Real estate is one of the major asset classes that can earn a decent rate of return on the Invested Capital provided you paid the right price and got at the right location.
Rate of Return = (Annual Rental Income - Expenses)/Purchase Price
The rent you receive every month is the income generated by the property. Will the property be rented through out the year? Of course Not. If you want to be conservative you should take out 1 month for vacancy.
Annual Rental Income = Monthly Rental Income * 12
Property has 2 types of expenses. They are operating and financing expenses. I am assuming that the property is purchased using cash and hence I am going to cover only the operating expenses. There are 2 types of operating expenses or costs
- Fixed Cost
- Variable Cost
Fixed Costs are the ones that you need to pay even if your property is vacant. They are definite expenses which cannot be deferred or avoided.
- Property Taxes – What you pay to the Government
- Property Insurance – So that you can have a peaceful sleep
- HOA Fees
Why do I need to pay HOA for single family homes? Not all single family homes have HOA. But some of them do as they might have recreational amenities like Gym and Swimming Pool which needs to be maintained.
What about Maintenance expenses? Does it not come in Fixed Costs. I thought about this and decided it to keep it in Variable Costs because it is not fixed and you can defer it if you want to. Remember it is hard/impossible to rent out a broken house.
Variable Costs is going to be different for everyone
- Property Management Fees
Maintenance costs are very hard to predict. You can assume it to be 1% of the purchase price every year. They are very sporadic in nature and certain remodeling expenses may come to around 5% to 10% of the purchase price.
Let me do an example and the numbers that I use in my calculations are for Single Family Homes in Texas. These calculations are going to be different depending on the city and the price you paid for it and the rents you receive.
Purchase Price = $110,000 Rental Income = $ 13,200 12.00% Property Tax = $ 2,750 2.50% Insurance = $ 900 0.82% HOA = $ 315 0.29% Fixed Cost = $ 3,965(A) 3.60% Property Management = $ 924 0.84%(7% of rent) Maintenance = $ 1,100 1.00% Variable Cost = $ 2,024(B) 1.84% Total Cost = $ 5,989(A + B) 5.44% Operating Profit(Pre Tax) = $ 7,211 6.56%
As you can see starting at 12% I ended up getting 6.56%(pre tax). Remember this is an optimistic estimate as I have not taken vacancy into consideration. Also as I mentioned above the maintenance is not in our control and it can make or break the deal.
Should I pay taxes on the entire amount $7,211. The answer is No. Why? Because Depreciation will come to the rescue. (If you need to understand how depreciation is calculated refer to Depreciation blog.)
Operating Profit(Pre Tax) = $7,211 Depreciation($77,000)(70% building value) = $2,800($77,000/27.5) Profit For Tax = $4,411
Is pretax return of 6.56% good?
As of this writing US 30 year treasury is yielding 3.06%. Banks are giving interest of around 0.5%. If you can find investments which can earn more than 6.56% then you should go for it. If not I find this rate of return reasonable. Remember odds of inflation going up is very high in the coming years and it will increase the Rent and the value of the property hopefully. This should increase the rate of return.
Does it not make sense to take mortgage for 75% of the purchase price and buy 4 properties instead of 1? Let us see how it works.
Down payment 110,000 * 25% = $27,500 Loan amount 110,000 * 75% = $82,500 Operating Profit(Pre Tax) = $7,211.00 - A Mortgage(Principal + Interest) = $4,726.44 - B Net Profit After Financing Expenses = $2,484.56(A - B) Interest Portion 1st Year = $3,300.00 - C Principal Portion 1st Year = $1426.44 Net Profit for Tax = $3,911 (A - C) Depreciation($77,000)(70% building value) = $2,800($77,000/27.5) For Taxes = $1,111
As we can see there are several advantages with Leverage
- Only 25% of the cash was deployed and the rate of return is higher $2484.56/27500 = 9.03% vs 6.56%
- The tenant paid the principal for the entire loan amount. Let us imagine property price did not appreciate for 30 years and at the end of it you own the property which is worth $110,000. Your initial investment was $27,500 and your compounded return is 4.73%
- What you need to pay in taxes has gone down. Interest portion of the mortgage is tax deductible. Over the period this will go down. Why? As the interest portion of the mortgage goes down and the principal portion goes up.
- You can buy 4 properties instead of 1.
If it is that simple then everyone would have been a millionaire by owning properties. Then who will be the tenant? It is not that easy and everything in Life requires hard work, discipline, knowledge and serendipity. Real Estate is no exception. In the calculations I used there are lots of variables and assumptions that are not in our complete control. Remember Garbage In Garbage Out. This can result in negative cash flows. Excerpt from Investing in Real Estate
One such investor bought a $300,000 fourplex with a down payment of $30,000. After paying property operating expenses and mortgage payments, the investor faced an alligator(negative cash flow) that chewed up $1,000 a month.
Remember the alligator before jumping into real estate investments. What do you mean I am a smart guy and I can handle leverage better than the average person. Ok I agree but read the excerpt from the speech made by Warren Buffet, on the collapse of Long Term Capital Management
If you take John Meriwether, Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani and the Nobel prize winner Myron Scholes. If you take the 16 of them, they probably have the highest average IQ of any 16 people working together in one business in the country,including Microsoft or whoever you want to name–so incredible is the amount of intellect in that room. Now if you combine that with the fact that those 16 have had extensive experience in the field in which they operate. I mean, this is not a bunch of guys who made their money selling men’s clothing and all of the sudden went to the security business or anything. They had, in aggregate, probably 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worth in the business. They have their own money tied up, hundreds of hundred of millions of dollars of their own money tied up, a super high intellect, they were working in a field they knew, and they went broke. And that to me is absolutely fascinating. If I write a book, it’s going to be called “Why do smart people do dumb things?”
To make the money they didn’t have and they didn’t need, they risked what they did have and did need–that’s foolish, that’s just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed, or 1,000 to 1 that you succeed. If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in one chamber and you said ‘put it to your temple and pull it’ , I’m not going to pull it. You can name any sum you want. It doesn’t do anything for me on the upside, and I think the downsize is fairly clear. I’m not interested in that kind of a game, and yet people do it financially without thinking about it very much. It’s like Henry Kauffman said the other day– the people going broke in these situations are just two types: the ones who know nothing, and the ones who know everything.