The competitive advantage in real estate investing

02.27.09
By Randy Johnson

In another article I wrote recently I discussed the long-term benefits of owning investment property. You have the cumulative effects of appreciation that is greater than the rate of inflation, as well as leverage and tax sheltering of cash flow. But, as I mentioned, real estate needs to be managed. Managing real estate is a business. Like any other business, it requires work. If you work hard and work smart, your business will run better and the results will be more satisfying.

The other aspect of business is that you have competitors. Most people don’t think much about this. You just think that you are buying a property. But your customers, the renters, have choices. They can rent from you or they can rent from someone else down the street. Why would they rent from you?

Well, your property may be in a more desirable location. Your home may have features that meet a tenant’s particular needs, like the number of bedrooms. For example, it may be the case that in your area three bedroom homes are more attractive and popular than two bedroom homes. This kind of information is important to know before you buy. I saw an appraisal on a home that has only 765 square feet. Most people need a larger space, and for this reason the home has a more limited market appeal.

Of course, the biggest factor is the rent that the landlord wants for the home. If the market rent in your area for comparable homes is $2,000 per month, you can certainly attract tenants if you are willing to rent for $1,800 per month. But why shouldn’t you get $2,000? Let’s say that the cash flow breaks even at $1,800 per month. That means that $200 was your profit margin. You don’t run a successful business if you give away your profit. Right?

Your competitors – all those other landlords – set the market rental price. Your goal is to be able to collect rent that is at or a little above everyone else so as to maximize your rental income.

Now let’s assume that you have an opportunity to buy a home for $200,000. The data show that the identical house next door sold three years ago for $300,000, but property values have fallen 33% so your price is in line with current market.  

Now let us examine the cash flow over 30 years, the period of time it takes to pay off the loans. We’ll also assume that the first buyer put 30% down and got a loan at 6.5%.  

The difference in annual cash flow between the two looks like this.

Purchase Price:	300,000	200,000
Loan amt @ 70%:	210,000	140,000
Monthly rent:	1,800	1,800
Mortgage payment:	1,327	885
Insurance:	50	50
Property taxes:	313	208
Total expenses:	1,690	1,143
Cash flow per month:	110	657
Annual:	1,322	7,881
Difference:	$6,559

This is huge! Not only did the lower-price property cost less, but the profit is substantially more – like 600% more. You make a lot more money. Not only that, but in a period when rents drop – it will likely do so for a few years here and there – you are the low-cost producer. If market rent drops to $1,600, your competitor is going to lose over $1,000 per year and you will still make over $5,000 per year.

When you examine the numbers over 30 years, the cumulative advantage is cash flow, even assuming that you pay off your loan in 27 years. Your competitor’s cumulative cash flow is $451,000. Not bad. He owns a home free and clear, and he made $450,000 over 30 years.

How did you do? Remember that you got the same rent he did, but your lower expenses really add up. Your cumulative cash flow is $616,000. That’s a difference of $165,000.

You read it right. You make $165,000 more profit than your competitor did.

Not only that, but your properties will likely be worth the same amount of money, so you will make an additional capital gain of $100,000 because you bought for $100,000 cheaper than your competitor.

Thus the cumulative advantage of buying is now $265,000. 

If you choose to dedicate a portion of your increased cash flow to paying your mortgage loan off more quickly, like by getting a 15-year loan, the result is a profit advantage of $266,000, an ADDITIONAL $100,000. Along with the capital gains of $100,000, this brings the total profit ADVANTAGE to $366,000.

Bottom line: Purchasing an investment property at the prices you can buy at today is an incredible opportunity. 

Footnote – this is a simple example that ignored several factors, like income taxes. But this factor doesn’t make a big enough difference to change the advantage. You’re not going to tell me you don’t want to do this because you’d have to pay taxes, are you?

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Purchasing an investment property at the prices you can buy at today is an incredible opportunity.