Ideas to Help Our Youth Get a Strong Financial Head Start.
Part 3: Moving Ahead in the Financial Life Cycle with the Help of Rental Income
Creating a Cash Flow Source in Your 20s or 30s
OK, so let’s say you’re in your 20s and with the help of a family savings and investment account (see Part 2 of this series) you have little or no debt and $20-25,000 in liquid accounts (savings, stock). What can you do to build on your momentum and start generating monthly cash flow from a source other than your salary? One option to consider is a rental property.
As explained in our e-booklet Wealth is Good, Cash Flow is Better©, a rental property is an example of a “Best” asset type because it can appreciate in value AND generate positive monthly cash flow (from the rental income). A single family primary residence on the other hand is a “2nd Best” asset; for while it also appreciates over the long term it always creates a negative cash flow. (Even if the mortgage is paid off, property taxes and homeowner’s insurance keep you in negative territory.)
What are the advantages of rental real estate? To explain, let’s use hypothetical 1-family and 2-family properties as examples.
Assume you qualify for, say, a $150,000 1-family house. If you make a $22,500 down payment then your mortgage will be $127,500. At 4.0%, a 30-year mortgage payment will be $848 per month.
Now let’s look at a $225,000 2-family property. If you put the same $22,500 down, it leaves you with a mortgage of $202,500 and a monthly payment of $1,348, or $500 more than the 1-family. But if you rent one unit at $1,000 per month, even assuming you keep it rented 80% of the time it will generate average monthly income of $800. So all other things equal, your net monthly cost for the 2-family will be $300 lower than the 1-family.
That’s the income side. Now look at the appreciation side. Assume a long term average appreciation rate of 4% in home prices. Over 10 years, the $150,000 single family appreciates to $222,000. But over the same period the $225,000 two-family grows to $333,000.
One significant advantage of a rental property is that it offers an opportunity to generate cash flow with no age restrictions.
So the same $22,500 down payment can yield very different outcomes depending on your property choice. In this hypothetical example the multifamily choice results in both a better (less negative) cash flow and a higher long term appreciation value.
But the multifamily cash flow is still negative. So your challenge is to turn it positive. In some rare cases an investment property can break even or generate positive cash flow immediately upon purchase. Otherwise, it’s a matter of paying down and ultimately paying off the mortgage. But even then, if you don’t do your due diligence up front, an investment property with no mortgage can still be a cash flow loser. We’ll discuss some of the considerations and evaluation techniques when shopping for a rental property in an upcoming article.
While we’re on the subject of potential pitfalls, it’s important to also point out that rental properties are NOT for everyone. If you don’t think you could effectively choose and deal with tenants, then becoming a landlord might not work for you. Being handy with repairs isn’t a requirement but making sure they are done in a timely manner is important, and if you pay someone else to do them it cuts into your bottom line. There are a host of other considerations, and many other sources of information on this topic that can give you more detailed guidance.
So, as with any investment option there are pros and cons. But one significant advantage of a rental property is that it offers an opportunity to generate cash flow with no age restrictions. Retirement account distributions are not accessible until at least age 59 ½, and you have to wait until your 60s before receiving monthly Social Security pension payments. But it’s possible to acquire an investment property and turn it into an income producer even in your 20s or 30s. That extra cash flow can go a long way in helping to clear a path through the early stages of the financial life cycle.
Keith Whelan is Cashflownavigator’s founder, resident financial expert, and author of the “Wealth is Good, Cash Flow is Better” e-booklet. He is a graduate of Columbia University Business School, teaches at Rutgers University, and has over 30 years experience in the banking and financial services industry. Keith, his wife Cindy, and their two sons live in New Jersey.