Low-cost properties are appealing because you can acquire and generate income with less initial capital. However, they are actually the most expensive way to achieve and maintain financial freedom. Here’s why.
What Determines Prices and Rents?
Real estate prices and rents are driven by supply and demand. When the number of sellers equals or exceeds the number of buyers consistently, property prices remain low. If prices do increase, the rise will be gradual. Furthermore, when prices are low, more people can afford to buy, leading to fewer renters. This results in stagnant or slowly increasing rents.
Where there are consistently more buyers than sellers, property prices are higher, and rents and prices rise. In the right locations, rents outpace inflation.
Here are two (of many) indicators of a location where rents and prices are likely to keep pace with inflation:
- Significant, sustained metro population growth: Only when the population increases rapidly will demand for housing be enough to raise prices and rents at a rate that outpaces inflation.
- Low crime: On average, a corporation lasts for 10 years, while an S&P 500 company typically survives for 18 years. This means most nongovernment jobs your tenants currently have may disappear in the foreseeable future. In order for your tenants to sustain their current rent level, new companies must set up operations in the city, offering jobs with similar wages and requiring similar skills. High-crime cities are not typically chosen for new business operations. Without these replacement jobs, your tenants may be forced to accept lower-paying service sector jobs. This could lead to a decrease in rent or, at best, limit potential rent increases.
Capital Required to Reach Financial Security
To replace your current income, you will likely need multiple properties. The capital required to purchase the properties depends on the appreciation rate.
Low appreciation cities
Cities with a low appreciation rate have low prices due to limited long-term housing demand. With a low appreciation rate, you can’t use a cash-out refinance to buy additional properties. Therefore, all the funds required to purchase multiple properties would have to come from your savings.
An example will help. Suppose each property costs $200,000, and you need 20 properties to match your current income. Assuming a 25% down payment, how much must come from your savings just for the down payments?
Total capital from savings: 20 x $200,000 x 25% = $1,000,000.
High appreciation cities
Suppose you purchase property in a city with high appreciation. You could then use cash-out refinancing on existing properties to fund the down payments on future properties.
Another example: Suppose each property costs $400,000 and you can use a cash-out refinance for the down payment on the next property. In this case, the total capital required from savings to purchase 20 properties will be:
Total capital from savings: $400,000 x 25% = $100,000
The question then is how long you need to wait in order to accumulate sufficient equity for a $100,000 down payment. In the following calculation, I will assume a 7% appreciation rate.
The formula for future value:
Future Value = Present Value x (1 + Annual Appreciation %)^Number of Years Into the Future
Here is the net investable capital after years one to five:
- After year 1: $400,000 x (1 + 7%)^1 x 75% — $300,000 (pay off existing loan) = $21,000
- After year 2: $400,000 x (1 + 7%)^2 x 75% — $300,000 = $43,470
- After year 3: $400,000 x (1 + 7%)^3 x 75% — $300,000 = $67,513
- After year 4: $400,000 x (1 + 7%)^4 x 75% — $300,000 = $93,239
- After year 5: $400,000 x (1 + 7%)^5 x 75% — $300,000 = $120,766
After four or five years, you can use the net proceeds from a 75% cash-out refinance as the down payment for your next property without dipping into your savings.
This diagram shows the almost geometric progression of acquiring properties this way.
Many of our clients have successfully used this method to grow their portfolios.
Capital Required to Maintain Financial Security
According to the government, inflation is currently at about 3.5%. In low-cost cities, rents appear to increase by 1% to 2% a year.
To show the impact of rents not outpacing inflation, suppose you own a property that rents for $1,000 a month. What will be the rent’s present value (purchasing power) at five, 10, 15, and 20 years?
In this example, I will assume an annual rent growth of 1.5% and use the following formula.
FV = PV x (1 + r)^n / (1 + R)^n
- R: Annual inflation rate (%)
- r: Annual appreciation or rent growth rate (%)
- n: The number of years into the future
- PV: The rent or price today
- FV: The future value after “n” years.
The calculations:
- Year 5: $1,000 x (1 + 1.5%)^5 / (1 + 3.5%)^5 = $907 in today’s dollars.
- Year 10: $1,000 x (1 + 1.5%)^10 / (1 + 3.5%)^10 = $823 in today’s dollars.
- Year 15: $1,000 x (1 + 1.5%)^15 / (1 + 3.5%)^15 = $746 in today’s dollars.
- Year 20: $1,000 x (1 + 1.5%)^20 / (1 + 3.5%)^20 = $677 in today’s dollars.
As you can see, buying power declines every month, so it is only a matter of time before you will be forced to return to the daily worker treadmill or invest more capital to acquire more properties.
In cities with high appreciation, rents typically outpace inflation. This means the purchasing power of your rental income remains the same or increases over time, leading to true financial freedom.
Final Thoughts
Low-cost properties are the most expensive because cities with low property prices have limited appreciation. With limited appreciation, you cannot grow your portfolio through cash-out refinancing. Therefore, every dollar invested must come from savings.
If rents do not keep pace with inflation, you must constantly buy more properties to maintain your standard of living or return to work.
Higher-cost properties are the least expensive because in cities with high housing demand, prices and rents rise rapidly. This enables the use of cash-out refinancing to purchase additional properties. This significantly reduces the total capital from savings needed to purchase the number of properties required to replace your current income.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.