A common mistake I see committed by new real estate investors is purchasing a rental property and hoping it will appreciate naturally due to a hot market. Not only is this akin to gambling, but it's also a great way to ensure you have a bad experience with real estate. When evaluating a rental property as a potential investment, it is extremely important that your primary focus is cash flow and appreciation is secondary. Three reasons you should buy for cash flow are:
1. Cashflow helps you manage unforeseen repairs and expenses
Focusing on the property's potential cash flow will provide you with a steady stream of income and soften the blow of unforeseen repairs, like plumbing issues, or large capital expenditures, such as a new roof. Having a property that appreciates very quickly is great until you have a major repair that is needed and all of a sudden don't have any cash to pay for it. Another thing cash flow allows you to do is save up and protect yourself against extended periods of vacancies or a tenant's inability to pay rent (shout out to Covid-19).
2. You will never be able to time the market perfectly
In addition to providing some protection during larger repairs, you will rarely (never) be able to time the market perfectly. Most of us have a plan for when we want to liquidate or sell the investment, but life rarely happens as expected. You could have a significant life event or medical emergency that would require you to sell the property. If that life event coincides with a housing market recession, you will very likely lose money on it and could even be required to pay additional cash at closing just to sell the property! The last housing market recession lasted almost a year and a half and most of us can't wait that long if we need the money due to an emergency.
3. Accessing equity will cost you money in the form of banker's fees or closing costs
However, if you are lucky enough to purchase a property that appreciates quickly and want to access some of the equity, you typically have two options: establishing a line of credit on the property or selling it. If you establish a line of credit on the property, you will have to pay bank fees to establish and draw on that line of credit. If you want to access the equity in the property by selling it, your profit will be quickly eaten up by 8 - 10 % in the form of closing costs. Below you will find typical closing costs for a $200,000 property with a $150,000 mortgage. As you can see, your $50,000 profit is quickly reduced to a mere $20,000.
By investing in real estate primarily for cash flow, you can protect yourself against some of the risks such as unforeseen repairs and recessions. Most housing markets will naturally appreciate over time due to inflation, which is why your determining factor in a real estate investment should be cash flow.