bank assume that you can not only afford the loan but also your livelihood and still have enough money for unexpected events. Currently, however, we have a significantly lower mortgage rate. Therefore, real estate investments are of paramount importance to investors right now.
At the moment interest rates of less than 2% are achievable. This is the unique opportunity the market offers the private investor. Suddenly, your $250 repayment will only add $250 interest. With the upkeep and security buffers the bank demands, you would only need $2,000 to get a loan to buy an investment property.
Basic investment strategy
You need a fundamental strategy for real estate investments as well as for investments in equities. How do you build a real estate portfolio? How should you design the financing and what income can be achieved? Often, there is the belief that buying a property requires a tremendous amount of private capital. Often people say that about 20% would be necessary.
In our example, you would have to pay $30,000 out of your own pocket to get the property funded. The use of such an enormous amount of money to pay the purchase price of a property is to be avoided under all circumstances. Because a real estate investment is the more profitable, the less equity you use. This becomes clear in the following two examples.
On the one hand, we highlight the purchase of a property that is 100% financed. Then we buy a property where you pay 20% of the purchase price yourself. How did the two real estate investments develop after 10 years? Why we look at only 10 years, you will learn later. For the calculation, we assume a rental yield of 4.64%.
|100 % financed||80 % financed|
|Notary (2 %)||$3.000||$3.000|
|Real estate transfer tax 3,5 %||$5.250||$5.250|
|Own contribution purchase price||$0||$30.000|
|Total personal capital||$8.250||$38.250|
|The period||10 Jahre||10 Jahre|
|Assumed sales price||$179.263,80||$179.263,89|
|Possible sales proceeds||$54.248,82||$79.171,83|
|Average liquidity p.a.||$649,21||$1.504,14|
|Return on equity||25,09 %||10,51 %|
The return on capital employed is vastly different between the investment in which you paid 20% of the purchase price out of pocket and the property where you paid only the incidental acquisition costs. These are usually not financed by a bank and must be funded by you in any case.
Why are we looking at the time period of 10 years? Real estate is very interesting in addition to asset accumulation from a tax point of view. After all, sometimes profits from real estate investments are tax-free after a holding period of 10 years, provided that there is no commercial land sale. This means that in the example of 100% financing, you could keep the sales proceeds of $54.148,82 completely. No taxes, no deductions, instead, complete net proceeds.
To illustrate the huge effect of real estate investments, I would like to show you the real estate scissors. For real estate investments, two major factors play a role. On the one hand the value of your property and on the other the repayment of the loan. For tested properties, the rental income is large enough to cover both the cost of the loan, as well as the complete interest.
Often, only a small monthly amount of $30 to $50 has to be paid at the beginning, since the costs for repayments and interest are covered, but the investor is still faced with additional costs for the property management and the maintenance reserve. After the first rent increase these costs are covered as a rule.
Requirements for your first real estate investment
You may be wondering what conditions you need to fulfill in order to invest in real estate. Many people think that they have to have a huge net income of at least $3,000 or a high amount of savings before they can even consider real estate investment. The current low-interest phase plays in the cards of the inclined real estate investor.
As you have already learned, it makes sense to let the property be 100% financed.
This not only avoids that too much of your money is tied up in a real estate deal, but you can also look forward to a higher return on investment. But what requirements must be met to get 100% financing from a bank?
The first requirement is that your assets exceed your consumer debt.
A new credit guideline, which became effective at the beginning of 2016, requires banks to check not only the property but also the borrower. An audit aspect is the financial position. In order to obtain a real estate loan, you must therefore not be too indebted.
It often happens that a consumer loan is taken for the purchase of a car. This is the case, for example, if you have your car financed for $10,000. In addition, sometimes there are still “smaller” loans for 0%, for example, consumer loans for laptops, sofas or kitchens. All these loans, even if they are financed at 0%, count as debts. The bank takes great care that the applicant is not over-indebted before financing and looks at these loans.
You should therefore have enough equity to cover these loans ideally. What is considered equity, is depending a lot on the bank. Stocks, overnight money, insurance or precious metals are usually credited as capital, even if they are not immediately liquid. Let’s get to the salary. It is important to the bank that you can sustain both your livelihood and all credit burdens and still have a buffer to handle any short-term burdens like the broken washing machine.
As you have already seen above, your incomes and expenses as well as a budget gap are considered. What counts as input and output and how big the budget gap has to be varied from bank to bank. For example, some banks are running some livelihood flat-rates that may exceed your actual living expenses.
For you personally, however, you should still make additional reserves when unplanned special charges arise, for example, because the roof or the facade must be renovated or repaired. Although such costs can usually be paid by the maintenance reserve that has been assessed for the property, it can always be that something like this is surprisingly happening.
You should also make a reserve for modernization. If the tenant changes, it often makes sense, for example, to replace the old laminate floor with parquet in order to allow a constant rent increase and thus to increase the rental yield. In short, in many cases, even with an income of less than $2,000 a month, it is possible to get credit from the bank.
Why did not I include the rate for the real estate loan to be included in the income? This is because, at best, a property does not affect your credit rating. You take out a loan in the amount of the value of the property. So here we have a difference of zero. At the same time, the property should have rental income equal to or higher than the installment.
So we have a difference of zero here as well. This means that theoretically you could buy any number of properties if the conditions are right, as a properly selected and tested property is neutral in terms of creditworthiness and does not have a negative impact on future credit inquiries, and later even positively.
Administrative expenses of a property
Many are afraid of a real estate investment, because the effort seems too big. What if the tenant complains about defects in the apartment? How is a utility bill created? When the rent may be increased? These are all legitimate questions. After all, you want to invest and not get a new hobby. The solution for this is a property management.
A good property management takes care of all matters that affect your property. They will take care of the search and inspection of your tenants, the maintenance, the billing and any concerns your tenant may have. Thus, you can reduce your administrative burden on your real estate investment to a minimum. As a rule, you only agree to a rent increase and are invited to the owners’ meeting once a year. Even for this you can create a power of attorney for your property management, so that they participate and represent you during the meeting.
General investment strategy
Now that you know the basics of real estate investment, I want to talk about a possible investment strategy. There are many different strategies that differ in terms of risk and profitability. One investor, for example, aims for the highest possible rental yields and invests more in C and D locations, where rental yields are generally higher, but no appreciation in value is to be expected. The other is more concerned about wealth preservation and invests in prestige properties in urban locations, where neither an increase in value nor a high rental yield can be expected. However, the money is not exposed to inflation and is invested quite crisis-proof.
Our recommended strategy requires a different approach. We recommend investing in locations that still have development potential. Here we attach great importance to the fact that the purchase price is in good relation to the rent taken. The rental income should be large enough to cover the monthly installment. At the same time, the city in which the property stands should enjoy positive growth and low debt.
As a rule, a constant increase in the purchase price can be assumed. Specifically, we currently see developing cities as the most profitable locations. In recent years, there has been a demographic development like in other large cities, but not at the same price development. As a result, there is still enormous growth potential for the future in these locations.
This has come true in the last two years and we strongly believe that this development will continue in the future. According to the strategy, you would buy a property in one of these promising locations. As a rule, we recommend a property for less than $100,000. With the average land transfer tax is 3.5%, together with the notary cost of 2% you would have a property worth $99,000 financed with an equity needed of only $5,445 you need to have. The purchase price of $99,000 would be financed by the bank.
You will keep this property for 10 years. Then you sell the property and can use the profit tax-free for further investment. From the proceeds, you could, for example, buy four or five more properties or a global property, for example, a whole rental house with 8 flats. As a result, you can usually earn a higher rental yield and at the same time benefit from the increase in the purchase price.
After you have bought the second property, you will again save enough money for the next real estate investment. So, you always buy a property once you have accumulated enough equity. For example, some people buy two or three properties a year, and others buy real estate every three years.
Of course, you have to be careful to diversify your real estate portfolio. This means that you not only invest in one location and do not sell every property after 10 years. It may make sense to keep the third property and to pay it off over time in order to obtain passive income over the long term through rental income.
If you regularly buy real estate, you have the opportunity to continuously sell real estate and reinvest the sales proceeds after 10 years. It gives you a long-term passive income stream that you can sustain with very little overhead.
The market currently offers private investors a unique opportunity to invest in real estate investments. The first property is the most important. Once you’ve secured them, your tenant will ensure constant asset growth. If he pays $600 a month, he will provide you with thousands of dollars in passive assets that you do not have to work for.
Of course, real estate investments are always associated with risks. You take out loans that significantly exceed your annual salary. In addition, prices have increased significantly in recent months and years. It is imperative that you build up as much knowledge as possible. Above all, books and workshops are ideal for this. The leverage on third party equity gives you a very good return on your invested equity and allows you to build sustainable and ethically sound assets.
What are your thoughts, and do you have any experience with real estate investment? Feel free to leave a comment below and share the article on social media.