Real estate through different types of rental homes is an amazing way to build your wealth. No secret there. It’s long-term, can give you consistent rental cashflow, and a nice chunk of money for when you decide to sell. But until you’ve done it a few times, choosing the right home to invest in can be confusing.
After poring through listings upon listings comparing different homes can feel like comparing apples to oranges. Even worse, different investors will give you conflicting advice about what makes for a worthy investment. All of this can only compound the feeling that you’re about to make a mistake. But don’t worry.
After ten years of investing in rentals, I can tell you that when it comes to real estate – there are indeed apples, oranges, and bananas – and they each require a different strategy.
3 Types of Rental Homes:
To be exact, when I’m looking to buy a new rental property, it usually falls into one of three categories:
- Cashflow homes,
- Growth homes, and
- Low-income homes.
I’ve owned a couple of types of rental homes in each category and they each have their own pros and cons. Let’s break down each one, and see how we can make it work for you.
Also, keep reading to learn what I would do if I was starting over again in real estate investing, and my current portfolio goals.
Cashflow Rental Homes.
Cashflow houses means that you’re getting a consistent income without much in expenses. Basically, predictable profit. They’re usually cheaper – which means they won’t appreciate much, and it makes more sense to buy them in cash.
(Honestly, mortgage origination fees can get so high that it feels wrong to pay them for such a tiny mortgage.)
Houses like that make for a great backbone of a retirement portfolio because they are stable and are always positive. You can either own them through direct ownership or even better – through crowdfunded real estate (like Crowdstreet, etc.) since having several cheaper houses is annoying to keep up with.
Mr. FIREescape’s portfolio:
Personally, I have 3 houses in this category. When I bought them, they cost around $60,000 each and each brought in $1000/month in rent.
Fast forward five years later, these houses have basically printed $180K in cash for me. Not to mention that they’re now each worth double what I paid and bring in $1200/month in rent. I just sold one of those houses, and after all’s said and done, It gave me 19%/year in net returns. Not bad at all.
The idea behind growth homes is that they’ll appreciate like crazy over time. They’re nice houses in nice areas and you’ll definitely grow in value when you sell. The downside to these nice houses in nice areas is that they’re expensive. (No duh!) You’ll likely have to carry a hefty mortgage and won’t produce any real cashflow when you invest.
They might even be cashflow negative, which wasn’t very attractive for me at first glance. I didn’t want to be stuck with payments that I didn’t know I could support.
But I do regret overlooking growth homes when I first started investing, and I wish I prioritized them in the beginning.
I remember going to a pre-build sales event and people were scooping up properties, even though there’s no way they’d break even in terms of cashflow. I remember looking at those people and wondering what they were thinking. Now I wish I had one of those houses because it has more than doubled in value in just a few years.
Truth be told, you’ll likely have a few painful years, maybe 5-10 at the beginning where your investment feels more like a money pit. But after that, you will have built a wealth machine!
If you’re in an up-and-coming neighborhood, you can raise your rent every year. You’ll be gaining more income while the house gains value as well.
So Are Growth Homes Always The Way To Go?
No, sometimes it’s the wrong call. If you have too many growth houses, that haven’t grown yet, you could get into trouble. Keeping up with all those payments with nothing to show for it is usually unsustainable. The smart thing to do is to have a mix of growth homes and cashflow homes.
My rule of thumb is to make sure I can cover the home’s expenses like mortgage and repairs with an alternative source of income (Like a job) if the home was vacant. That way you won’t be forced to sell just because you had a few months of bad luck.
Mr. FIREescape’s Portfolio:
I have two growth homes and they’ve done incredibly well.
- One was a $60K bargain ten years ago that I bought in cash, which is now worth $350K, and has produced $60K in rent over that time frame. That’s 21%/year in net returns.
- The other one was $410K, mortgaged that I bought with an $85K downpayment. It would sell for $750K now and has brought me $23K in rent in just 5 years, netting a cartoonishly large return of 55%/year.
The lesson here is that growth homes really shine when you leverage up with mortgages, especially since all the mortgage fees are worth it in pricier homes.
I’m writing this from experience because I’ve owned several low-income rental properties. I bought them because they look so good on paper, but they brought me just as much regret as they did actual income.
First, let’s look at the numbers. They were the siren that got me to sign. You buy a house for $40K which brings in $700/month in rent. That’s a cap ratio of 21%! (700×12 / 40,000) What could go wrong, right?
Well… Here are the 3 big downsides to these types of houses:
- If the area isn’t that nice, it won’t appreciate, which means you don’t gain much as time goes by. You don’t gain much when you sell, and you can’t really raise your rent.
- Tenants don’t stick around too long. If they see a better deal, they bail. This means you have to deal with high turnover which can be very costly.
- The monthly profit can be negated very easily with something such as a simple plumber visit.
Every real estate horror story I’ve ever heard involved low-income housing.
I am glad I tried it though, but only so that I can advise my readers against it.
If I Was Doing It Over Again.
Knowing what I know now, I would definitely skip the whole low-income rentals experience and just put my money into a high-growth house instead.
I can’t really complain about my cashflow homes, but when I started crowdfunded real estate like CrowdStreet didn’t exist yet, so if I was doing it over again, I wouldn’t really bother with all the effort when I could get the same returns from a simple fund.
My Short-Term Real Estate Goals.
At the moment I’m selling off some of my lower-valued rentals for downpayments for growth homes. I can’t go back in time, but I can course-correct.