Remember when we bought House #3? It’s now rented! Let’s see if this deal is hot or not.
Excuse Me, Did You Say House #3?
As long-time Afford Anything readers know, Will and I bought our third rental property in May. It’s a 3-bed, 1.5-bath single-family home in a good school district in Atlanta. The asking price was $125,000, and we snagged it for $94,000.
This needed the fewest repairs of any of our houses. Here are the “before” pictures. As you can see, the scope of work was small. Knock out a wall or two; bust up some concrete steps; install a skylight. Voila – instant awesome!
Check out the “after” photos, below.
The total cost of the renovations came to $6,000, which means our “total purchase price” (purchase plus upfront repairs) was a solid $100,000.
It now rents for $1,295 per month. Passive cash, baby! Right away, we see that this passes the One Percent Rule with flying colors.
(The One Percent Rule states that the monthly rent should be at least one percent of the purchase price. Move the decimal point two spaces left. If the monthly rent isn’t at least that high, buy a different rental.)
But let’s dig down deeper. How do those numbers check out?
What’s the Cap Rate?
First, let’s find the “capitalization rate,” or cap rate. This measures the net return that the house provides, excluding your financing arrangement.
Why examine this? Because it shows you the strength/weakness of the deal itself, in a vacuum. Remember, ANYTHING can be cash-flow positive if you buy it with cash. That doesn’t mean it’s a good deal.
The “cap rate” helps you examine the quality of the underlying deal. Once you decide whether or not the investment is worth pursuing, you can calculate how different cash/financing scenarios will affect your passive income.
How do you find the cap rate? It’s easy: Just divide the house’s price by its net income.
Gross Income: $15,540 per year
Management – 10 percent of rent – $1,554/year
Taxes – $1,100/year (includes trash service)
General Repair/Maintenance Fund – 1 percent of purchase price – $940/year
Utilities – The tenant pays everything! That’s one huge benefit of renting out a single-family home, as opposed to a multi-unit building. (In contrast, we pay $300+ per month to cover the tenants’ water bills in our three-unit building.)
Yard Work – The tenant handles it!
Total Expenses: $3,594 per year
NET Income (Income after Expenses): $11,946 per year. Yeah baby!
Right off the bat, I can see that this is a sweet deal. I’m netting almost $12,000 a year for a $100,000 house. That’s roughly 12 percent.
Crunch the numbers, and the cap rate is $11,946/$100,000 = 0.1194, or 11.94 percent.
I don’t know about you, but I think a near-12 percent return is pretty stellar. It’s not as sweet as the 17.8 percent return I’m getting on House #2, but hey, you can’t strike gold every time. ☺
So How Much Cash Goes In Your Pocket Each Month?
Okay, now we know the cap rate. How much passive income are we collecting?
We have a private loan in which we’re making interest-only payments at 7 percent. (Hold your horses! I know this might create chaos in the comments section. I’ll explain why we choose this below.)
Let’s look again at the numbers.
Net Income: $11,946 per year
Financing Payments: $7,000 per year
CASH FLOW after debt service: $4,946 per year! Wahoo!!
We’re getting $5,000 in passive income each year from this house! That’s one huge step closer to financial freedom.
Why did we get the financing that we did? Look again at the numbers. Look carefully. How much money did we pay out-of-pocket for this investment?
Zero. Zip. Zilch. Nada.
Without spending a dime of our own money, we set up a deal in which we receive about $5,000 in passive income per year. That’s AFTER paying a property manager to do the actual work, plus setting aside a “rainy day” fund for long-term maintenance and repairs.
In other words, we borrowed at 7 percent and used the money to snag an investment that pays 12 percent. This practice is called “arbitrage,” which might be my favorite word in the English language. ☺
“Why get interest-only financing?”
It gives us the most flexibility. We’re earning $5,000 a year in passive income, with no money down.
We can choose – CHOOSE – to use that $5,000 to pay down the principal on the house. (There is no pre-payment penalty). We can use the money to buy another house. Heck, we can blow it on champagne and strippers, if we wanted. It’s our choice.
“What are you doing with that money?
First we’ll buy a few more rental units. Then we’ll start paying down the loans. In other words, we’re reinvesting the profits back into the business.
“Are you disciplined enough to re-invest that money?”
DUH!! If you’re not, get out of the game!
“Why not just borrow from a bank?”
I’d love to. But banks are sick of us.
“Are you worried that you’re over-leveraged?”
Nope. We use cash frequently, and we have kick-ass equity. We bought House #2 in cash. We paid for repairs on House #1, Unit B with cash. Relative to many real estate investors, we’re quite conservative.
“You allot $1,554 for paying a property manager. Why not manage it yourself?”
“Then why do you include a ‘management’ line-item?”
Because I pay myself for my time.
The management fee is active income I pay myself for the time I spend managing the property. It’s a radically different beast than the passive income I earn from the investment.
Rookie real estate investors conflate ‘paying themselves’ with ‘profit.’ You can’t pay yourself $0, pay someone else a a fair wage, and make an apples-to-apples comparison.
Every investment must allow me to make a profit after paying myself. That way, I can remove myself from the equation and the numbers will stay the same. Remember, the goal is financial freedom, not a lifetime job.
“Are you talking to yourself, in the form of italicized questions?”
“In public? On a blog?”
“You’re a dork.”
That’s not a question.
“You just proved my point.”