Make the rental real estate calculations add up for you
Q: How do you feel about owning rental property for a single family home versus investing in the stock market?
A: I’ve seen many families succeed with rental real estate, but only by owning multiple properties for many years (even decades). As rents increase, positive cash flow often occurs as the mortgage is paid off by tenants. But the calculation is difficult, especially in the early years.
Here is an example.
A client family asked about renting a house they were leaving. The house was worth about $400,000 and they had about $200,000 left on the mortgage. Their monthly cost for mortgage, property tax and insurance was estimated at $3,000 per month and they estimated they could rent the property for $3,500 per month. We also noted that the fact that they had a mortgage technically meant that they had less cash tied up, giving them leverage for earnings. However, leverage works both ways. A loss of a quarter of the home’s value would cut its net worth in half.
I noticed that owning this property and putting time and work into it for many years might pay off, but it wouldn’t really make them any money in the first few years. The only two ways to make money would be through the accumulation of equity with each mortgage payment and the possibility of the house going up in value.
On the expense side, we discussed that their $200,000 capital sitting in the house had an opportunity cost, i.e. it could be invested elsewhere and probably make money there. -down. Even if we were looking at a low expected return of 3%, that would mean $6,000 per year.
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They should also consider an allowance for the property being empty for a certain period of time and at least recognize the risk and cost of a ‘bad’ tenant. The property will have scheduled/scheduled maintenance (water heater, air conditioning unit, roof, etc.) and unscheduled maintenance and repairs.
So we discussed the fact that they were investing in a highly illiquid product that also had invisible risks (property prices can certainly go down) for perhaps no net income for several years. Presumably and hopefully, rents will rise enough in future years to produce net income while the mortgage balance also declines. We have observed that most of our client families who have chosen to own one or two properties often comment to us that it is “not worth it”.
Historically, residential real estate appreciates at roughly the historical rate of inflation (two to three percent per year). The US stock market historically appreciates at double that rate over the past 70 years and is a truly “passive” investment.
I would conclude with the belief that rental property can be a good investment, but it takes patience, time and work. The most successful real estate investors I’ve seen typically acquire multiple (or multiple) properties slowly over a period of years and don’t rely on real estate price appreciation to provide most of their gains.
Steven Podnos is a paid financial planner in Central Florida. He can be contacted at [email protected] and at www.WealthCareLLC.com.