Rental Property Investing

Real estate is an asset class comprised of many different forms. You can invest in real estate in a variety of ways. Owning a primary residence is one way. Owning rental properties is another way, these can be single family homes or multi-family homes. An enterprising real estate investor may buy an entire apartment complex. On the commercial side, a shopping plaza could be bought and rented to businesses. Larger commercial projects are typically undertaken by a real estate investment trust (REIT) which are often publicly traded. REITs may own the real estate under an Amazon fulfillment center, Walmart, or large hotel chain.

Is owning your home the key to becoming a millionaire?

The classic American dream involves buying a home. Over time, as you pay down your mortgage you will build more equity (ownership) in your home. This allows you the comfort of having a place to live, and also an “asset” that you can borrow money against if need be (asset in quotes because owning a home is not always an asset, see Rich Dad Poor Dad Review). You can use a HELOC (home equity line of credit) to access the equity in your home and use it for your expenses, emergencies, or other investments.

CNBC and other organizations that talk about money often discuss the causal link between buying a home and becoming a millionaire. Here’s a quote: “If millennials don’t buy a home, their chances of actually having any wealth in this country are little to none. The average homeowner to this day is 38 times wealthier than a renter.” CNBC makes a misleading mistake in conflating correlation with causation. You may read this and think “If I buy a home I will end up being 38 times wealthier than if I rent.” This conclusion is vulnerable. First, just because this is the case now does not mean it will be the case in the future. It is possible that home prices rose precipitously over the last 50 years and will not continue to rise at the same pace, or at all, over the next 50 years. Therefore, buying a home now may not lead you to the same gains the generation before obtained.

Second, those who have the ability to put a downpayment on a home are skewed towards those with higher paying jobs and possibly have help from parents who have higher paying jobs and own their own home. If your parents have a $10,000,000 net worth, and they give you $100,000 to buy a home and then 20 years later they die and you inherit $10,000,000 naturally you are going to be much richer than the renter who does not have these parents, regardless of whether or not your house went up in value at all over the previous 20 years. In other words, while a correlation between home ownership and wealth exists, this does not mean that owning the home caused your wealth to be higher. It’s important to set aside all the misleading information surrounding home ownership and know that while owning your primary residence is a possible way to slowly build wealth over time, it is not the only way.

Owning your own home is not always a good investment. At best, your home will appreciate over time and your annual costs of home ownership will be cheaper than renting an equivalent residence. The leverage you gain from using a mortgage allows you to buy an asset far greater than you could afford with cash and therefore even though housing prices only rise 3-5% a year, you are effectively gaining a larger return as a percentage of the cash tied up in your home.

Assume you buy a home for $100,000 and it rises 5% to $105,000 in the first year. You have gained $5,000 in equity. But, because you only put down 20% or $20,000 as a down payment, the $5,000 gain is actually a 25% return on your cash. A 5% gain if you had bought the home in cash became a 25% gain. This is the power of leverage, you are able to take the other $80,000 that you borrowed from the bank at a 3% interest rate and invest it elsewhere. Other benefits of a mortgage include tax deductions for interest paid on the loan, and inflation making the borrowed amount worth less over time (assuming you borrowed at a fixed rate). When gradual inflation occurs, real assets (stocks, real estate, gold I suppose) become worth more, so while your fixed rate debt slowly becomes worth less in real dollars, your invested capital in stocks and real estate become worth more, this divergence is powerful and a strong argument for using as much low fixed rate leverage as you can to buy a home.

All of this is null and void if your home does not appreciate in value. Buying an overpriced home at the wrong time can destroy wealth. While home ownership can be a good long term investment, it does not always make sense depending on individual circumstances and market prices.

How do I make money investing in rental properties?

This is where the book comes in. The author, Brandon Turner, a real estate jock and founder of biggerpockets.com, states there are four ways to make money from real estate: Appreciation, Cash Flow, Tax Savings, and Loan Paydown.

Appreciation

There are two types of appreciation: natural and forced. Natural appreciation occurs over time, and should never be counted on when thinking about investing. At best, you can try to buy in a good area and hope that prices rise over time. If other parts of the deal, namely cashflow do not workout, you can loose money investing for appreciation alone. Rule number #1 of real estate investing: Do NOT buy a property unless it cash flows.

Forced appreciation–in addition to sounding super cool–is a necessary component in any great real estate deal. Forced appreciation involves buying a home and finding a way to make it worth more. Say we buy a property with shag carpet flooring, holes in the walls, trash everywhere, a destroyed kitchen, and a nice big office that is not currently listed as a bedroom. Let’s buy this home for $250,000 and invest $25,000 into repairs. We remove the carpeting, and discover beautiful hard wood underneath. We fix the holes in the walls and repaint it. We remove all the trash, install a new kitchen, and convert the office into an additional bedroom. After these repairs, we get a new appraisal on the property and it is appraised at $325,000. We forced the property to appreciate and net of our investment in repairs, we now have $50,000 more in home equity.

Cash Flow

This is by far the most important aspect of any real estate deal: does the property cash flow and how much. Cash flow is the amount of money you will make each month net of expenses. Let’s revisit that newly rehabbed home that we purchased for $250,000. Don’t be scared by the numbers, this is elementary math.

Income

Expenses

Cash flow = Income – Expenses: ($2500 – $1700) = $800 / month. Every month we own this home and are able to rent it, it will cash flow $800 this is also called net operating income. In order to judge if this is a good deal we want to find out what our return (sometimes called a cash on cash return) is. If we invested $100,000,000 and our return was $800 a month this would be a very bad deal, if we invested $1 and earned $800 a month it would be an incredible deal. When we purchased the house for $250,000 we put 20% down, therefore our cash in the deal is $50,000. $9600 ( our annual cash flow) / $50,000 (cash in deal)= .192 when we multiply this by 100 to turn it into a percent, we get a 19.2% return. This is a very good return, and does not include the $50,000 in forced appreciation we gained through our rehab. Currently, a bank account returns under 1%, a high yield savings account may return 2%, stocks on average return 6-9%, therefore a 19.2% return is very exciting.

Two things greatly influence the cash on cash return. The first is the purchase price. Too high a purchase price can turn a great deal into a bad once. If we bought this same home for $350,000, instead of $225,000 and had to put $75,000 down, our mortgage would be more expensive, making our expenses roughly $2,100 per month. Even though we would still cash flow $400 per month, or $4,800 per year, our cash on cash return would be much lower as $4,800/$75,000 = 6.4%. A 6.4% return is not that exciting, especially considering the work that goes into maintaining a rental property. If I had to choose between putting $75,000 into a down payment where I would earn a 6.4% return in real estate versus buying $75,000 worth of the S&P 500 index, I’d choose the index as it requires much less work than the rental property.

The second thing that influences the return is the amount of rent that can be charged and the expenses. If we were able to charge $2700 in rent rather than $2500 and slash repairs by $50 and obtain a lower interest rate mortgage saving an extra $50 we would increase our monthly cash flow by $300. This would equate to an extra $3,600 annually which would juice our return from 19.2% to 26.4%. This cuts both ways, one big unaccounted for expense can devour our entire yearly returns. Hence, it is important that we use conservative assumptions when creating our pro forma (fancy word for projections).

Tax savings

In addition to the tax deductibility of the interest paid on a mortgage that was discussed earlier, real estate as an asset class has specific tax advantages. Depreciation is the most advantageous to a small investor, and 1031 exchanges are another way to defer taxes when it comes time to sell their property. Let’s focus on depreciation, as anyone who wants to own a (profitable) rental property will take advantage of it.

Depreciation is a non-cash expense that involves an asset being worth less over time. The general population understands depreciation in the context of a loss of value, typically when buying a new car: “When you drive it off the lot it will depreciate by 20%.” With the car, that loss is technically a non-cash expense as even though the car is worth less, the buyer does not have to pay the 20% loss in value to anyone, they will only realize it when they sell the car.

In real estate, investors are able to use depreciation to reduce the taxes that must be paid on the cash flow a property generates. Because homes wear out over time, you can take the value of the home (house not land), say $275,000 and depreciate it over 27.5 years. $275,000 basis / 27.5 years = $10,000 / year. What this means is that if your cash flow (remember cash flow = income – expenses) is $10,000 annually, you would owe taxes on that $10,000. At 22%, $2200 would be owed in taxes. When depreciation is taken into account, we are able to subtract depreciation from our cash flow as if it were an expense. $10,000 Cash flow – $10,000 deprecation = $0 taxable income owed. Unlike a car, homes typically appreciate in value over time. This $10,000 depreciation expense shields us from taxes and makes income from real estate more desirable than income from other sources where depreciation can not be used to shield the investor from taxes.

Loan Paydown

Mortgages allow investors to leverage their money. Assume I have $500,000, I could buy one house worth $500,000 without a mortgage. Or, I could buy five houses each worth $500,000, by putting down a $100,000 (20%) down payment on each. In each of the mortgages, I will make a mortgage payment monthly. Part of my payment will go towards paying down the interest portion of the loan and another part will go towards the principal. Let’s take a quick look at an amortization schedule to see how this works.

This is an amortization schedule for a $100,000 mortgage with a 3.5% interstate’s rate. In November 2020, a $449 payment will be owed. $291 of it is interest paid to the bank (which is tax deductible), and $157 goes towards your principal, or loan balance. As you can see, the $100,000 loan – $99,842.62 balance = $157.38 which was the amount of equity in your home you bought back from the bank. Every month you pay down your loan, you gain more equity in your home. When you rent a property, and your rental income covers your expenses including your mortgage, you are getting paid to have your tenant pay down your mortgage. If you can repeat this process for 30 years, you will own your investment property outright.

Let’s put it all together. In the perfect deal, you will buy a property that needs repairs, you will repair it and the value after you repair it will be greater than the cost of repairs. You have gained equity through forced appreciation. Your income from rent will be greater than your expenses and each month your property will cash flow. You will have a mortgage on your property and every month when you make a payment you will increase your net worth through equity gains made by paying down your loan. At the end of the year, you will use depreciation to reduce the taxes you owe. Sounds pretty amazing right? Why wouldn’t everyone do this?

Everyone is doing this. There is competition for great deals (both between individual investors and publicly traded companies buying single family homes). This competition leads to appreciation in prices. This is great for current landlords looking to sell their investment property, but not great for new investors looking to buy their first. As we saw earlier, a higher purchase price means a more expensive mortgage and–all else equal–less cash flow. The large companies are able to use their size and economies of scale to push return rates lower, making most deals unattractive to individual investors who will have to manage properties themselves.

I’m always on the hunt for a great deal, but from what I have seen, it’s a tough market. For individual investors right now, it seems that the best deals are in low cost of living areas where a home can be purchased for $100,000. This investor may achieve a high rate of return, maybe 10% or even 15%. But on a $100,000 home with a $20,000 downpayment, a 15% return is $3000 annually, or $250 a month. This sucks! A new water heater, roof issue, appliance problem or other unexpected issue can easily wipe out a year of cash flow. Even at $3000 a year, if you spend 300 hours working on finding deals, screening tenants, making repairs, you are making $10 an hour if all goes well.

I think there is money to be made investing in real estate, but deal selection is by far the most important and most difficult part of the process. I would search for multi-family houses for sale in a market you are familiar with and run some numbers. Start figuring out what rents go for and what expenses will be. Once you do a dozen of these, you will be able to spot a property that will cash flow easily. From what I’ve seen in markets I’m familiar with, 95%+ of properties will not even break even. Those that do are typically in a bad area and will likely not appreciate naturally at the same rate as a non cash flowing property in a better area. There are deals out there, but you have to get creative to find them. Deals go fast, so knowing the basics and getting everything teed up is necessary if you are to pounce when given the opportunity. Check out this book to learn the basics and get your creative real estate juices flowing.