Summary: Buying a rental property and holding onto it long-term is one of the best ways to build wealth. This article explains how this strategy compares to other common real estate investing strategies, and why we believe the buy and hold strategy is ideally suited for doctors and other high-income professionals.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
If you are thinking about buying a rental property as an investment, you should understand the different strategies used by investors to make money and build wealth.
While there are many variations of what you can do with a rental property once you own it, the methods essentially boil down to one of the following investment strategies: buy and hold, appreciation play (buy and sell), flipping (buy, fix and sell) and buying a personal residence as an investment (buy, live, fix, rent and repeat).
This article will discuss these strategies in detail and explain why the buy and hold strategy is ideally suited for doctors and other high-income professionals.
What is the Buy and Hold Strategy?
The buy and hold strategy is when you purchase a property and plan to hold onto it long-term (and perhaps even for a lifetime).
When buying properties using this strategy, you want to be sure that the property generates positive cashflow. This makes it easier for you to hold onto the property for a long period of time.
Imagine owning a property that loses money every month. You would need to cover this loss with the money that you make from your regular job for as long as you own the property. If you were to lose your job or if you couldn’t work because you became ill, you would have to cover these losses from your savings or worse, sell it at a loss.
You also want to buy properties that give you as much cashflow as possible. This is to not only ensure that you can cover unexpected expenses, but also maximize your return on investment using this strategy. We personally aim for at least a 10% cash-on-cash return. We say “at least ” because this is an initial target. This is discussed in more detail in a previous article.
Most real estate investors use a cash-on-cash calculator (COC) to determine whether the property will perform to their expectations. Make sure to download a FREE copy of our COC below
How Do You Build Wealth with the Buy and Hold Strategy?
When you buy and hold, you generate wealth in a number of different ways.
This is the income your property generates on a monthly basis. Cashflow is similar to the interest you make from your savings account. If you buy a property that gives you a 10% cash-on-cash return, you receive 10% “interest” on the money that you’ve invested in the property. However, it’s different in that your cashflow can sometimes go up or down depending on what happens to the rent or expenses. It’s also different because the cashflow is often earned tax-free.
This is the share of the property you own. You can gain equity in one of two ways. One is the equity you gain when your tenant pays your mortgage down with each rent payment, assuming you buy the property right and the rents cover the mortgage payment. The second way is when the property appreciates. This is a much more significant source of equity because of the power of leverage. When a property appreciates, the increase in value is based on the total value of the property, not the small portion that you own. It’s even more powerful when you force the property to go up in value. This is called forced appreciation and you can read more about it here.
In many cases, you won’t pay taxes on the cashflow your property generates. Therefore, your investment can grow tax-free. The benefits are even greater if you show a loss on your tax returns and you shelter your income using real estate professional status. We explain this in an article, you can read about it here.
While rent appreciation rates vary significantly depending on market conditions and location, it’s probably reasonable to assume that rents will go up on average by at least one to two percent per year. When rents go up, so does your cashflow.
This is one source of wealth building that investors often miss. If you re-invest all of the above cashflow, tax savings, and rent appreciation, your money grows much faster than if you used this income to pay for living expenses. To illustrate the power of compounding, refer to the chart below. The chart shows how your money grows with compound interest versus simple interest. Assume in both cases, you start with $100,000 and you receive a 10% return. With compound interest, your $100,000 grows to nearly $700,000 in 20 years. With simple interest, your money only grows to around $300,000. As you can see, if you reinvest your interest instead of spending it, your money grows much faster.
One other source of wealth building is through leverage when you sell a property. While the buy and hold strategy is not about selling, having a portfolio of properties in different neighborhoods gives you the opportunity to take advantage of a rapidly appreciating property.
In these situations, you are able to generate extremely high returns because of leverage. Leverage is when you use the bank’s money to buy a property, allowing you to put very little of your own money down (usually 25-30% of the purchase price). However, when the property appreciates and you sell, you keep all of the appreciated value while the bank gets none.
In order to maximize your wealth building, you’ll want to reinvest all of this money, ideally using a 1031 exchange in order to reinvest the money tax-free. We cover 1031 exchanges in this article.
How Does Buy and Hold Compare to Other Investment Strategies?
Appreciation Play (Buy and Sell)
This is when you buy a property and wait for it to appreciate in value before selling. It’s common for these properties to have negative cashflow. So one challenge with this strategy is the cost of holding onto these properties (mortgage, taxes, etc.), sometimes for years, or even decades.
I pursued this strategy in Florida before the market crash in 2007. Between 2004 and 2007, it was common for these properties to double or triple in value in one year. However, once the market crashed, the values of these properties declined by 90% or more. Properties I bought for $125,000 were valued at less than $5,000.
Because I bought raw land, there was no chance to collect rent to cover the mortgage and taxes. At one point, I had to work 26 hospitalist shifts every month in order to cover the mortgage payments. I have since sold these properties at a considerable loss. That’s after paying the mortgage and property taxes for over 10 years. You can read more about my experience HERE.
Some would call appreciation plays to be akin to gambling and, based on my experience, I would agree.
Flipping (Buy, Fix and Sell)
This is when you buy a property, fix it up and hopefully sell it for a profit. There are many risks involved with flipping, and success with this type of investing requires considerable skill.
First, you have to be able to properly assess the “bones” of the property. Is the foundation solid? How are the main structural elements of the house? Is there any evidence of leaking in the basement or from the roof? If you get any of these wrong, you could go way over budget on your renovation. You could also lose money on the flip.
Second, you need to be able to properly assess the renovation cost. Coming up with accurate estimates for both materials and labor costs usually requires years of experience to get right. You also need to build in a cushion for unexpected issues that often arise in these types of projects. Getting any of these wrong means losing money on the project.
Third, you have to fix up the property in a way that appeals to a broad audience. This requires you to have some interior design skills. Getting it wrong means that the property doesn’t sell or it sells for less than expected.
Last, you need to be able to come up with an accurate market price for the property once the project is completed. This requires you to be able to assess comparable sales (comps), as well as understand the “x-factors” that will raise the value of the property above the comps. If you price the property too high, you run the risk of having the property sit on the market, adding to your selling costs because you have to continue to pay financing costs, insurance and taxes until you sell the property.
In addition to the above risks, another problem with this strategy are the costs you incur every time you sell. These include selling costs and taxes.
Selling costs include real estate agent fees (usually 6% of the sale price, paid by the seller) and closing costs (usually 2-5% of the sale price). Some states like Washington have a real estate excise tax of 1.28%. Add it up and your selling cost can be as much as 10%.
Your taxes on the sale depend on how long you hold onto the property. If you own the property for less than a year, then you pay short-term capital gains taxes, which are taxed at ordinary income tax rates. If you own the property for more than a year, then you pay long-term capital gains taxes at a rate of 15 or 20% depending on your income level plus an additional 3.8% if your income level is above a certain threshold.
Buying a Personal Residence as an Investment (Buy, Live, Fix, Rent and Repeat)
Some believe their home is an investment – we generally do not. The reason is that most overspend on a personal residence. This results in a large down payment and a high monthly mortgage payment, which makes it hard to save enough for investments.
It’s certainly possible for you to make money on your personal residence if it appreciates, however, this is a form of appreciation play. There is no guarantee that the house will appreciate. In the meantime, your down payment is tied up in the property. You are also stuck paying a large monthly mortgage payment.
There is one way to make this strategy work as an investment, which can be especially attractive for doctors who are just coming out of residency. It’s when you purchase a property with little or money down (using a doctor loan, an FHA loan, or a down payment assistance program offered by many employers), fix it up while living in it in order to build some equity in the property, and then eventually rent it out after you move out. You can repeat this process multiple times until you are in a better financial position. This is an efficient way to build up your investment portfolio because you are putting very little of your own money down and you are making improvements to the property while you are living in it. You also will get the lowest mortgage interest rates because the property will be owner-occupied.
If you want to vet some of our recommended vendor partners, be sure to check out our Vendor Directory to find lenders for both residential and commercial real estate, or personal lending.
When purchasing each property, you want to be sure that it will cashflow when you eventually rent it out. You never want to be in a situation where you buy a place, only to later find out that it isn’t even close to cashflowing. Also, you want to be sure that any improvements you make to the property are within reason. In other words, this isn’t your dream home, so don’t go over the top with expensive improvements. Remember, the more you spend on improvements, the lower your cash-on-cash return.
One variation of this strategy is to buy a multifamily property and live in one of the units. This is sometimes referred to as “house hacking.” The benefit of house hacking is that you get rent from the other units while you’re living in the property. We have personally house hacked before and found it to be a great way to live rent-free and build wealth.
Why is the Buy and Hold Strategy Ideally Suited for Doctors and High-Income Professionals?
For most people with high-paying jobs, the goal of real estate investing is to build wealth, not have real estate investing become another job.
Other forms of real estate investing such as buy and sell (i.e., flipping) can generate significant yearly income, but it’s so hands-on that you are essentially signing up for a job.
Therefore, it is likely going to be more difficult to balance a “flipping” business with your demanding day job. Whereas it is relatively easy to balance your day job with a portfolio of rental properties.
High-income professionals are uniquely positioned for buy and hold investing. The reason is that it’s relatively easy for them to come up with the down payment and qualify for a loan. For most people, these are huge barriers to entry. This gives doctors and high-income professionals an advantage over others when buying properties.
This advantage is magnified when buying properties with cash. When the competition for a particular property is fierce, cash buyers have a distinct advantage over others. Sellers prefer cash buyers. Unlike stocks, where anybody, regardless of their credit can purchase a stock, the ability to buy a property is limited to those with good credit and enough savings for the down payment or the entire purchase price.
One last reason the buy and hold strategy is ideally suited for doctors and high-income professionals, is the potential tax savings. If you have a high W2 or 1099 salary, you’re already taxed at the highest rates. In turn, there are very few options for sheltering your income.
Compared to other forms of investing, you can generate income from your properties tax-free. This is due to the fact that cashflowing properties often don’t generate taxable income. This is covered in more detail here.
One powerful way to shelter your income is to combine the buy and hold strategy with real estate professional status to lower your taxable income. Those who take advantage of this tax loophole can grow their wealth much more quickly than those who don’t.
When Should You Sell Your Buy and Hold Property?
It’s important to point out that buy and hold does not mean you will never sell. One of the main reasons you may want to consider selling is to cash in on a rapidly appreciating property.
This happened to one of our properties in Seattle. Seattle home prices have grown faster than any other U.S. city. In addition, our property is close to one of the new light rail stations. So the city is investing in the surrounding neighborhoods. We estimated that our property appreciated by about 30-40% in the last two years. Therefore, we decided to put the property on the market. We used the proceeds using a tax efficient 1031 exchange to buy a mixed-use property and another property, which eventually turned into our 32-unit multifamily property.
This is one of the main benefits of the buy-and-hold strategy. When you have cashflowing properties, there is no pressure to sell. You have the luxury of waiting for a property’s value to explode. If you have properties in multiple locations, it’s like having multiple bets at a roulette table and seeing which one hits. Unlike gambling, however, you win even if your properties never appreciate (which is unlikely).
It’s important to point out that any time a property appreciates, you experience a step up in your net worth. While you aren’t counting on this happening, the likelihood that something like this happens goes up the more bets you have out there. This is one reason we are looking to invest in multiple cities across the country (read about out-of-state investing here).
The other reason to consider selling your buy and hold property is when it fails to meet your cash-on-cash criteria. Sometimes your cash-on-cash estimates are off because your income or expense estimates were wrong. This might happen if the rental estimates you received were too favorable. This is actually quite common because sellers will inflate the rents in order to attract buyers. You might also have higher than expected vacancies or higher maintenance costs. If your property doesn’t provide an adequate return, you should sell if that money can be used elsewhere to generate higher returns.
One thing we try to do on a regular basis is to measure the return we are generating for each of our properties and compare them head-to-head. You may find that some properties are underperforming, and the money invested in those properties would be better spent reinvested into a new property.
One last reason we’ve been selling our buy and hold properties is to take advantage of 100% bonus depreciation. We’ve been using bonus depreciation and real estate professional status to shelter our W2 income for years.
With 100% bonus depreciation being phased out, this might slow down our selling and we may shift to holding our properties for a longer period of time.
If you’re thinking about investing in rental properties, be sure to understand the different investing strategies.
We believe the buy-and-hold strategy is ideally suited to doctors and other high-income professionals.
You can achieve large step-ups in wealth when your property appreciates in value. This can happen naturally with market appreciation but you can also force appreciation.
Have you found a way to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Physicians (for MDs or DOs only) or Professionals group!
Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.