What Are the Minimum Profit Requirements for Today?

I got this excellent question from an investor and thought that it would make sense to share my response with the entire BP community. 

The minimum profit requirements depend on your time frame and goals.

One of the many things I urge investors to consider is the fact that real estate investment hold times are in the 10+ year range. So, what happens in the future is in many ways more important that what is happening today. Yet, most of the investors I communicate with on Biggerpockets and other sites seem only concerned with ROI today.

If you buy properties in a good location, which means that they meet the criteria below, you income is likely to rise over time while the majority of your costs are fixed.

• Sustained profitability - The property must generate a positive cash flow today and into the foreseeable future.
• Likely to appreciate over time - You would never buy a property just for appreciation but appreciation is very desirable. Especially when using a 1031 to reinvest equity or adapting to market changes.
• Located in an area where you can make money and risks are low. Key factors include state income tax, property tax, insurance cost and landlord favorable regulations. Regulations include property related laws like the time and cost of evictions, rent control, code compliance requirements, etc. Nevada / Las Vegas is a business friendly state. No state taxes, evictions typically take less than 30 days and cost less than $500.

Sustained profitability and appreciation are functions of demand. Ongoing demand is dependent on the following factors:

• Sustainable population growth (no boom towns)
• Increasing job quality and job quantity
• Little or no urban sprawl. A metro area can have a stable population but areas within the metro area have a declining population or declining income.
• The major employers are in market segments which have proven to perform in the past and are very likely to perform well in the future.

So, if you need retirement income in 10+ years, then buy a class A property in an area very likely to both have rising rents and appreciation. You can start with a lower return today.

Minimum return:

I consider real estate as one investment option out of a fairly broad range of investment options. Each investment option has advantages and disadvantages. Real estate is the most forgiving of all. As long as you buy investment real estate in a good area, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. The downside of real estate is liquidity.

When I look at investments that offer a similar level of security to real estate in good areas I look at instruments like CDs. Currently, CDs are paying in the 1.5% to 2% range depending on the term. According to the federal government, current inflation is running between 1% and 2%, which is ridiculous. Starting in the 1990 the feds began removing all meaningful items from the inflation calculations including food, energy, etc. No matter which inflation number you choose to believe, CDs are not keeping pace with inflation. Plus, you are taxed at the capital gains tax rate of 15% on any income from the CD.

Real estate has a clear advantage because while the biggest cost is fixed (debt service) the rents track inflation. Plus, while you are taxed at marginal rate on profit (rent - expenses - debt service interest - depreciation), few people have much in the way of taxable profits. Also, you are not taxed on appreciation, until you dispose of the property. If you wish to reinvest accumulated equity or adjust to market changes, a 1031 exchange differs taxes.

If I were to state a minimum acceptable return on a property in a good market, I would choose 3% knowing that my return will increase over time. Others seek much higher returns in declining markets. In my opinion, they are just buying into a long term financial disaster. (See Investing in Declining Markets for more information on this subject.)

If you are looking for cash flow today, I would look for a balanced return property (cash flow and likely appreciation) paying in the 5% to 6% range. Above this rate in the current market you are looking at the equivalent of junk bonds.