Real estate investors often say that there are three paths to becoming wealthy:
- Owning a significant chunk of a successful business,
- Passive investing through personal finance (which is this book's focus), and
- Real estate, which is sort of a combination of the other two.
There are many ways to invest in real estate! The most well-known is speculation, wherein a person picks a neighborhood that they think is under-priced, buys some property there, waits until its value goes up, and sells.
I think of this as analogous to picking individual stocks: it may work, especially if you buy after a crash, but you're taking a big risk.
Another approach is “buy and hold” investing. In this model, you buy a property in a neighborhood where rent is high relative to property values and rent it out to a tenant.
What makes a good rental property? There are two popular rules of thumb that can help you think about cash flow:
- The “1% rule” suggests that a good rental property should pay at least 1% of its cost in rent every month. That is, if you're thinking about buying a property for $100,000, you'll first want to be sure that you can collect at least $1,000 per month in rent. If you can't charge at least that much, it's unlikely to be a good investment.
- The “50% rule” states that about half of the gross income from the property will be taken up by expenses: paying the mortgage, property taxes, insurance, maintenance, property management, and the occasional roof replacement.
Real estate investing requires much more research and active attention than passive index fund investing, but it can also produce higher and more consistent returns.
Let's suppose you've found a neighborhood where you can buy a property for $140,000 and rent it for $1,500 per month. That fulfills the 1% rule, so it probably merits a closer look.
Since you're buying this as an investment property instead of a personal residence, you might need to put as much as 30% down to get a mortgage. That's an initial investment of $42,000.
You'll collect $1,500 in rent every month, of which about half will go toward expenses. That gives you a net return of $750 per month, or $9,000 per year.
That's quite good! You've spent $42,000 to buy a $9,000/year income stream, which translates to an annual cash-on-cash return of around 21.4%.
As an additional bonus, your tenant will have eventually paid down your mortgage, leaving you with a fully paid-off property.
The 1% rule and 50% rule are just general guidelines, not ironclad laws! Don't blindly trust them. Please, please properly analyze any deal you're considering.
If you're interested in learning how to do that, check out the Bigger Pockets online community. They've got a ton of information about real estate investing. I'd suggest starting by reading their Ultimate Beginner's Guide. I'm also a big fan of their podcast.
In the interest of full disclosure, I personally haven't done any real estate investing yet (though I'm planning on making a move Real Soon Now)! As such, please take this advice with a grain of salt.