Excellent comments on this thread. I decided to add my 2¢’s.
Return Calculation Limitations
Return calculations only predict how a property is likely to perform on day one under ideal conditions. Return calculations tell you nothing about the future. Because you will hold a property for many years, what happens after the first day is far more important than what happens on day one.
Financial Independence
In order to have financial independence you need a income replacement equal to your current income that also meets three requirements:
- Inflation compensating: Rental income keeps pace with inflation, enabling you to pay inflated prices to maintain your standard of living.
- Persistent income: Your income will last so you will not run out of money.
- Reliable income: Your income continues even in difficult economic times.
Unless rents keep pace with inflation, your time off the daily worker treadmill will be short. This is because inflation will continue to increase prices, and you will not have the additional dollars you need. Regardless of how many “Property A’s” you own, your buying power will decrease each month, and you will be forced back onto the treadmill of daily work.
Rent Follows Prices
Property prices are driven by supply and demand.
- If there are more sellers than buyers, prices will fall.
- If there are more buyers than sellers, prices will rise.
Rental rates are driven by property prices.
- If prices rise, fewer people can afford to buy and will be forced to rent. Demand for rental properties increases as will rents.
- If prices fall, more people will be able to buy so fewer people will rent. Demand for rental properties decreases as will rents.
In short, where prices go, rents follow. However, rents typically take 2 to 5 years to catch up with changes in property prices. This lag is primarily due to leases, which are usually for one year or longer.
What Drives Demand?
Population change is what drives housing demand.
In cities where the population is increasing, the demand for housing exceeds the current supply. This causes prices to rise until a balance is reached between the number of sellers and the number of people who can afford to buy.
In cities where the population is static or declining, there are more sellers than buyers. This results in a decrease or stagnation of property prices. This trend continues until there is a balance between sellers and buyers. Low property prices are the result of years of low demand for housing. In other words, housing prices have not kept pace with inflation, resulting in lower property prices when compared to cities with increasing populations. Rents follow property prices, so if prices have not kept pace with inflation, neither will rents. If you buy in such a location, rent increases will not keep pace with inflation, and your buying power will continue to decline over time. No matter how many low-cost properties you own, your days of financial freedom are limited by how long you can continuously decrease your living costs.
If you purchase property in a city with higher demand, prices will be higher, but rent increases are likely to keep pace with inflation. If they do, you will achieve permanent financial freedom.
Your financial independence is tied to the city's ability to quickly grow its economy, create jobs, and increase its population. Do you want to risk your financial independence by betting that cities like Detroit, Cleveland, and many others with declining populations will somehow turn around and become economic powerhouses?
Do You Make the Most Money With Cash Flow or Appreciation?
An example will explain far better than text.
Suppose you have two properties. Property A has a 7% appreciation rate with no cash flow. Property B has a 7% cash flow but no appreciation. To keep the example simple, I ignored all other variables except for personal income taxes, which I assumed to be 30%.
Why Low-Cost Properties Are the Most Expensive
To replace your current income, you will likely need to acquire multiple properties. The total amount of capital required to acquire multiple properties depends on the city's appreciation rate. In the following examples, I will assume you need 20 properties to replace your current income. I will also assume the downpayment is 25% of the purchase price.
In a low-priced location, I will assume each property costs $200,000. To keep things simple, I will only consider the capital needed for down payments and ignore all the other costs like renovation, closing costs, etc., and no inflation.
Total capital from savings required for 20 down payments: 20 x $200,000 x 25% = $1,000,000 in after-tax dollars. The fact that all capital will come from after-tax dollars means that if your marginal tax rate is 35%, you will need to earn (gross) 1,428,571 to have $1,000,000 after taxes. $1.4M will take a lot of years to accumulate. And, if there is inflation you will need a lot more capital.
Higher price location - Suppose you purchased in a high appreciation market and each property costs $400,000. In a high-appreciation location, you use cash-out refinance when there is sufficient equity for the down payment on the next property. In this case, the total capital required for down payments will be:
First property capital requirement: $400,000 x 25% = $100,000
Each additional property is purchased with accumulated equity from the previous properties. This is how many of our clients grew their portfolios. The process is illustrated below.
In summary, if you buy in low-cost locations, every investment dollar must come from your after-tax savings. If you buy in a high-appreciation location, even though prices are higher, you will need significantly less capital because the majority of the capital required can be obtained from cash-out refinance.
Summary
Low-cost locations may seem alluring initially, but it's important to look beyond the first-day returns and consider the long-term performance of the property over the next 20 to 40 years.
