As we all know, interest rates have doubled in the last year and the playbook investors have been using to make money from rental properties for the last few years may no longer work in today’s environment.
Some investors are sitting on the sidelines hoping that rates will return to the 3.0% we saw last year, but that is a losing strategy. As shown in the graph below, 3.0% mortgage rates (for a 30-year fixed mortgage) are a historical anomaly – a freak accident really – due to the Fed’s reaction to the Covid pandemic. In fact, there was no other time in the last fifty years in which mortgage rates were at 3.0%:
If you’re waiting for rates to get back to 3.0% before you start investing again, you may be waiting a very long time! What if they never go back to 3.0%?
The reality is that the 7.0%, the 30-year fixed rates we’re seeing today are very close to the average historical rates we’ve seen over the last 50 years (7.76%). All the Fed did over the last year was move interest rates up from abnormally low levels to ones approaching normal. The bottom line is that if you want to make money in real estate and keep building your portfolio, you’re going to have to learn how to do it with mortgage rates in the 6-7% range.
In this article, I’ll cover three approaches you can take to do that.
#1 - The Risk-Averse Approach: Invest in Linear Markets
The first approach to making money from rental properties in 2023 is for the risk averse.
A linear market (as the name implies) is a market with very stable home prices: They don’t boom in good times, and they don’t bust in bad times. Many Midwestern markets fall into this category such as Cleveland, Indianapolis, Cincinnati, and Pittsburgh.
The reason prices are stable in these markets is because population growth is flat or in some cases even slightly declining. This contrasts with growth markets like Florida or Texas where both job and population growth are booming and driving up the prices of homes (which we’ll discuss next).
Linear markets are great for cash flow. As you can see in the sample property below, homes can be bought in the $140,000 range and rent for $1,200 or more per month – providing several hundred dollars per month of cash flow each. An investor could buy two homes in such a market for the price of one home in a growth market and get $400 to $500 a month in positive cash flow even at current interest rates.
#2 - The More Aggressive Approach: Invest in Growth Markets
The second way to make money from rental properties is to use a more aggressive strategy to invest in growth markets. As mentioned earlier, growth markets are defined by job and population growth. When the population is growing, the demand for housing grows, so generally rents go up and property values go up. Markets that fall into this category are often in the sunbelt, such as Phoenix, Dallas, Atlanta, Tampa and Orlando.
The downside of properties in growth markets is that they’re more expensive and don’t cash flow as well as properties in linear markets, which means this type of investment requires a different strategy for those seeking to make money with rental properties. As you can see in the example below (left column), this Florida home has negative cash flow when financed with a traditional 30-year fixed loan.
Adding to your risk, with negative cash flow it’ll be harder to build up your cash reserves so you can pay your expenses when the inevitable vacancies occur.
To mitigate that risk, you can use a 7/1 Adjustable-Rate Mortgage (ARM) which offers a much lower mortgage payment because the interest rate is lower AND it’s an interest- only loan for the first seven years. As shown in the table, using this financing approach turns the subject property from negative cash flow to positive $239 per month.
Between now and seven years from now if/when the loan rate adjusts, you have several options:
- If rates are lower then than they are now, they you can refinance at the lower rate;
- If not, rent increases over seven years should be more than enough to cover any increase in mortgage payments, as ARMs have limits on how much the rate can increase each year (check with your lender);
- You can sell the property after having enjoyed seven years of cash flow, appreciation, principal paydown and interest and depreciation tax write-offs.
Of course, no one knows the future, so while this property offers more potential upside appreciation, you’d be taking on a little more risk.
With 20-20 hindsight, buying this property at 2021’s fixed-rate mortgage rates would have been ideal, but even with the “new normal” investors are facing today, it’s still possible to make the numbers work using more creative financing.
A Word About ARMs
Some investors balk at using ARMs because there’s no principal paydown for the first seven years (in our example) but really, even with a 30-year fixed mortgage, you don’t pay off much principal in the first seven years anyway. Ask your lender to run the numbers for you.
Also, some investors are reticent about using ARMs because they’ve heard horror stories about investors getting burned from ARMs during the 2008 financial crisis. The problem back then wasn’t the ARM product itself; it was that lenders were giving loans to people with no requirement to prove income, or who were barely able to make the payments before the loan rate adjusted. Lenders today are not making those mistakes anymore.
ARMs are a legitimate and viable tool for today’s investor.
#3 - A Hybrid Strategy
Of course, there’s nothing that says you can’t use both strategies to make money from rentals in the coming year: Buy one property for appreciation in a growth market and another one for cash flow in a linear market. It’s like having a balanced portfolio of stocks and bonds. In effect, the positive cash flow from one property can help subsidize any negative or break-even cash flow for the other. This approach also helps you build your cash reserves for your portfolio overall.
If you want to build equity but are a little uneasy about rates and the economy, this hybrid approach enables you to participate in a growth market’s price appreciation while protecting yourself on the downside.
Finally, How NOT to Make Money from Rental Properties
The sure-fire way to NOT make money from rental properties is to sit on the sidelines waiting for rates to go back to 3.0% or waiting for conditions to be ideal.
Investing isn’t about waiting for the perfect time to invest; it’s about executing a disciplined strategy over time. Whatever approach you chose – linear or growth or both – execute!!
How RealWealth Can Help You Make Money from Rental Properties
Become a member of RealWealth, so we can help you learn more about making money from rental properties one-on-one. With our network of professionals, you will find a team of trusted experts dedicated to helping you achieve your real estate investing goals. To start investing, join today for free.