Buying Rental Property

Buying rental property? You may be wondering how to determine if a property is a good rental property investment.

What To Consider

Only analyzing financial returns is short-sighted. If you are considering becoming a landlord for the first time, this post has some thoughts about the non-financial aspects evaluating rental property as an investment. A rental property will inevitably consume some of your time so you want to make sure the lifestyle adjustment is worth it to you.

Finding Your Property

Once you’ve decided you want to own rental property, the next step is finding the right one. If you are using a real estate agent, I’ve found using agents who specialize in rental properties are worth the money. In my city, the top real estate agent for rental property claims to sell 4x the volume of the second-closest agent. He must be doing something right. The right agent will be able to guide you to neighborhoods where rent might appreciate faster than inflation. They might also be able to help you avoid houses that are run-down. I try to follow this rental property maintenance checklist on an annual basis to prevent properties from becoming run-down.

Evaluating Rental Property

I built a custom rental property calculator in Excel (available here). This helps calculate the returns and benchmark different rental properties. Once I’ve narrowed my list down to a few properties I print a comparison of the possible financial returns from the calculator. Here’s a quick screenshot:

Excel Duplex Model - Summary

Example Financials For Rental Property

Here’s a real example from a past purchase. I found a desirable neighborhood in my city that is stable and centrally located. Crime is low and there is a healthy mix of families, students, and young professionals. It is near public transportation and is zoned for a great public school. The house is also on a large lot, and is considered a duplex with two different addresses. The house needed updating and maintenance work but has been a great investment. But what were the potential returns I considered?

I start with the list price of $260,000. This bought a 7,500 sq ft lot and house with 1,850 sq ft of living space. That comes to $141 per square foot. It’s a 2BR/1BA + 1BR/1BA with separate utilities.

The rent was $1,850 per month. It’s a 3 bedroom, or about $617 per bedroom. That’s in line with low-end rental properties in the neighborhood.

I estimated 6% of rents would go to paying maintenance. With $1,850 in rent, that’s about $110 per month in maintenance. I could verify with my Home Depot receipts, but that sounds about right. The model assumes maintenance is an even amount each month, but it’s much lumpier. When I first bought the property it was much higher as I made needed repairs, but then there have been long stretches where no maintenance has been required.

Supply of rental properties in this area is tight, so 95% occupancy was reasonable for my calculation. I bought this house five years ago and it has never had a vacancy. Changing your assumption about vacancy to 80% would drastically affect the returns so be sure and spend time estimating the impact of vacancy on your rental property.

For this property, I made a 20% downpayment and got a 30 year mortgage at 4.5% (thanks, recession!).  Assume property taxes are 2% of the property value each year and insurance runs $100 per month. Closing costs were estimated at 3% of the purchase price.

After vacancy assumptions, I think rent growth and growth in the value of the property are extremely important considerations. In general, I believe rent can only grow at the rate of inflation in a stable population area over the long run, ceteris paribus. If the population is growing, however, rent prices can appreciate faster than inflation. For my purposes I assume rent and the property would both grow at 5%. If these appreciate at 5% and I locked in a fixed-rate loan at 4.5% … this house seemed liked a great deal.

The downpayment plus closing costs was around $60,000. The full mortgage payment (PITI) comes to $1,850.

What Are The Projected Returns?

Using my model, I looked at several ratios. The cap rate was 5.6%. The gross rent multiplier was 11.7. One rule of thumb, 100x rents, valued the property at $185,000. The first year cash-on-cash returns are awful because of the large downpayment. However, the property cashflows in the first month.

I don’t intend to sell the property. Thus, the most important factors to me are cashflow and the annualized return over 10 years. If the returns were much lower than what I could generate from the stock market, then it might not be worth it. However, the model projects an annualized return over 10 years of 18.1%. I certainly can’t generate that return in the stock market. Cashflow is also important. While not a primary source of income, this rental property will need to provide income when I retire. I look at the monthly detail to look at rent and estimated expenses, and see that in Month 100 this house generates over $600 per month in cashflow based on my assumptions. Not bad.

Some people who own rental properties as their primary source of income would consider these returns pretty poor. However, I live in the same neighborhood where this particular property is. It’s easy for me to manage, the tenants have been great, and it requires very little time. There is a major redevelopment happening a few blocks away that should really help the property value in the long term. While I could have been a “slumlord” and bought in a different part of the city for a higher return, I wanted to own this particular house.

How Did This Investment Go?

The rental property investment detailed above has gone a little better than expected. Those are the real values I modeled when I bought the property. I made major repairs to one side of the property – taped and floated walls, painted, added crown molding, removed carpet and restored hardwood floors, repaired a fence, upgraded kitchen and bathroom faucets, insulated the attic, added basic landscaping, and quite a few small other items.

Unit A: I’ve done no major upgrades to this side. I still have the original tenants who pay $1,075 per month. Each year I give the tenants around $200 to spend on upgrades — one year we added ceiling fans, another year we replaced the outdated oven. I’ve never raised the rent on these tenants because one of them is a plumber who does all my repair work on other properties on his time off.

Unit B: The 1 bedroom side was renting for $775 when I bought. After the upgrades, the new tenant for the one bedroom is paying $1,100 per month. That’s an outrageous 42% increase in rent in a few years. The repairs and upgrades cost me $5,000 over three years, plus a significant amount of my time (but hey, I love home renovation projects on the weekend). With the model showing 6% of rent as the maintenance budget, I would’ve spent $1,300 per year on repairs. Technically I’m probably about $1k under my 6% estimate, but I better knock on wood because the HVAC units are 18 years old and break down about once per summer.

What’s the property worth today? If I had to sell the property, I think $300k would be a good deal for a buyer. Similar properties go for much more. That’s an increase in the value of the property of 15% over five years. I don’t count the realtor commission when I calculate that increase in value because I don’t intend to sell.

What does the model think the property is worth? Well, if I bought at a GRM of 11.7 .. and the rent has gone from $1,850 per month to $2,175 .. then to keep the GRM at 11.7 the property would have to sell at $305k. I ball-parked $300k and the model suggests $305k .. eerily close.

Rental Property Scenarios

The best part of the model to me is changing my assumptions and watching the financial impact.

What if vacancy changed from 95% to 80%? I change one number, and voila: the annual return drops to 16.5%.

What if maintenance is 10% of rents? The return drops to 17.7%.

What if I can get away with only putting 10% down on the mortgage? The return jumps to 23%. Leverage!

What if rent is only $1,500 per month? Well, the property doesn’t cashflow until Month 83. Ouch.

Conclusion

I hope this post is helpful to those considering rental property. It’s exciting but requires some caution too. I’ve owned in boom and bust markets, and in different states. I’ve never lost money in real estate but have watched close friends and family declare bankruptcy. In fact, the house mentioned above was almost foreclosed on before I bought. I think the key is to understand the full picture, have reasonable assumptions, and don’t over-extend yourself. A good Excel model and a little luck never hurts either.

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