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I get this question, or some variation thereof, quite frequently. The answer is never straight forward or black and white. Part of my job is to figure out what’s important to the client and make their financial decisions easier to digest. I need to understand the purpose of the investment and how it fits into their entire financial picture. This post is not an analysis of the real estate market. It’s a few checkboxes to apply to your financial situation if you are thinking about real estate investing.
I live in Nashville, TN and the real estate market is on a tear. This is in large part due to the major growth the city is experiencing. It’s a love hate thing for us locals. It’s great to see new business and people coming to town, as this makes Nashville a thriving and exciting city to be in. That said, the construction and traffic can be a drag. The same goes for the bigger problems with infrastructure, housing costs, and cost of living. The real estate market has been good to those who have bought homes within the last few years. As with anything in finance, there are trade offs and risk when getting involved.
If you have extra cash saved and are thinking about investing in real estate keep reading. Start by answering these three questions.
Do You Have an Emergency Fund?
My first question is, what does your cash position look like? There are a couple ways you could go about investing extra cash. I hope you have, and plan to still have, an emergency fund of 3 to 6 months of basic living expenses (or whatever is comfortable for you) after your investment. I have seen people invest all their money into rental properties or houses that they plan to flip. At this point your hands are tied. You are the mercy of the market. It could take time to find a buyer resulting in having to sell at a lower price to get the house sold. Also, the last thing you want to do is take on debt through credit cards or loans to fund an unexpected emergency.
If the emergency fund box is checked, and you have money left over, then you can start thinking about next steps for investing.
What Are You Investing For?
Why do you want to invest your extra money? What are your expectations for the investment? Try to really understand your desires and goals for the real estate investment. Be honest with yourself. If you are getting involved for the wrong reasons, it may be a good idea to not move forward. If you can afford it, and are doing it for the right reasons, then move to step 3. Reasons include:
- Is it for additional cash flow?
- Are you hoping to sell the property in six months in hopes to make some money?
- Is it greed?
- Are you following the crowd?
- Is it the cool thing to do right now?
- Do you enjoy real estate investing and managing properties?
- Are you interested in getting in the real estate business?
- Do you already own a house and are thinking about moving or upsizing?
What Are Your Alternatives to Real Estate and How Do They Compare?
Opening a Brokerage Account:
An alternative to a rental is opening a brokerage account. This can be invested in a globally diversified portfolio of stocks and bonds. This may sound boring but this reduces the risk of a single company or asset class (such as real estate) compromising your portfolio. You can own thousands of companies in a diversified portfolio. If one company goes under in your diversified portfolio it may not affect your bottom line nearly as much as the real estate market taking a hit or not being able to find a renter.
You do want to invest for the long term, so have a good understanding of your time horizon for the funds. The funds in a brokerage account are accessible should a need arise for the money. This is opposed to having to take out a line of credit or second mortgage on the house. It helps you stay out of your retirement accounts, and not take on debt, if a need comes up. I try to focus on building liquidity through savings and investments.
There are typically three ways to make money on a rental.
- One is on the pay down of the mortgage from the rent check.
- The second is any amount received above the mortgage payment from the rent check.
- The third is on the appreciation of the home once you sell it.
Do you feel confident that these three things can be fulfilled? Number 3 is a tough call since we cannot predict the future. Will you be able to find quality renters and what kind of area is the house in? Can you afford the mortgage payment if you can’t find renters at some point? How about home maintenance?
These are a few things to think through before taking the leap to buy. Take a hard look at the numbers and costs associated with the investment. A realtor and lender can help assess your situation. I would recommend shopping a few.
Lastly, do you want to be a landlord? Managing rentals or flipping houses in the short term can come with a lot of work and is not without risk – getting the loan, going through the buying process, deciding if you’re going to manage the property or hire a company to do so, funding home maintenance, and eventually selling it. My main point is to think through the risks, your goals, and costs.
Owning rental properties can have a place in a portfolio and be a good source of extra income. Make sure you are doing it for the right reasons and have a well rounded financial plan in place.
This is what I help with. Feel free to reach out to me with any questions!
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ at Applied Capital. Email him at firstname.lastname@example.org
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.