How much can much can an investor really expect to make by investing in single-family rental houses?
Do you want to see an example with some real numbers?
What’s your average annual return on your Wall Street investments? When I say Wall Street, I’m referring to stocks, bonds and mutual funds; the only choices allowed (or offered) by those Wall Street investment firms offering you a brokerage account or managing your 401(k) accounts.
In my last blog post on July 8, I asked the question “Do You Invest in Main Street or Wall Street?” I made the comparison of how risky investments in stocks, bonds and mutual funds are relative to real estate. I also pointed out that real estate returns are generally much better in the long-term than the returns from Wall Street products.
On June 29th, I wrote about the five ways to profit from rental houses and with those five ways, you should easily average an annualized return on your investment in the high teens or reasonably above 20%. And, this is the investment return you should end up with after covering your income taxes.
In this post, I will show you with some real number examples how well you can profit. First, let’s just remind ourselves of those five methods to profit. You’ll remember that I used the acronym IDEAL to help us remember.
I-D-E-A-L
- I = Income…this is the net cash operating cash flow from the rental house.
- D = Depreciation…depreciation is a non-cash tax deduction you can take advantage of to reduce your taxable income from this investment. In most cases, this will reduce your average taxable income over several years to very close to $0.
- E = Equity amortization…this comes from the fact that when you use a mortgage to get this property, the net operating cash flow can cover the monthly payments on the mortgage and reduce the principal every month which increases the equity value to the investor.
- A = Appreciation…if you invest in the right places, places with growing jobs and population, you will likely experience an increase in the market value of the investment property which we call appreciation.
- L = Leverage…real estate is generally the only investment available where you can leverage up to 80% of the market value of the investment. And, as long as you can make the monthly debt payments, even if the market value drops, you won’t have a call from the bank to pay down the debt.
Financial Returns
Now, let’s walk through some numbers to show how these profit centers play out on a typical investment property. For this example (done in June 2020), I pulled a nice little house off Zillow to use as an example. Here are the details I pulled off Zillow:
- Purchase Price = $135,000
- Monthly Rent = $1300
- Property tax is estimated at 1% of market value
- Property management is estimated at 7.5% of rent
- Insurance is estimated at 0.35% of market value
- We will also allocate 5% of rent per month as a reserve to cover repairs and maintenance.
- A Vacancy Factor is estimated at 5%
- The mortgage rate is estimated at 4.75%
- We will use 2% per year as a long-term normalized inflation of market values and rents.
Let’s walk through this…
Initial Investment
If we purchase this property at $135,000 and use a mortgage for 80%, then we will need $27,000 for the down payment. I would also estimate about $5,000 to cover closing costs and loan fees bringing our total investment to $32,000.
“I” = Income
Starting monthly rent is $1300 per month, or $15,600 in the first year. Our cash costs as a percentage of rent are 5% for a vacancy factor, 7.5% for property management and 5% for repairs and maintenance. Then we have costs based on a percentage of market value, such as 1% for property taxes and 0.35% for insurance. The table below shows how I look at Net Operating Cash Flow of a Property.
Monthly | Annually | ||
Gross Rent | $ 1,300 | $ 15,600 | |
Vacancy Factor | 5% | (65) | (780) |
Expected Net Rent | $ 1,235 | $ 14,820 | |
Expenses: | |||
Property taxes | 1.0% | $ 113 | $ 1,350 |
Property management | 7.5% | 93 | 1,112 |
Insurance | 0.35% | 39 | 473 |
Repairs & maintenance | 5% | 65 | 780 |
Total expenses | $ 310 | $ 3,715 | |
Net Operating Cash Flow | $ 925 | $ 11,105 | |
Mortgage Payment | (562) | (6,744) | |
Total Net Cash Flow | $ 363 | $ 4,361 |
Based on this table, the first year Cash-on-Cash (CoC) return is 13.6%. This is your return before income taxes. The taxable income, and your resulting “after-tax” cash flow, is calculated in the table below. I am using a 35% tax bracket as that is a very common rate for my accredited investors.
Annual | ||
Net Operating Cash Flow | $ 11,105 | |
Less: interest on mortgage payments (1st yr) | (5,094) | |
Taxable Passive Income | $ 6,011 | |
35% tax bracket (typical for an accredited investor) | 35% | (2,104) |
After-tax net income | $ 3,907 | |
Less: principal portion of mortgage payment (1st yr) | (1,650) | |
Net (after-tax) Cash Flow | $ 2,257 | |
After-tax Cash-on-Cash Return on Investment | 7.1% |
“D” = Depreciation
To calculate our depreciation, we first have to determine how much is improved property and how much value is related to land. You cannot depreciate land. As a rule of thumb in neighborhoods like this house, we estimate that 80% of the market value can be allocated to the house. So we can depreciate $108,000 over 27.5 years (the length of time to use for this type of asset per IRS guidelines). So we can also have a tax deduction of $3,927 per year.
So, let’s update our taxable income calculation from above.
Annual | ||
Net Operating Cash Flow | $ 11,105 | |
Less: interest on mortgage payments (1st yr) | (5,094) | |
Less: non-cash tax depreciation deduction | (3,927) | |
Taxable Passive Income | $ 2,084 | |
35% tax bracket (typical for an accredited investor) | 35% | (729) |
After-tax net income | $ 1,355 | |
Add-back depreciation (not cash) | 3,927 | |
Less: principal portion of mortgage payment (1st yr) | (1,650) | |
Net (after-tax) Cash Flow | $ 3,632 | |
After-tax Cash-on-Cash Return on Investment | 11.4% |
So, we subtracted the depreciation before we calculated our tax expense, which resulted in lower tax expense. Then to get back to our true cash flow, we started with the new after-tax net income and added back the depreciation expense (remember there is no cash outflow for this expense), then subtracted the mortgage portion of the payment (remember the interest portion is already taken out above because it is a tax deduction). Our new Net “After-Tax” Cash Flow is $3,632 per year, or 11.4% CoC on our investment of $32,000.
Remember that this is after taxes are paid. If you are comparing to the long-term average return in the stock market of 8%, then this 8% has to be adjusted for the capital gains tax rate of 20%, which results in an after-tax return of 6.4%. If some of that stock market return comes from dividends, then the taxes will be higher since dividends get taxed at ordinary rates, like 35%. This will lower the after-tax return even further.
“E” = Equity Amortization
As the mortgage payments are made using the net operating cash flow, the principal of the note is paid down creating additional equity value, i.e., the difference between the market value and the principal of the mortgage. I like to use a 5-year holding period for this analysis. So, in the first 5 years, the mortgage payments will reduce the mortgage from $108,000 to slightly less than $100,000. Let’s just call that $8,000 of additional equity. You can’t get that additional value as cash unless you sell the property or re-finance the debt. However, this is additional value to your investment. So, $8,000 over 5 years is $1,600 per year, or an additional 5% annual return on your investment.
“A” = Appreciation
Over many years and decades, housing has generally averaged 2% appreciation per year. Now I always target cities with higher than normal job growth and higher than normal population growth because this not only reduces the risk of loss of equity value, it also increases the chances that we will experience much higher than 2% annual appreciation. Even a 3% or 4% rate of appreciation creates a big difference over a 5-year holding period.
But for today, I will use 2% and a 5-year holding period again. After 5 years, a 2% rate of appreciation brings the market value of our investment property to $149,000. This is an additional $14,000 of value created, or an additional $2,800 per year. This $2,800 per year is an additional 8.8% of return on our investment. It’s not cash-on-cash because we have to sell or re-finance to get the cash out, but it’s return nonetheless.
“L” = Leverage
Remember from above, the “L” represents Leverage. If you don’t use leverage, your investment would be much higher, your taxable income would be higher because you don’t have interest expense to deduct and you wouldn’t get the benefit of the Equity Amortization described above.
So, to put that into numbers…your investment would be $140,000 ($135,000 plus about $5,000 closing costs). Your taxable income would be approximately $7,178 because you don’t have an interest deduction. So, after-tax net income is now $4,666. Then adding back the $3,927 of non-cash depreciation makes your after-tax net cash flow approximately $8,593. This results in a 6.1% cash-on-cash return compared to the 11.4% calculated above when using leverage.
Also, without leverage, you don’t get the advantage of the “E”, or Equity Amortization.
Summary
To summarize the five different ways to profit, I have put the numbers into the table below. I also included the model without leverage to compare. This is an annual comparison. The values are the average expected per year (after-taxes) during the first five years of holding this asset.
Line Item | With Leverage | Return | Without Leverage |
Return |
Investment | $ 32,000 | $ 140,000 | ||
“I” = Net Cash Flow | $ 2,257 | 7.1% | $ 7,218 | 5.2% |
“D” = Depreciation (incremental) | $ 1,375 | 4.3% | $ 1,375 | 1.0% |
“E” = Equity Amortization | $ 1,600 | 5.0% | $ 0 | 0.0% |
“A” = Appreciation | $ 2,800 | 8.8% | $ 2,800 | 2.0% |
Total | $ 8,032 | 25.1% | $ 11,393 | 8.1% |
You might look at this and say, but I have enough cash to invest without the mortgage and the total dollar return will be higher without the mortgage. To this I would say, then you should invest in four houses with leverage, not one house without leverage. For the four houses, your total investment would be $132,000 and your total return would be $32,128 which is a lot higher than $11,393.
Additionally, you will reduce your risk. If one is vacant for a month, you still have income from the other three properties. You can also spread out the four properties by investing in four different cities. This reduces the risk that the job market changes in one city detrimentally affecting all of your investment properties.
There could be other ways to profit, but these five are the ones that I focus on. For me, my priority is in this order 1) positive monthly and annual cash flow, 2) tax benefits to reduce taxes (taxes are the largest expense in most people’s lives and reducing them helps you keep more cash) and finally 3) potential for the equity appreciation over time. So, for me, those are the basic economic reasons for investing in this class of real estate. If done right, I can easily get an annualized return greater than 20% (after taxes) on my investment which is way better than I can expect in the financial markets.
Let’s Talk
If you’d like to have a conversation about this type of investment, feel free to email me or set up a call with me or just call me if you already have my phone number. I’d love to hear what you think.
For now, be safe and take care of your family.
Mark