Have you ever wondered whether buying rental real estate is a better investment than the stock market? What are the costs, challenges, and likely returns for being a landlord? Analyzing all of the cash flows can get confusing, so let me elucidate. That means shed light upon…just in case the word elucidate needed any elucidation. 🙂
The best way to understand rental real estate is to analyze an actual rental property:
A friend of mine, let’s call him “Yeremy,” has a single-family rental in Las Vegas that is currently worth $380,000. The property rents for $2,250. Yeremy’s payments would be $1,585 per month if he were buying the house today with 20% down and a 30-year fixed rate mortgage at 4.75%. Note that the interest rate on rental properties is typically about a quarter-percent to half-a-percent higher than on a primary residence.
Of course, we need to add taxes and insurance ($310) to the principal and interest payments, so the total is $1,895. This sounds good so far. Many prospective real estate investors would end their analysis there, assuming that they are going to have positive cash flow each month. Not so fast.
In addition to the monthly payments, my friend Yeremy pays $105 for the pool guy, $110 for the gardener, $180 for a property manager (Yeremy doesn’t like to get his hands dirty), $40 for HOA, and $250 is set aside each month for maintenance and vacancies. The total cost when you add it all up is $2,580 per month. Therefore, the property has a negative cash flow of $330 per month.
Projected price appreciation and rent increases:
Yeremy still thinks this is a good investment because he expects the house to appreciate, rents to increase, and he is building equity with each mortgage payment. He was not sure how to analyze all this, so he consulted his crackerjack financial advisor (at Planning Great Retirements, of course). His advisor told him that real estate values and rents tend to rise at approximately the same rate as median wages. Therefore, they decided to use 2.5% as the expected annualized increase in the value of the property. Note: historically residential real estate appreciation nationwide has averaged 3.1%, but wage growth and inflation were a bit higher over the past 100 years than they are currently.
Yeremy’s house will be worth $797,075 in 30 years if it appreciates at 2.5% per year. The internal rate of return on this investment would be 8.09% when you account for the original down payment, the cash flows over 30 years, and the proceeds from selling the property after deducting a 5% real estate commission. The annualized rate of return drops to 6.64% if Yeremy paid cash for the property instead of getting a mortgage.
You may be wondering how much the returns would improve if Yeremy were not so lazy and managed the property himself. He was paying 8% of rents to a property manager (the going rate is 10% but Yeremy has two rentals so he got a deal). Nevertheless, the answer is his annualized return would have been 9.45% instead of 8.09% in the scenario where he had a mortgage, or 7.24% instead of 6.64% if he had paid cash for the property.
That’s not supposed to happen:
Yeremy had one problem with all this analysis. Apparently, he bought the property 10 years ago for $415,000. It should be worth over $530,000 based on the 2.5% forecasted appreciation each year. Unfortunately, it is only worth $380,000. Yeah, it is worth less than he paid for it 10 years ago! At one point, the value of the property had declined to $250,000. Yikes! That wasn’t supposed to happen!
This reminds us of the danger of assuming long-term averages will be valid when applied to a shorter time horizon. Maybe there will be a happy ending if he holds the property another 20 years.
Lastly, how does the investment compare to the stock market? A balanced portfolio of stocks and bonds, held for 30 years with no leverage, is likely to equal or possibly even exceed the 6.64% that our real estate investor is expecting. The other consideration, which favors the stock market over real estate, is the stock/bond portfolio is much less hassle and more liquid. That being said, there is still a place for real estate. It is a good diversifier to be held in addition to stocks, bonds, and other asset classes. It also acts as forces savings each month as you make the mortgage payment, and can provide some tax benefits along the way (interest expense and depreciation deductions).
How much does the location of your real estate matter?
It’s everything…besides cash flow. If I asked 100 people: What is the most important element of a real estate investment? The most common answer would be: location, location, location.
Why? The better the location, the more investors expect the property to appreciate. Rents will go up as the property appreciates. There is a natural correlation between property values and rents.
You may be thinking, “Aha!, I’ll just buy a rental on the beach.” The concept you need to understand is that rentals in the most desirable areas typically have the worst cash flows. In other words, the property has to appreciate more in order to compete as an investment with properties in less desirable areas.
Valuations: purchase price compared to rents?
The key valuation metric in commercial real estate is called the “cap rate.” The cap rate is the annual rate of return you would receive, after all expenses, if you had paid cash for the property. The cap rate on a property in a highly desirable location may only be 2%, whereas a less desirable location may be 6-8%. The beachfront property (in our example), therefore, needs to make up for the substandard cash flow with faster appreciation.
Pay cash or get a mortgage?
Another important concept to understand is how “leverage” (AKA: the mortgage) impacts the risk and rate of return on a real estate investment.
Leverage typically magnifies returns on both the upside and downside. In our example of previous weeks, we analyzed the expected returns for my friend Yeremy, assuming he were to buy his rental property at today’s prices, interest rates, and rents, and hold it for 30 years.
What if he doesn’t hold the property for 30 years? How do the numbers look after 10 years? A property purchased for $380,000 should be worth $486,432 (assuming 2.5% annual appreciation) after 10 years and the remaining loan balance would be $244,781. The annualized rate of return for the shorter holding period increases from 8.09% to 8.84% in the scenario where he had a mortgage. Selling after 10 years creates a higher rate of return because leverage is the highest in the early part of the loan term. However, the expected return dropped from 6.64% to 6.28% in the scenario where he paid cash. The cash buyer has a lower rate of return with the shorter holding period because there is no leverage to magnify gains; therefore, the transaction costs have a more noticeable effect (when applied to a shorter holding period with less appreciation).
The reason Yeremy would make a higher rate of return in an appreciating market if he used leverage is because he would have made the 8.09% on the money he invested (down payment and monthly payments) and he would also have made money on the portion he borrowed. This works especially well when the property returns 8% or so and he borrowed money at 4-5%. However, the leverage would also magnify losses if the property value declined.
Leverage can spell disaster:
Many people are shocked by how hard their investment gets hit when leveraged real estate declines in value. Here is a simplified example to illustrate this important point. Suppose you bought a $500k home with 20% down ($100k) and took out a mortgage for the remaining 80% ($400k). Let’s assume that you had breakeven cash flow, no maintenance costs and no commissions to sell the property. Even in this rosy scenario with very few expenses, a 20% decline in the property would result in a 93% loss of your downpayment. This is because you would only have paid off $7k of principal in the first year and therefore still owe $393k to the bank (of the $400k sales price). If this were a real scenario, you would likely have lost 100% of your investment (after sales commissions) and had to come out pocket with additional funds to pay off the loan.
In the above example, the investor with 80% leverage lost 100% of his investment due to a 20% decline in property value. He would have only lost 20% of his investment if he had paid cash for the property. I’ll just say this one more time…leverage magnifies returns. Paying cash is a much more conservative way to own real estate.
The human side of being a landlord:
Lastly, let me add a word about being a landlord. It is not all about the numbers. There is a human side that you should consider. What are you going to do if you rent to a young family, and the family breadwinner loses his job and can’t make the rent? Do you have the heart to evict them? What about when the tenant wants repairs or upgrades that you can’t afford or you feel are unreasonable? Is that going to make you uncomfortable? Just food for thought.
I hope this article does not discourage you from investing in rental properties. Real estate is a great alternative asset class and has been created tremendous wealth. I hope you will just remember it is a long-term, illiquid investment and you need to have a solid cash / emergency fund for the unforeseen, yet inevitable expenses.