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Three returns on rentals



* I am not an investment adviser or accountant. This post is for informational purposes only around the context of a hypothetical investment. Please consult a Registered Investment Adviser before making any investments.

There are a lot of variables that go into purchasing an investment property. To the uninitiated it might look like buying the house for a given price, collect the rents and calculate a return on investment. If it is above 8% it looks like a good deal and if we get any appreciation that is a bonus. Many people buy investment properties this way, at least their first one.

There are many other factors to consider both to your benefit and detriment, so it's important to know them all before choosing to invest. This article discusses investment properties that are one to four family residences. Once you get into larger projects, value and income is calculated differently which is for another day.

Rents

Rent is not as simple as looking at the market and multiplying an estimated rent by twelve. A major loss for investors in the single family space is vacancy. If you get a good tenant, they can stay there for years, but changing tenants is very expensive. When it does occur, you will usually end up with more than one month's lost rent. You will need to clean and update the unit to meet current market standards which generally comes with a significant cost. So not only will you be out the time of switching out the tenant, but you will also take on capital expense to upgrade the home.

Tenant screening is probably the most important thing you can do in order to provide stable income for a rental property. Multiple sources of income, good credit scores, and a low debt to income ratio are all good indicators to track. Plus it helps if you like the person and can get along with them.

For the purposes of this sheet, be sure to keep your vacancy rate 5-8%. You might get lucky with a 0% for a few years, but if you have two or three months missing during a transition, you just averaged out to 8% for those three years.

Each year you are likely going to have to raise rents by the amount of the tax increase if you live in a state with property taxes. So to maintain your returns, rents will always go up with taxes.

Equity

One of the fantastic benefits of investing in real estate is leverage though debt. So how much equity should you put into an investment property? Well it depends on your lender and your risk tolerance. You can make greater yield with lower equity, but your lender ends up taking on more risk since you have less skin in the game. There is also something psychologically nice about having no debt on a property. This is mostly a personal choice. The worksheet allows you to calculate the cost of a first and second lien position.

Expenses

Annual expenses on a single family rental are often almost nothing or very expensive when you have to replace a mechanical system like the AC or a roof. Most of your expenses are going to be consumed when these long term repairs come along. I like to alleviate this by replacing or upgrading all of the major mechanical systems at the time of purchase. When you cook these high priced expenses into the purchase, you are more likely to be able to negotiate the price to cover them, plus you defer maintenance costs by many years which allows the property to appreciate substantially. So when they come due again, you have lots of equity to play with.

I also like to put rentals on a 6 month mechanical checkup rotation. You can hire this out to someone like ARS for about $300 a year or do it yourself. Renters are not likely to keep tabs on mechanical systems, and regular inspection will allow you to make cheap fixes that will extend the life of those systems for many years.

Tax Benefits

The two biggies here are deducting your interest expenses and depreciating the cost of the home. If you pay $10,000 in interest in a year on the property, then you will end up paying $2,800 less in taxes that year if your tax bracket is 28%.

Depreciation is simply reducing your tax burden by 1/27.5th of the house price. This is just free money the government gives you for owning real estate.

Depreciating returns

Your best return year assuming appreciation is fixed is your first year. Over time you build up equity and your leverage goes down each year because you are paying off the note. So at some point your capital drops to a point of efficiency that may no longer be suitable for your goals. At that time you can refinance, sell the property and invest in something else, or just keep the inefficiency as well as the lower risk that comes with more equity.

I like buying homes in the growth zone where their initial price is very affordable and the growth of the city is directly in the path of my investment. In Austin an affordable home is around $250k. You will find these in North Austin, Pflugerville and some of the surrounding suburbs. Look where the city is growing, where they are spending money in infrastructure like the Montopolis area. That is where people will be moving and prices will rise. Those $250k homes will be in the $300s in 5+ years. Then you can sell them and look for the new growth spot.

Is it worth it?

Ultimately you need to decide what your required return is and how hard you are willing to work for it. Once you have a tenant in place, your work is not over. Homes require repair, maintenance, and upgrading between tenants. So there is going to be a time component as well. You can even divide your return by the number of hours you spend on each property to see what your time value becomes. Using a property manager usually costs about 8-10% of the rent which in many cases is your margin, so they don't make sense unless you have a very high equity position and the cost of management per dollar of margin is low enough to work. Otherwise you're going to be doing some management yourself.

If you contemplate all of the above numbers and not just cash on cash, you will hopefully have a clearer understanding of what it takes to own a successful investment property.

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