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
• 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?
Related Posts:
1) Before Retirement, Eliminate Your Biggest Expense
2) Adventures in Refinancing, Chapter 5
3) Which is Better – Points or No Points on Your Mortgage?
Photo Credit: MMD
I’ve heard some horror tenant stories, but somehow I’m still interested in having rental property. I’d make sure that I could handle that mortgage on my own in the even that I can’t find a tenant though.
Good point! There’s naturally going to be times where you may not get tenants or they will miss payments. Then you’ll be stuck with the mortgage! Being naturally able to carry those costs if need be would make a nice safety margin.
I’ve heard horror tenant stories but it’s from people that can’t afford to have rental properties. The #1 problem with rentals is that the majority of people owning them can’t afford to cash flow the rental payment (if the property goes unrented). Therefore, the landlord is forced to jump at the first tenant that shows interest and wants to rent.
Sure, you want to keep the place rented, but if you’re in a good financial position then you can turn away people that you think might be bad tenants.
Don’t forget you can deduct the mortgage interest on your taxes! And property taxes for that matter (I think).
Good points, especially on safety and being prepared to cover your own expenses. It always come back to “don’t buy it if you can’t afford it”, doesn’t it?
Great article! I always ask myself whether to rent or note. Thanks for running the numbers and for resolving my quantitative concerns.
Welcome to the site! It’s somewhat eye opening to crunch the numbers and see what you’d get. A LOT of assumptions though.
Given where I live, there is absolutely no way to buy a house and make a profit from it at this time because housing is so expensive. In fact, I think most places would take years and years for you to eventually turn a profit on your initial investment.
That may be true. But I was surprised at how much people were asking in my city for rent. You definitely have to leverage the rental income against the expenses.
Owning a rental property is very appealing especially if you can purchase a property for $80K. I envy you.
Several years ago my husband and I were very interested in owning rental properties. We love buying and selling homes and we really got caught up in the home flipping shows.
We made the mistake of spending a lot of money on the Robert Allen real estate program which teaches people how to buy and rent or buy and flip. We stopped ourselves from purchasing properites based on all of the negatives that you listed above.
The one thing that the Robert Allen program included was a property calculator that allows you to do your calculations before you buy. Once you input a percentage for repairs and a percentage for vacancies and for insurance, if you end up with an annual negative cash flow you obviously shouldn’t buy the property. But if you end up breaking even and if the value of the home will increase in 3 to 5 years, then the rental property is worth considering.
I’m usually skeptical of any [Name] [ Name] programs, but that does sound good that at least he had some calculations to help you determine if it was a good deal or not. Those flipping shows make it look so easy to turn a profit! I think it helps if you know what you’re doing and how to fix things up. I am unfortunately not very handy, so I would be one of those nightmare episodes where I spend way over budget and barely sell the house at cost 🙂
It would be interesting to get a feel for it all by buying a duplex or triplex and living in one unit. That way you’d have better behaved tenants and a place to live out of the deal. I, too, am interested, but it would take a few properties and sales to get me where I need to be on this.
It would be very interesting! Your logic is why I selected a home in my neighborhood for this example – to keep an eye on them! To further explore this, I’m going to have another post soon to compare rental income to the compound returns of an Index Fund.
I wrote a series of posts chronicling my family and our details decision on whether or not to get a rental property. Some things to consider… I talked to a mortgage banker and they said minimum down payment on an investment property was 25% and interest rates were going to be higher than for a principal residence. Just some food for thought as I am sure all banks aren’t the same.
Thanks Lance. Right there – the down payment and interest rate – would cut directly into our profits and change the benefits completely.
Another follow-up: I just spoke with our mortgage company and explained my intensions. They said they could do 20% at 3.75% for 30 years.
I don’t know if you’re suburban or not, and if the market where you live is the same as the one around here, but I know in my area there’s a shortage of rentals in the suburbs, so landlords usually have a choice in tenants. (In my observations.) So the big question is: are you going to do it?
There seems to be no shortage here. I live just outside a major US city. Having your choice of tenants would be nice!
No, I’m not going to do it yet. I’m just in the number crunching phase. This year all my discretionary investment money is in dividend stocks (also on my bucket list of things to learn more about).
Wow 79K doesnt even pay for a Door in my neighborhood. It’s a given you could get horrible tenants or you might not have the same terms as you mentioned. But if I had 15K of fun money I think I would lean more towards buying the investment property and getting high quality tenants from the realty company with a credit check to minimize any risks. After 5 years you should have a paid off mortgage with a passive income that will only grow with increases in rental income.
Ha! Houses in my area were hit pretty hard and have become quite cheap. It’s definitely a good time to catch one if you’ve got the cash for it.
My friends are looking for a new house (the ones I wrote about today actually!) and their mortgage is currently $900, and they could rent that same property for up to $2000. I can’t believe it. Renting is so much more expensive. My friends have decided not to do it themselves, though, because they are expecting a child and don’t really want to be landlords. There are management places that would take care of the property for you, but they of course cost a bit 😉
The whole management company aspect is another thing I noticed but left out of this example. I’ve heard both good and bad about them. Regardless, it is crazy how much people are asking for rent these days! You’d almost be better off with a mortgage if you can meet all the requirements!
MMD,
I keep enjoying reading your posts and how you share details. Buy/Rent decision is actually on our table right now and it occupies our minds. You showed cristal clear path how to apporach it in a simple yet very practical way – something i value very much.
Thank you
Thanks Alik! Always glad to help. Just remember that this example is very over-generalized! I think there are far more upkeep costs than people realize that would probably eat away the profits.
I think owning rental properties is the way to go. Sure, you hear stories of terrible tenants, but are the people renting to these people actually screening for good tenants? I have some family members who have had bad experiences but that rent to the first person interested and do no inquiries. In my are renting is just as much and nowadays more than a mortgage payment so it seems like a great opportunity.
I agree that you can’t sell out to the first person who shows interest. A solid credit rating, referrals, and “the feeling in your gut” can go a long ways in picking the right tenants. And those that manage to do so are the ones that praise rental income – go figure!
Great article! Some very good points I would’ve used when I bought my first house.
This comment is one I’ll be caching permanently…
“It’s meant to teach you to look for opportunities”.
Thanks and welcome to the site John! Whether its rental income, stocks, or anything really, its all about minimizing risks, recognizing opportunities, and finding the best return for your time (the greatest currency). I’m glad you touched on this subtle theme.
I’m still in shock houses can cost $80K. 🙂
Yeah, living next to one of the most dangerous cities in the USA will do that. The sad part is that six years ago that $80K house in the picture was selling at $160K during the peak of the housing boom. SAD……
This is something that we’ve definitely been thinking a lot about lately. The market is great for buying but I don’t know if I want to deal with the hassle.
I think you just summed up my whole opinion on the matter! Whether the numbers make sense or not, do I really want to deal with tenants (or pay someone else to)? My Index Fund never calls me to tell me there’s a problem with the water heater!?
It’s all about location, if you think you can find a tenant easily for that property. Then it’s a go!
I would assume, with the housing prices around that area so low that you live in a smaller town, you’ll have a hard time finding a good tenant that will stay for long.
But renting consistently is the best way to pay off your mortgage faster!!
Hi PC! Nice guess, but you are wrong about the small town. I actually live in a suburb just outside of a very large city.
I’m in total agreement about the possibility of keeping good tenants. We’ve had a few renters in our neighborhood before and it wasn’t for the best. Now maybe that was because the people who screened them didn’t do a great a job. Or maybe that’s the only type of people looking to rent.
On the subject of location, I’ve also considered picking an area near a college. It seems like college kids would be a steady stream of potential renters.
You’re lucky you live in an area where your rental scenario makes sense. Up here, 79,000 wouldn’t even buy you a 1 bedroom condo!
Ha, I’ll send you our crime statistics and then you can tell me if I’m lucky 🙂 But I see your point – The amount of money that houses are depressed right now varies from place to place. And right now is a prime “buy low” opportunity for those in my city.
I’m right there with BeatingtheIndex. I don’t think you can get anything for under 100k in Los Angeles.
Holy cow! When I watch house flipping shows on TV, I can’t BELIEVE how much houses go for in California!! 1,000 sqft homes for $500K! For me, that’s so crazy! I hope your pay wages are far greater than what we’re getting over here in the East! 🙂
I own a rental home. It produces income, but the upkeep numbers are much bigger than you’re considering here. (It almost seems like an afterthought).
I’m between renters right now (just lost an awesome one who stayed for quite a while). Here are some costs: I’m paying $10k for a new roof, $3k for new appliances and still have paint, hardwood floor refinish and some electrical work I’ll do myself. There goes much of your profit number.
I still like it, but it isn’t for everyone. Dealing with renters can be a harrowing process. REITs might make more sense for passive investors.
There you go! I didn’t even factor in home repairs and upkeep costs into the profit model. Those costs right there would devour your income! I’m sure this process is just as much about finding the right house as it is finding the right people to rent to.
I hear a lot of good and bad things about REIT’s. Sounds like your next blog topic AJ!
You can also deduct interest payment and depreciation expense through S-Corp(through schedule K-1).
Is that for your individual tax return or if you have an LLC?
I am most prefer to buy a house and rent it out rather rent a house alone. Glad to know some of your thoughts here and I really appreciate it. Thanks!
When you look at the numbers it does make sense, but you also need to know that you will also become a property manager. But even though it still sounds like a great way deal with the slow real estate market
Becoming a property manager or outsourcing a chunk of my profits to someone else to handle it is one of the biggest reasons that keeps me from not doing it. My 401k has never called to complain that the heat is isn’t working.
Great point! I would hate to be a property manager.
There would be no rest for the weary for sure!
MMD,
Enjoying your blog. My wife and I manage rental properties while holding our full time jobs. It’s certainly not passive, but a real wealth builder if you are prepared to make the commitment. You can read all the books you want – the only real to way tell is to pick up a property.
The deal you sampled above is not ideal. Your returns would not be this great as you have not calculated any maintenance costs or potential vacancy. This also assumes you are managing your property – which I think is fine – we manage ours too. Here again – be prepared its not as passive as many make it out to be.
I started blogging my rental experiences a couple years ago. I try and and get into the weeds of the day to day management as opposed to just high level stuff. You might find it interesting.
Good luck – enjoying your blog.
Chuck
BTW, I forgot to add. Now is an excellent time to buy. Values are down as we all know, and I doubt we will ever see rates this low again in our lifetimes.
We buy so that we are happy with the current returns – we dont speculate on appreciation. Any appreciation will be just gravy upside when we exit. Our exit plan is to sell with owner financing 20 years from now. Then all the maintenance, repairs, taxes, insurance, etc.. is all on the buyers side of the ledger. This is more like passive income.
I agree! I also don’t think we’ll ever see rates this low again for a while (it would be sad if the Fed kept interest rates at 0 to 0.25% forever!). For anyone with any ambition to pickup another property, now would be a good time. Just make sure you know what you’re getting yourself into first! 🙂
Thanks Chuck! I’ll have to check that out. I’m sure there is WAY more to being a landlord than my simple example demonstrates. And its those “weeds of the day to day management” that keep from actually going through with it 🙂
I am a new reader to your blog…have been reading about a month now. Love it. I am interested in purchasing single family rental home property as well and have been reading up a good bit on the subject lately.
Some of the numbers/formulas I’ve seen to evaluate rental properties are that rent should equal at least 1% of the purchase price or more, so if you believe that you could get $800 on a $79,000 home, then you are hitting this 1% number.
Some investors suggest you should get at least 1.15% or higher rent compared to purchase price in order to cashflow properly. The way some people suggest using this formula is to check rents on comparable properties. Then divide the expected rent by the percentage you choose (say 1.15%) and that’s what you should offer to purchase the home to make the deal work. $800/0.015 = $69,565, $850/0.015 = $73,913, etc.
Then, I’ve seen values as high as 40%-50% of gross rents suggested as an estimate for maintenance, insurance, taxes, repairs, etc. This is somewhat arbitrary as rents don’t necessarily relate 100% to the value of the property or its age. But, you get the general idea.
Also, when looking at the monthly mortgage payment, only look at principal and interest as taxes and insurance are included in the 40%-50% number above.
Whatever is left over after subtracting your principal and interest and the 40-50% of gross rent is your cashflow. Many places I’ve looked at suggest that $100/month cashflow is acceptable on a single family home once all of the above numbers are taken into account. Tax benefits and possible appreciation are not accounted for at this point.
Keep in mind the 40%-50% of gross rents for maintenance costs is a suggested average.
I’d like to keep my leverage around 70%-75% (i.e. put 25%-30% as a downpayment for each property) in order to maintain a decent cash on cash return. The more you put down on a property, the less your cash on cash return is…as many will tell you, “the best part of real estate investing is using other people’s money via leverage.” In order to feel comfortable doing this, I would want to have a large reserve of stable I-bonds, CD’s, and Treasuries to cover the majority of the balance of the mortgages in case things don’t go as planned. This would make me feel better about the mortgage debt that I would be carrying. That’s just a personal preference of mine. Of course, that means that it will take me longer to acquire my properties than simply leveraging up a bunch of debt via mortgages without an offset to this debt in the form of stable investments. But, that’s just me. Since I would have a large stable portfolio of I-bonds, treasuries, CD’s, etc., my strategy would coincide with a heavy asset allocation of various stock index funds in my brokerage accounts/401K.
So, when I am planning out my future rental portfolio, I look down the road at the free and clear properties once the mortgages are paid off. The numbers I come up with give me a cashflow at that point of 50%-60% of gross rents since I no longer have mortgage and interest payments.
If I follow through with my plans, and I’m unsure at this point if I will, 20 properties bringing in an average of $900/month each would give me a cashflow of $108,000 per year (([20 homes * $900 rent]*12) * 50% = $108,000). I’m 35, and it may take me 10 years or more to get 20 properties, but by the time I near retirement, they would theoretically all be paid off (use rent and any extra cashflow to throw at the mortgages). Also, this doesn’t account for appreciation or tax benefits.
This is my non-get-rich-quick plan to buy-and-hold real estate investing.
I wanted to share these numbers with you since, as others have mentioned, it seams you briefly talked about “repairs” and may not have taken into account many of the expenses associated with real estate investing when doing some of your calculations.
Anyway, those are the numbers that I’ve come up with so far. As I said, I’m definitely not a real estate investing professional, so I’m not sure how accurate these formulas and numbers are, but they seem doable if you are willing to wait for the prize. The $108,000/year (would likely adjust for inflation as rents would likely rise and properties would likely appreciate) sounds like a nice supplement to my 401K/IRA.
As others have mentioned, there are definitely risks with real estate, but there are risks to any investment.
Sorry for the long post, but I’m curious what you and other readers would have to say about my possible plans as they are all theoretical at this point.
Oh…almost forgot…I definitely would have a management company do as much of the grunt work as possible. While not totally passive income, this would help quite a bit. No burst pipe calls for me.
Hi Richard,
First of all, thank you for being a reader and providing this valuable insight. Your comment could have easily served as a great guest post feature on my blog.
I’m also not anything close to real estate professional and was really taking an outsider’s approach to trying to figure out much return I could expect.
I’m glad to see that my estimated mortgage cost fits with this 1% guideline. On my part, that was pure coincidence. The estimation was based on what other houses in the area were getting after doing a brief survey online for rentals. I like the idea of using the 1.15% and getting more money, but I think that supply and demand for your area is the dominant factor.
I completely agree with your logic to use other people’s money to finance these purchases. While I wouldn’t think you’d want to go to finance heavy on the property (given having a higher mortgage payment and PMI), I think at least covering the standard down payment should be sufficient.
The idea of holding such a good amount of cash in stable funds outside the rental property project is a really good idea. Call it an emergency fund if you will. There’s nothing wrong with creating your own safety net, right? It might take a while to build up, but I think it will go a long ways towards minimizing your risk profile.
Wow, 20 properties sounds pretty ambitious! But I like what you’re doing here. You’re building a diverse portfolio of income properties that will accumulate to over $100K per year. That’s a lot more than I could expect from my dividend stock portfolio. And some may even argue that it would be less risky.
Your 50% evaluation for expenses including taxes, insurance, repairs, and management company fees makes sense to me. I would also need the management company as I would not really have the time or resources to correct issues myself.
As you mentioned: This is by no means a quick get rich scheme. But it is a plan! It may take you a while to get to the point where you have paid off the mortgages and are retaining 50% for yourself. But that would be a very powerful income supplement. Not to mention the other thing we haven’t yet addressed: The equity in the houses! If you own 20 houses at $100K each, then you’re sitting on a portfolio of $2M in addition to whatever wealth you have. That’s not too bad!
We are buying a rental property soon. Here in Colorado, the rental property is on fire. Post a home on Craigslist and you’ll get 10 people calling you in the first hour.
I was a landlord before and never had a bad experience. I was extremely choosey on who we would rent to. People would come over and they’d seem great. We’d run their credit though and then realize what a disaster the individual’s personal finances were. The bottom line for me is that I’d much rather have the house sit empty for a month than rent to the wrong person.
That’s refreshing to hear. I don’t think a lot of people would have the gull to let an investment property sit vacant when they have people that want to rent it. But you’re right. What good is a tenant that doesn’t pay? If you can see the writing on the wall, then you’re better off not renting to them and keeping your standards high.
I’m about to get married in about a year or so. We both own houses. But she just refinanced so we can’t sell her house yet. I bought my house for $133,400 in 2005. and now it is estimated at $104,000. I live in Willoughby, Ohio. My house was built in 1956, its 960 sq ft Ranch style house. 3 bedrooms and 1 bathroom, Full basement. I still owe about 120’s on my house. So I was thinking of maybe renting it out. Atleast until the market comes back up. In the mean time, I put money back into the house by fixing up the house, windows, redoing the kitchen, A/C unit, Redoing the Bathroom, ect.. How much do you think I can get out of it in Rent?
Hi Dominic,
The best thing to do is check local listings for comparable houses to rent. Go to Craigslist, the newspaper, or any other renter service and see what people are paying each month. Then compare that figure to your mortgage plus bills, expenses to keep the house running. If you’d make some money, then great – perhaps it could be a potential rental property. However if not, then perhaps you may want to consider doing a short-sale. Have you tried to call your mortgage rep to see what kind of “exit” options you have?