Rate of Return – Single Family Homes

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

  1. Fixed Cost
  2. 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.

  1. Property Taxes – What you pay to the Government
  2. Property Insurance – So that you can have a peaceful sleep
  3. 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

  1. Property Management Fees
  2. Maintenance

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

  1. Only 25% of the cash was deployed and the rate of return is higher $2484.56/27500 = 9.03% vs 6.56%
  2. 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%
  3. 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.
  4. You can buy 4 properties instead of 1.

Hold On

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.

5 thoughts on “Rate of Return – Single Family Homes

  1. Jana,

    Great post and loved your example/numbers as usual. Good to know your Rate of Return of 6.5% matches my calculations. This begs the question, Why Rental Property , When We can own good Dividend paying stocks and get similar returns ( considering companies which have grown their dividends consistently).

    However its not straight forward when we consider Taxes & Depreciation ( I your post does a great job in explaining the difference)

    Here is an examples : Consider JNJ . if an investor bought the stock in 2001 at $51, the dividend was $0.62 or [ 1.21 % ] and today the dividend per share is 2.40 or 4.7% and possible will be more than 6% if the investor holds on to the stock, however the actual rate of return after is 15% less than the face-value ( i.e. 3.5 % rather than 4.7 % )

    However there are couple of advantages in owning Dividend paying stocks compared to real-estate and its best for each investor to consider his situation.

    1. Stocks are Liquid
    2. You can achieve diversification by owning multiple dividend paying stocks in a portfolio
    3. You can dollar cost average ( you dont have to invest all at once which is not possible when buying a rental property )
    4. You dont have to pay 8-10% management fee ( however you do pay 15%-20% tax depending on your bracket )
    5. There is no control on companies on the amount of dividend being paid out , ( you have rent control in many counties )
    6. You can rent your stocks while you collect dividends and make extra cash ( by writing covered calls on the stocks you own, though its not advisable if you don’t know what you are doing )

    Look fwd to knowing your thoughts


  2. Thanks Hari for taking time to read my post.

    Stocks are the best asset classes when it comes to earning superior returns. There is no doubt in my mind. But not everybody can do it successfully. Everybody cannot win in poker. There are many ways to make mistakes when picking individual stocks.

    I try to diversify between stocks,bonds and real estate. If I have $100 I would keep 50% in real estate and the remaining 50% in stocks and bond Indexes. By holding indexes you remove all the risks and what remains is the systemic risk(collapse of an entire financial system) which cannot be removed. The only stock in my US portfolio is Berkshire Hathaway(brk.b)


  3. Hi Jana,
    Very interesting, well written post. I have one question though. Why do you think maintenance expenditure equating to 1% of the purchasing price should be enough? I don’t think it isn’t — assuming you want to prevent most of the physical degradation (loss of quality) with your maintenance program (all is impossible anyhow). If you don’t want to do that, you have to correspondingly lower your value appreciation expectation which, of course, no-one does.😉 So, why is 1% not enough? (a) Firstly, a technicality: The percentage should relate to the (estimated) building value in the whole property, not the total property price – obviously some properties involve larger shares spent on the land plots than others. But this is a minor quibble. (b) More importantly, do you have any evidence for claiming that 1% of the property value should – on average – be sufficient? I personally do not think that even 1% on the building share of the total property value is sufficient. For instance the largest German property company (I am German, hence the example), owning around 200,000 apartments / condominiums, spent around 1.4% p.a. on maintenance relative to the market value of the properties over the last four years on average. Now, you can assume that these guys have incredible economies of scale and scope in their maintenance program compared to an amateur who owns one or two properties. The fact that their tenants tend to cause more wear and tear than an owner occupier will not fully offset this advantage. In addition free standing family homes or semi-detached houses (you are referring to “Single Family Homes”) obviously require higher maintenance than apartments which these guys own. I think I could come up with more evidence than this to show that 1% will not be sufficient, potentially be not nearly sufficient, for the average property. Now, why are so many people (you are not the only one) saying “it’s 1%”? My guess: A lot of authors (no offence intended) simply copy the “1% maintenance myth” from other publications and perpetuate the myth instead of looking for evidence to support whatever number they put forward. Most of the “other publications” of course come from people who are conflicted in the first place, i.e. members of the real estate industry.
    Would be interested in your views.
    Many thanks,

    • Gerd,

      When I wrote this post I was into my first year of ownership. At that time I got the 1% number from (1) books I read (2) my broker (3) some of my friends.

      After three years of experience, which is low, I have not had over 1% maintenance expenditure. One reason for the low maintenance is that my properties are relatively new – on average less than 7 years old. As they go older the expenditure might cross 1%. And you’re right that 1% number could be a result of perpetuation myth.


      • Jana, Thanks for the reply. No disrespect but I believe source (2) by definition is biased toward understating the “true number” in spite of possibly knowing it. Source (3) is, sorry to say so, basically useless (due to, inter alia, lacking technical competence and wide spread cognitive failures of home owners and retail investors as to the correct assessment of the profitability of their investments). As to source (1): Question is: Did those books give any evidence for the number (1%). I doubt it and would be genuinely grateful if you point out a popular audience real estate guide book to me that proves me wrong. I have looked at around 20 such books both American and German and probably 50+ popular audience articles on the subject of buy vs rent and another 100+ or more on general aspects of property investing and I have not found a single book or article that substantiated the 1% number although almost all of them use it or use even lower values. Again, no disrespect but your own 3 years of 1% or less also do not mean anything. They don’t mean anything because the measurement period is too short and because it is not clear whether you simply tolerated you properties to physically deteriorate in these three years (my hunch is you did). Over a period of three years with relatively new properties it would be possible to literally spend zero on maintenance. No, what does that proof? If you assume in your purchase decision that your property appreciates in value at least along the long term average and most people assume a higher rate you must (sorry) accept that your estimate implies a zero quality loss of your property over time. I this doubtful that you can achieve that with spending 1% pa on it in the long run if the largest commercial property investors (see my example above) spend almost 50% more and — BTW — still face widespread criticism in the media that they underinvest in order to maximise shareholder value. Think it over: Assuming 1% p.a. as sufficient basically equates to believing that without any maintenance the building would last 100 years — an obviously untenable assumption.
        Best regards

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