Financial planning clients asking this question may not understand that there are more important questions to ask.
Retirees often look for clues to answer the question, “Is today a good time to buy a rental property?” I can answer this with absolute clarity: Yes and no.
This Contradiction is Easy to Explain
When the media reports “favorable buying conditions” for buyers (investors), the investor can still make a poor real estate investment. Favorable buying conditions include low interest rates, loose underwriting standards, generous inventory, and an expanding local economy that results in higher discretionary income.
An investor who selects a poor investment property can also see that mistake negatively compounded by the routine risks of rental-property ownership, such as choosing poor tenants, an adverse change in local employment, detrimental changes in rental law, etc.
Yet even when the media reports “unfavorable buying conditions” for real estate, an investor can still make an excellent purchase decision—there are many examples of good real estate investments made when the market seemed dire.
Warren Buffet characterizes this as “the best chance to deploy capital is when things are going down.” The 18th-century British nobleman Baron Rothschild said, “Buy when there is blood in the street, even if the blood is your own.”
The point is that because a good or bad real estate investment selection can happen in any market, it stands to reason that timing the market doesn’t ultimately assure a real estate investor of a successful outcome. The question becomes, “If timing the market doesn’t ensure success, what does?”
Real Estate Principles: Boring But Productive
No standard checklist works for each transaction because property types, buildings, regions, and investor profiles differ. However, real estate investors can increase their chances of success by following sound real estate investment principles. Those principles do not change over time, which helps explain why choosing a “good rental” — which brings in steady, growing cash — can be done in any market condition. Here are two of those principles:
Principle #1: Master the Real Estate Cash Flow Model
The real estate cash flow model (CFM) forecasts likely performance for the first year and the near term. Surprisingly, many investors ignore this model or have difficulty executing it.
Through my financial planning practice and indirectly through the hundreds of advisors I have taught at the University of California, Berkeley, I have reviewed thousands of cash flow models representing thousands of real estate investments. Without exaggeration, 99% of these models underreported operating expenses.
Out of the more than 100 CFMs I review yearly, I am lucky if I see one that does not require meaningful modification. Most of the models I’ve reviewed have overreported projected rental income despite having existing tenants with contracted rents.
Why are small investors underreporting expenses and overreporting rental income? For most, it is a mistake — an oversight.
Three Ways to Help
Here are three default income and expense data areas that small investors typically use — and need more help understanding — when putting together a rental real estate cash flow projection:
Overestimated income. Over time, every property will have some level of vacancy. The more an investor seeks to charge above the prevailing market, the higher the vacancy rate. Some clients need help understanding this. To validate how this works, search out the concept of “The Law of Substitution.” The lower you are from average market rents for your property type, the lower the vacancy. It is more nuanced than this; getting to market rent is science. And an investor should not seek the lowest rent possible to keep the property occupied. Instead of using the gross amount of the contracted rent when calculating cash flow, the investor should assign an assumed vacancy rate. For example, plug in 5% to start; that seems to be the “healthy” long-term average for small residential rentals. Digging into local market data to find a better-assumed rate is better.
‘The Big Three Expenses (3EX).’ The three most often assumed expenses investors use to estimate cash flow are mortgage (if any), property taxes, and property insurance. Sometimes, I see utilities estimated, but they are rarely part of initial planning meetings.
Often-missed expenses. Management fees, repairs, and advertising are a few of the expenses that are often missed. You can read more about this article I wrote in 2022. At that time, the U.S. was experiencing “unfavorable buying conditions.” The numbers will have increased due to inflation, but the article and charts are still relevant because the principles have not changed.
When you see a couple hunched over a napkin at the kitchen table calculating the anticipated income from a potential new rental property — or when you see two college tech or construction buddies using a spreadsheet to dial in cash flow for their impending partnership — all three conditions described above will likely apply. If you throw an engineer in the mix, the “smarter mortal” will catch a few more expenses, but not the large ones.
Relying primarily on 3EX to estimate cash flow will have a meaningful, negative impact on meeting investor expectations. Let’s use the numbers for the fourplex referenced in the article above and imagine the couple or buddies are considering the same property. The numbers represent a real property; details are redacted, and numbers are rounded.
Specimen fourplex
Fourplex in Oakland, Calif.
$1,100,000 purchase price
$550,000 equity. (I am leaving off closing costs and 1st-year improvements to simplify this.)
$550,000 mortgage
5.00% interest, 30-year amortized (using today’s mortgage rates will not change the concept being shown)
Potential rental income: $98,000/1st year. This assumes the unit is fully leased.
Below is an abbreviated look at the year one cash flow.
Below is an abbreviated look at the year one cash flow when estimated expenses that reflected the reality of the investment were used.
There is a big difference between real estate cash flow of $34,000 and $3,500, especially with $550,000 in equity at stake. For a retiree expecting to sleep well on their cash flow, many are still sleeping well because they do not realize the opportunity cost of getting honest about property performance. They are not dumb or stubborn. Most do not know how to look at their property. This is also the case for real estate professionals and tax preparers. They can be equally passionate about the asset class. And even defensive, but still unaware. (I’ll speak more about expenses in a future article.)
Principle #2: ‘Can You Survive Your Property’s Worst Day?’
A rental-property investor may recognize this as, “What happens if I have an extended vacancy?” or “Am I using too much leverage?” These two examples are about liquidity or managing reserves. Think back, too, to the mortgage-backed securities crisis of 2008 and the experience of people losing properties from 2009 to 2011.
Another big problem is a tenant who has learned to squat successfully for a considerable period. Some organizations teach people how to do this successfully for a while. The payoff is not the nine months of free rent. The big-picture payoff is the lawsuit filed against the investor.
What about if the rental burns down? My first investment rental caught fire but did not burn down. I had two things going for me: an excellent property manager and outstanding property insurance. (Here’s an article about Deferring Real-Estate Taxes After Disasters.)
To wrap up this principle, imagine that your client lost all the equity in their real estate rental. It’s rare, but it happens more than you imagine. One client lost just over 50 homes in the “attractive” central California market from 2009 to 2011. The answer to this second principle is to assume they lost the asset and the equity for one property. Will their retirement plan still work?
You don’t have to be a real estate expert to encourage your clients to consider the questions they should ask themselves if they’re interested in buying or continuing to own rental properties. It’s also important to enable clients to look beyond the real estate headlines before they act. For example, since the beginning of the pandemic, the value of single-family homes has risen sharply while Class A office buildings in major markets have dropped 50% to 75%, with no end in sight. Yet, both are classified as real estate.
About the author/planner/teacher
As the Founder and CEO of The Real Estate Whisperer™ Financial Planning, Rich Arzaga, CFP®, CCIM, is a flat-fee financial advisor who provides advice only. By focusing solely on delivering client-centered financial advice rather than managing investments, he ensures his undivided attention to his clients' needs.
Drawing on his extensive expertise, Rich provides valuable advice on various real estate topics, including buy-sell-hold strategies, tax-deferred and highly appreciated tax reduction strategies, real estate succession planning, and rental property cash flow analysis.
His exceptional knowledge and real estate strategies have earned him recognition in business and finance publications such as the Wall Street Journal, The New York Times, Newsweek, Kiplinger, and The Journal of Financial Planning. As an esteemed adjunct professor at UC Berkeley Personal Financial Planning programs, Rich has been Honored for his excellence in teaching.
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