When it comes to buying stocks, the old rule of thumb is to “buy low and sell high”. If you’re fortunate enough to understand this saying, then you’ll know that it doesn’t just apply to stocks. It’s meant to teach you to look for opportunities.
So even though the value of my home seems to go down, down, down every year, perhaps therein lies an opportunity. As I walk the dog through my neighborhood, there is an abundance of houses for sale. And what’s more is that I KNOW they are selling for FAR less than what I paid for mine. So this gets me thinking:
• If I have any aspirations to buy a house and rent it out, is now the time?
Why Am I Thinking About This?
Real estate is one of the things on my “investment bucket list” that I have yet to try out as part of My Money Design. It’s hard to ignore all the buzz about it. Of all the personal finance blogs I read, I’d say at least 25 to 50% of them proclaim that receiving rental checks is a great (if not the ultimate) source of passive income. In addition there are lots of financial guru’s out there that have made their millions off of real estate.
Now granted these claims come from a diverse range of geography. In my own my personal and local sphere of life, I’ve certainly heard terrible things about become a landlord (especially with nightmare, non-paying tenants).
However, I’m willing to believe that some good opportunities do exist. I might be able to find some good country houses for sale or other local options if I’m willing to put in the effort. So understanding that the clientele may be a roll of dice, let’s run the cold, hard numbers and see what kind of rate of return this type of investment would produce.
Crunching the Numbers:
Let’s begin by selecting a smaller ranch home in my neighborhood. It’s a recently built 3 bedroom, 2 bathroom estimated at 1250 sqft. Assuming I put down 20% and take out a 30 year mortgage at 4.00%, I’d have the following payments:
• Sale Price: $79,900
• Down Payment (20%): $15,980
• Loan Amount: $63,920
• Interest Rate: 4.00%
• Monthly Principal and Interest: $305.16
• Annual Property Taxes: $1,782
• Annual Hazard Insurance: $420
• Annual HOA: $360
• Monthly Loan Payment: $519
So now after doing a quick search of rental homes in my area at a comparable home size, I estimate that I could ask roughly about $800 per month in rent. If I was successful in finding a tenant, I’d receive:
• Monthly Rent: $800
• Monthly Profit: $281
• Total Annual Profit: $3,372
Return on Investment:
So by investing about $15,980, I’d make roughly a 21% return in the first year. Although that’s better than getting 8% from a stock market Index Fund, is $3,372 per year a great return? Why I bet that if I worked really hard on this blog, I could probably make that much in a year in advertising with far less capital investment. So why take the risk?
Rental Properties are More Than Just Cash Flow:
Slow down there a second! Is $3,372 REALLY all I’d be making? Of course not! Don’t forget that the house itself is also an asset in this investment. To illustrate this, let’s take a closer look:
If I were to set up a Balance Sheet for this project, at the beginning (Year 0) it would read:
• ASSETS: House Value $79,900 (market value of the house)
• LIABILITIES: Mortgage Debt -$109,859 (total interest and principal I owe the bank)
• EQUITY: Net Equity -$29,959 (the difference between the two)
What would I really be doing with those $800 rent checks? Paying the $519 mortgage and pocketing the other $281. Now remember: Of that $519, $305 is going towards the principal and interest. So at the end of the first full year (Year 1), my Balance Sheet would change to look like this:
• ASSETS: House Value $79,900 + Total Annual Profit $3,372 = $83,272
• LIABILITIES: Mortgage Debt -$109,859 + Twelve P&I payments $3,662 = -$106,197
• EQUITY: Net Equity -$22,925
• Change in Equity: $7,034 (a 44% return on that $15,980 down payment!!!)
NOW how does that 8% return on a stock Index Fund look? Pretty puny, huh?
Consider the Bad with the Good:
Okay, don’t get too excited after reading this EXTREMELY overly optimistic example. We totally ignored:
• Closing costs
• Income taxes on the rent
• Administrative and legal costs
• Change in value of the market price of the house
• What if the mortgage terms were different?
• What if I didn’t have 20% to put down?
• What if I had to charge less than $800 per month?
• What if no one rented from me?
• What if my tenants were scum and never paid on time or at all?
• What if something happened to the house and I needed to pay repair costs?
• What happens when appliances break? Will you call out a repairman? Will you go to the hardware store and fix it yourself?
• What happens if the home is a victim of a home burglary? Do I have to install a home security system?
Although this exercise was meant to crunch the numbers, you still have to consider the qualitative factors. All investments carry risk. These points are not deterrents; but they should not be taken lightly as each one can significantly impact your return. The point is to make sure you consider all your risks before you just jump in.
Do you own houses that you rent? How much return do you make on your properties? Are your tenants a terror or are they pretty good? Would you recommend this as a good investment strategy?
Photo Credit: MMD