Determining if Rental Real Estate is a Good Investment
“Do you love it?”
I say this half-jokingly when someone asks me:
“Should I invest in real estate?”
After we laugh a little, my answer is actually:
WENT
Which is short for:
Why: do you want to own real estate?
Experience: of repair/maintenance of property &/or working with a network of professionals who can
Numbers: Do they make sense?
Time: commitment/bandwidth available for working on the property
Let’s explore this in more detail:
Numbers:
I love to start with this because, well, quite frankly I think they’re the primary greenlight to purchase.
If the numbers don’t make sense, you move on.
So what numbers should you consider?
Total return.
Which is simply:
Your gross cash flow + price appreciation - all costs of owning the property - value of your time
But there’s one problem:
You don’t know this number when you purchase the property - you’re dealing with a lot of uncertainty.
Yes, you can have a positive net cash flow - but what happens if you lose a renter and now your net property cash flow is negative?
Yes, you experience tons of equity appreciation but you’ll have to either sell the property, perform a cash out refinance, use a reverse mortgage, or use a home equity line of credit to tap into that equity (of which, all options that require a tradeoff of having another loan or having to sell the property).
Yes, you can have a positive return with cash flow and price appreciation but if the property took a ton of your time, how are you factoring in the intangible cost of your time over the life of the investment? (hint: it’s worth something compared to other alternatives)
So how do you deal with this uncertainty upfront when buying a home?
Consider multiple numbers and play out a few scenarios.
When I look at whether a rental property will make sense on paper, here’s a few things I consider:
Monthly cash flow = Gross rents expected (to include any other revenue sources, parking, laundry, etc.)
Monthly expenses = maintenance & repairs, property management (if applicable), property taxes, HOA, insurance, other expenses
Net Operating Income (NOI) = monthly cash flow - monthly expenses
Net Cash Flow = net operating income - monthly mortgage payment
Cash on Cash Return = net cash flow / invested equity (down payment + closing costs/prepaids/maintenance/repairs)
Rental Yield = gross cash flow / current property value
Capitalization rate = yearly net cash flow / current property value
I like to pay the most attention to net cash flow.
If the property isn’t generating positive cash flow above all the expenses associated with the property, it’s not going to be a good investment.
Profit > Revenue
Having a rent roll of $200,000 sounds great, but if your expenses are $240,000… suddenly that doesn’t sound as nice.
Cash on cash return does a great job of opening the door into opportunity cost.
Are your invested dollars generating a return that you couldn’t get anywhere else?
I consider the stock market as a fair alternative to real estate, where long-term rates of return for a globally diversified equity portfolio can be around 8.20%.
When you factor in the value of your time, your cash-on-cash return hurdle rate may be around 9.20%+.
Because anything less may indicate owning a basket of stocks may be a lower hassle, similar return option.
But you can’t leave out equity appreciation - same applies to your cap rate. If it’s attractive (above 9.2% as well) you may consider further pursuing real estate.
But there’s a wrinkle here:
Because you’re using borrowed money you increase your potential return in real estate.
So while real estate equity appreciation may not be as large as stock market appreciation, you don’t need a higher rate of return to make the total real estate appreciation to be greater than the total return on the same cash amount in the stock market.
But the numbers don’t end with just the total return on the property, there are also attractive tax incentives for owning real estate, the primary culprit?
Depreciation & 1031 exchanges.
Depreciation allows you to reduce the value of an asset with the passage of time on your tax return.
This creates a phantom expense that helps reduce the taxes owed on your net property cash flow.
The depreciation that you take each year, while it sounds great, it’s not a freebie - it’s recapture upon sale. More on that HERE.
Further, there’s the ability to utilize losses created from your real estate portfolio, but that’s limited to those who are active participants in real estate or real estate professionals.
That’s behind the scope of today’s article, but you can read more about that HERE.
1031 exchanges allow you to defer the capital gain and depreciation recapture when you purchase a new investment property allowing you to roll the proceeds from the previous property into the new property (simply stated - there’s various stipulations here).
This also restarts the depreciation clock allowing you to fully depreciate the new property.
Bonus: Keep the 1031 exchanges rolling until you die, then your heirs receive the property tax-free because they get a step up in basis.
But that’s just the numbers, next up?
Your “Why”:
Why do you want to own real estate?
If you just read Rich Dad, Poor Dad & now think you’re going to be a real estate millionaire and will have 10 rentals in a couple years and retire:
That’s probably not an answer I’d feel confident in.
On the other hand:
If your Dad has a few properties that have paid off for him, you’ve enjoyed working with him on property maintenance and understanding the potential hassle that can be created from real estate & you’d like to start building your own property:
I like that answer a bit more (just one example).
There are no get rich quick schemes and if you’re looking at real estate as a way to supercharge your net worth, you might as well be playing with fire.
I’ve seen it worth both ways, I’ve seen investors burned from a desire to get into real estate (when they really shouldn’t be) & investors make a killing in real estate.
It’s all case dependent.
On the heels of your “Why” is our next pillar:
Experience
Do you know what you’re doing if the property needs to be repaired or there’s maintenance to perform?
It’s fine if you don’t have the skill yet but do you have the desire for the skill?
Just getting into real estate with a project that will require work, but you have the desire and time to devote to it could be a great experience for you.
You just may want to make sure you tame your expectations as you get going.
Or do you have a trusted and vetted network of professionals who you can call to deal with the problem at hand?
You can easily hire a property management company to handle much of the hassle associated with the property but I’ve also seen it where instead of managing tenants, you just manage the property management company.
I’ve also seen it where investors say:
“Don’t call me unless the property is on fire”
It works both ways.
Last one is a big one:
Time.
Do you have the commitment/bandwidth available for working on the property?
If you’re getting into real estate because it’s a “passive” vehicle…
You may want to think again.
I don’t know many investors who get into real estate who just passively collect a check without regard to dealing with the property.
You will always be involved to some degree - even if it’s just the mental burden of knowing you have another property on your balance sheet to worry about.
I know plenty of people who LOVE real estate.
They spend their weekends working on rehabbing properties, extra time researching and finding deals, visiting homes, driving around neighborhoods to scout out the intangibles of a potential property.
These are the types of individuals who real estate works best for - those who love it.
But funny enough:
Isn’t that most of the case where the people who have the highest likelihood of success are the ones who love it?