Buying an Investment Property

For the sake of diversification, many homeowners will search to spread their assets across a variety of different investment platforms, and rental properties can be one of those attractive alternatives.  Below you find a lot of useful information that you can use when deciding whether or not an investment in real estate is right for you.

At first glimpse, buying a rental property can seem like a no-brainer investment opportunity. As we have all seen on a random Thursday night, on any of the multiple channels on TV featuring a new and innovative way to invest in real estate, the strategy can make people millions (at least that’s what’s advertised).  We all know that many fortunes have been built exclusively around real-estate, but let’s put things into perspective.  While you may not become a millionaire with a rental property, making the investment into real-estate can prove to be VERY lucrative.   

We will break things down a few different ways.  First we will explain the real way in which you would want to value an investment opportunity.  This is no different than analyzing a stock purchase or any other investment vehicle.  Second we will break down some things to consider when investing in real-estate, and lastly we will list some final thoughts.

 Let’s begin with a real world example.

You just bought a three unit building for $200,000 with a $40,000 down payment, at today’s rates, your 30-year mortgage payment would be right around $1,350 a month (this is assuming yearly taxes of $5,000 and yearly property insurance of $1,800).

Charging $900 per unit would mean that the property could be rented out for $2,700 a month.

 

Ok, now lets get to the fun part… expenses.

Major property expenses

The first major expense (for most people at least), will be the mortgage taken out to purchase the property.  A mortgage for a rental property will have a higher interest rate as well as stricter guidelines (like higher down payment requirement).

Depending on whether or not you will hire someone to manage the building will affect your cash flows.  For this example let’s assume you decide to outsource the responsibilities to a management company.  While the fees vary by city and area, it’s safe to assume the cost will fall around 10% of the total rent.

Aside from a handful of markets, units tend to have (on average) some form of vacancy.  This is the time between renters as well as the cost to find new renters. A 10% loss of income due to vacancy is also a good figure to use.

You also want to consider the fact that properties depreciate.  What this means is that properties wear and tear and generally require some form of upkeep or repair maintenance.  A good figure to use is 10% (it seems like a lot to figure for repairs but when you average in the major ones, i.e. replacing a boiler or furnace, it makes sense).  A good idea is to create a “maintenance fund” for this expense.  If at the end of your investment you have money left over, well then that’s just icing on the cake!

So roughly 80% of that $2,700 (when you consider the mortgage payment) will be taken off for expenses, so far….

Other expenses to consider

People often times stop there when analyzing property investment expenses, but there is still a few more things to consider. 

City fees- many towns, villages, and cities charge homeowners for things like garbage, sewer, and water.  Although the utilities are commonly the responsibility of the renter, the aforementioned costs get covered by the building’s owner.

Lastly, you must consider the tax implication the property will have on you.  Rental income is taxable and although there are exemptions and deductions that one can take, you must still consider that you may actually have to pay taxes on the rental income.  A good rule of thumb is to take 8-11% of the net rent after all expenses (to calculate the tax expense). 

 

Ok so now let’s do some math…

 

First we have to make some assumptions

  • Let’s say the rent trends indicate that rents increase on average by 2% a year.
  • Let’s also say values of homes, historically, go up on average 4% (their appreciation rate).
  • Lastly we need to account for inflation (more on this later) –we will use the 30yr (1983-2013) average of 2.75%

 

Now the actual numbers…

Using the assumptions from above, you will have received a net total of $457,408 in rent (net means total after expenses and taxes).  But wait! What does $457,408 in 30years really mean?  As most of us know, inflation causes prices to go up and inevitably makes our money worth less.  In other words a dollar today has more buying power than a dollar in a year, or any time in the future.  Therefore in reality in order to understand what $457,408 means in TODAY’S dollars we need to discount that figure for inflation.  This is actually very easy to do.  You simply discount the amount received each year by an average inflation rate (in our case the 2.75% we stated in our assumptions).  After the adjustment the amount of total net rent received in today’s dollars is $293,483.10.  

The cash flows (or rent) is one half of the equation.  For some people this can go on for a very long time.  They continue to collect the rent on the properties for their entire lifetime and beyond via inheritance by their children.  Others sell their properties at the end of the 30years or sooner.  Let’s look at the latter.  Again using our assumptions from above, we calculate that the property in 30years (with an average appreciation rate of 4%) will be worth roughly $648,700.  If you have every sold a home in the past you know that it costs money to hire a real estate agent to list and sell the home.  The average cost is 5% of the sales price.  We will also consider seller closing costs at 2% of the sales price.  We now come up with a net sales price of $603,000.  Lastly let’s not forget good ol’ Uncle Sam’s rake.  We will assume that 30 years from now, the government will still tax Americans for gains they receive when selling investment properties.  Now we are down to roughly $482,700. 

So again I ask – is $482,700 in 30 years the same as $482,700 today?  After our lesson in inflation, we know the answer is NO.  After we adjust for inflation our final number after taxes and expenses is $213,869.  How can this be you ask??  Well, if we look at historic data, this sort of makes sense.  Housing prices have historically, on average, only been around 1.25% higher than inflation rates (a quick Google search can prove this in seconds).  So the sales price today ($200,000) really only grew by 1.25% in real terms or to $290,300 in 30years.  After we subtract the realtor sales expense and taxes we arrive at our previous number of $213,869.

Let’s put it all together….

You are now in the 30th year, what was your total return on your investment? You received a total of $293,483 in rent payments (after taxes, expenses, and adjusted for inflation).  You also sold the property and netted $213,869 (after taxes, expenses, and adjusted for inflation).  That’s a total of $507,352.28 in TODAY’s dollars.  Ok now we’re talking!  So in this example you turned your $40,000 investment into $507,532.28 in 30years.  That is a whopping 1,168.38% ROI (Return on Investment) after 30years.  That’s a compound annualized return of 8.84%!!  Not too shabby.  There are very few financial investments that can consistently produce that kind of annualized return for that many years.

 

WOW!!! THAT’S A NO BRAINER right?!! Well hold on, before you click over to Zillow to look for rental properties to buy in your city and run to the bank to empty out our account for the down payment- it’s important to note that although a 1168% return over a 30 year time horizon is eye-popping at first glimpse, if you take that same $40,000 investment and put it in the S&P 500, at the historical average return of right around 8% per year, your return after 30 years would be roughly 900% (without the headache of dealing with tenants, managing a property, or worrying about frozen pipes in the winter).

But you know that and still want to venture into real estate.  Some consider real estate a fairly safe investment and you count yourself in that same school of thought.  Of course you know nothing in life is free and there are obvious risks associated with rental properties.  Tenants issues, housing/rental bubbles and busts, property issues, and of course changes in neighborhoods and or demographics. 

Now that you think you are ready to purchase your first, second, third, or n’th home, we have complied a quick list of things to consider. 

 

1. You make your money when you purchase your property

The best principle to have in any real estate transaction is the understanding that you make your money when you buy it, not when you sell it.  HUH??  Think about it for a second.  Given that we just discussed the true appreciation rates of properties (remember in real terms they are only really around 1.25%) the price you pay for the property today is GRAVELY important. If you pay too much for it, you’re never going to make any real money because the appreciation rate will take a long time to catch up to the inflated initial sales price.

 

2.  Know the area you are investing in.

This seems like a no brainer, but sometimes investors don’t pay enough attention to the area in which the seemingly great (too good to be true) investment is in.  Since the majority of investors buy properties often buy them in neighborhoods other than their own, or even in different cities all together, it’s easy to be lured by what is perceived to be a good deal in an unfamiliar market. Yet just because a home is less expensive than those around it, or in an area on the “rebound,” doesn’t mean it’s worth investing in.  Often, investors see a home at a low price and think they’ve found a great deal, but you must do your research and your homework on the area to truly evaluate whether or not it’s a good investment.  Things to look for are vacancy rates, trends or changes in demographics, planned or scheduled development, school districts, etc.

 

3. Have an exit strategy

Investors can at times be overly optimistic and are sometimes misguided into thinking that only the good things will happen, and that’s what they plan for, but it’s crucially important to have an exit strategy too.

While investing in a rental property can certainly be a profitable and worthwhile investment — don’t allow it to be such a large part of your total investment pool that losing returns from it could ultimately bring you crumbling down with it.  This is especially true for those that may only have a total of three or four units (which is usually the case).  In this scenario, having one unit unrented would result in a 33% total loss.  That’s why it’s so important to have an exit plan if “all of your assumptions don’t work out.” For example, if your rental property from the scenario in the first paragraph were to go unoccupied for a few months, the $2,700 monthly gross income instead turns into a $1,400 monthly expense very quickly — and that could result in dire consequences if you’re not prepared.

 

4. Expect the unexpected

As with any investment decision, and close to any decision at all, things can take an unexpected turn quite quickly, sometimes faster than you would be able to react to it. Just as an example, if the building furnace and roof were to be needed to be replaced during the same month, the cost of the repairs could reach over $10,000, essentially clearing out most if not all of the year’s profits.  Even worse couple that with a tenant who has stopped paying and the consequential loss of income resulting from the eviction process and more than a year’s worth of income can quickly be erased.  Some of these things are not avoidable and uncontrollable, but what one can control is the system in place to deal with these issues.  Better tenant screening processes, repair reserve funds, and larger security deposits are just some of the many combatants to help ease the effects of these unexpected events. 

 

 

 

SIDE NOTE

The Compound Annualized Return Percentage isn’t the actual return in reality. It’s an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of it as a way to smooth out the returns.

Don’t worry if this concept is still unclear to you – the Compound Annualized Return Rate is one of those terms best understood by example.

Let’s assume you invested $10,000 on Jan 1, 2005. Let’s say by Jan 1, 2006, your investment had grown to $13,000, then $14,000 by 2007, and finally ended up at $19,500 by 2008.

Your Compound Annual Growth Rate (CAGR in investment lingo) would be the ratio of your ending value to beginning value ($19,500 / $10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then subtracted by 1 for the resulting number:

1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333).

1.2493 – 1 = 0.2493

Another way of writing 0.2493 is 24.93%.

Therefore, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon.