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Ownership of real estate is a tried and true path to accumulating and storing wealth. But what makes a good real estate investment? Of course, it must produce a good investment return in any economic scenario. It also can’t be stressful, distracting, or time-consuming. Another often overlooked component is that it must have the potential to really hit it out of the park. Combining these characteristics in any real-estate investment inevitably sets you up for good outcomes.
The fundamental goal of real estate ownership should be to generate excess cash for the owner. This cash flow is produced through rental arrangements, paid by tenants who pay the real estate owner to use a space they don’t own. These cash flows are generally contracted via leases, and although they aren’t guaranteed and need to be evaluated for counterparty risk, they have historically served well as a reliable source of investment income. This cash flow also serves as the focus of investment returns.
If I put up $1,000,000 in equity to purchase a property that produces $150,000 of excess cash, I’m making 15% on my money. If this is happening, I don’t really care what the future market price of the asset is, what the economy is doing, or anything else. These are non-factors in my investment returns. If this box is checked, I’m well on my way to a good real estate investment.
The second component of a good investment is a bit less tangible. Real estate can be very hands-on and can drive you nuts if you don’t like dealing with it. Tenants miss payments. Maintenance issues arise. Disputes with lenders, government agencies, and the like are common, and if it stresses you out, it’s no fun to own. Your time is your most finite asset, and if the distractions of owning real estate have a very high opportunity cost, you need excellent returns to justify its ownership.
Fortunately, you can outsource much of the pain, albeit at a cost. If you can hire a property manager, passively own real estate, not deal with the headache, and still generate adequate cash returns, you’re in a great place. This combination of being happy and generating acceptable cash returns produces most of the deliberate, predictable successful investments.
The last component is all about luck, and you must deliberately position yourself to get lucky. When the income streams of the owned real estate increase, typically driven by increases in rental rates, the value of the asset generally responds in kind. Given the debt that is usually associated with real estate ownership, any increases in property value flow to the owner in a magnified way. This is how you make the big bucks.
This third component of the investment is a bit more speculative in nature. That’s because it’s never totally obvious where rental rates are going to increase without paying a steep premium. You try to get lucky by picking properties that are going to benefit from rent growth without paying for it upfront. If the other two bases are covered, you can and should roll the dice. You won’t strike it rich every time, but occasionally you will, and on average, your portfolio will be better off for doing so.
Bottom line. Focus on the cash flow generated by the asset relative to the amount invested as the baseline returns. Then don’t drive yourself crazy by owning it. Finally, look for opportunities that have the potential for market rents to increase in an unusually accelerated way. It won’t happen every time, but occasionally it can generate huge outliers in returns. A portfolio that does all these things is very well positioned to deliver solid results.