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When it comes to buying real estate as an investment, there are several different models you can follow to plan and forecast your returns. An entrance strategy defines how you choose a unit that you believe will be profitable vis-a-vis the market it’s located in.
The four most common investment strategies when it comes to selecting and purchasing a property are:
- Bargain Purchase
- Increase Value
- Double-Digit Cap Rate and
- Appreciation Strategy
A bargain purchase involves attempting to buy real estate at 20% or more below the current market value. For example, homes that have been foreclosed are often obtained at a price considerably lower what they are worth. As many investors know, this strategy comes with it’s own share of complications, since foreclosed homes are very hard to finance from a traditional lender and will often require private money. Bargain purchases can also be identified by calculating whether a unit is listed at a much lower price per square footage than the average in its borough, and whether the passive income it generates will outweigh its holding costs. Find out how to do that in this article on identifying a good investment opportunity >>.
In the increase-value strategy, you pay market value for a property, but you select only those homes that have an unrealized potential. For example, if you notice that a home could sell for much more with some simple renovations and touch-ups, you could increase the value of the property in a short amount of time and resell. This entrance often goes hand in hand with the “Fix and Flip” holding strategy. Once taxes and purchase costs have been weighed in, a property needs to increase at least 20% in value within 6 months to qualify as a profitable flip.
Double-digit cap rate involves buys a building that has a capitalization rate of 10% or more. Capitalization rate is the net operating income (rent minus operating expenses but before debt service) divided by the purchase price. You can think of it as the cash-on-cash rate of return you would get if you owned the property free and clear. In general, double-digit cap rates are very hard to find., occurring only temporarily in depressed markets or in small niched market.
Appreciation strategy: This is probably the most common entrance strategy. It involves buying real estate at market value in a place where the investor believes there will be a market-wise increase in home prices. For an appreciation strategy to work, an investor must “buy and hold” the property, occupying it or renting it for at least 5 years to increase its returns. The risk in this strategy lies in the fact that no one really knows what the real estate market will do, and therefore any appreciation forecasts made are pure speculation. However, with some research and market knowledge, it’s possible to make a smart and educated guess. Read our article on “What Makes a Neighbourhood Valuable” for some pointers.