Hello @Jamiru Mutebi,
Your most important investment decision is the location (city), not the property. The city is critical because it determines how fast rents (and prices) rise.
Financial Freedom
Financial freedom goes beyond simply replacing your current income; it requires maintaining your current lifestyle for the rest of your life. To attain lifelong financial freedom, you need a passive income that meets three requirements:
- Rents must outpace inflation
- Persistent: You will not outlive the income.
- Dependable: The rental income must come every month, even in bad economic times.
Whether rents outpace inflation and how long your income will persist depends on the city where you invest. Income dependability depends on the tenants and their employers. I will only talk about the location in this post.
The Allure of Low-Cost Cities
Why do properties cost less in some cities than others? Prices are determined by the imbalance between buyers and sellers. When there are more buyers than sellers, prices increase until the number of buyers and sellers is roughly equal. Conversely, when more sellers than buyers exist, prices drop until the number of buyers and sellers is roughly equal.
Prices determine rents. Fewer people can afford to buy when prices are high, so more turn to renting, driving up demand for rental properties and causing rents to rise. When prices are low, more people can buy, which reduces demand for rental properties, and rents fall.
What caused prices to be lower in some cities? Multi-year lack of buyer demand resulted in cities having low-cost real estate. Simply put, prices rose so slowly that they fell behind other cities. Rent follows prices, so where prices are low, rents will increase slowly.
You can never achieve financial freedom with properties in low-cost cities. An example will show the problem.
Suppose you buy a property in a city where rents rise 2% a year and inflation is 4%. You decided to buy this property because it has good cash flow. But what will inflation-adjusted cash flow look like in 5, 10, and 15 years? Let's assume the initial rent is $1,000 a month.
The formula to calculate future value is:
- FV = PV x (1 + r)^n / (1 + R)^n
Where:
- r: growth rate
- R: decrease rate
- n: number of years into the future
- PV: present value
Using the above formula, I will calculate the rent for 5, 10, and 15 years with 2% growth.
- 5 years: $1,000 x (1 + 2%)^5 ≈ $1,104
- 10 years: $1,000 x (1 + 2%)^10 ≈ $1,219
- 15 years: $1,000 x (1 + 2%)^15 ≈ $1,346
In our example, rents are rising by 2% each year, but inflation is reducing the buying power of your money by 4%/Yr. Here are the combined effects of a 2% rent growth and 4% inflation.
- 5 years: $1,000 x (1 + 2%)^5 / (1 + 4%)^5 ≈ $907
- 10 years: $1,000 x (1 + 2%)^10 / (1 + 4%)^10 ≈ $824
- 15 years: $1,000 x (1 + 2%)^15 / (1 + 4%)^15 ≈ $747
What does this mean?
- In 5 years, the rent will be $1,104, but it will only buy what $907 buys today.
- In 10 years, the rent will be $1,219, but it will only buy what $824 buys today.
- In 15 years, the rent will be $1,346, but it will only buy what $747 buys today.
This is the result of buying in a city where rents do not outpace inflation. No matter how many properties you own in such cities, it is only a matter of time before you will be forced to get a job.
What if you buy in a city where rents increase faster than inflation? For example, suppose you buy in a city where rents increase 6%/Yr, and inflation is 4%, and initial rent is $1,000/Mo.
- 5 years: $1,000 x (1 + 6%)^5 / (1 + 4%)^5 ≈ $1,100
- 10 years: $1,000 x (1 + 6%)^10 / (1 + 4%)^10 ≈ $1,210
- 15 years: $1,000 x (1 + 6%)^15 / (1 + 4%)^15 ≈ $1,331
Despite inflation, your buying power is increasing, so you maintain (and improve) your standard of living. Said another way, only if you buy properties in cities where rents outpace inflation can you achieve financial freedom.
The Most Important Criteria
There are several criteria for selecting a city to achieve financial freedom. The most important is population growth.
As I stated earlier, prices only increase when there are more buyers than sellers. This only occurs when the population is increasing. And, for rents to rise faster than inflation, population growth must be significant and sustained. Here is one source for population growth: Wikipedia
Jamiru, if you buy in a city where rents are increasing faster than inflation, rent growth and appreciation will correct all but the worst mistakes over time. If you buy in a city where rents do not outpace inflation, there is nothing you can do but sell the property and buy in a better location.
Let me know if anyone wants to see the process for selecting a city for financial freedom.
FERNWOOD Team, KW VIP Realty520 Reviews