House #2 is officially rented!
Last week I showed the house to a man who liked it so much, he grabbed his checkbook and handed me a deposit on the spot.
I ran the necessary screening – credit check, criminal background – and he looks great.
He drives a brand-new Mercedes Benz, which costs twice as much as the house. 🙂
So how good of a deal was this?
The total cost – purchase plus repairs – came to $30,000, and the monthly rent is $895 per month.
The One Percent Rule says that a rental is a good deal if the gross monthly rent is 1 percent or more of the purchase price. In this case, the monthly gross rent is 2.98 percent of the purchase price. Score!!
But Does It Cash Flow?
Most new investors – myself included – start with the question, “Does this house have a positive cash flow?”
The problem with that question is that almost ANYTHING will positive cash flow if you buy in cash. You can’t decipher whether or not a house is a good investment based on that.
The better question is “What’s the house’s return on investment?” The common way to measure this is through a metric called the cap rate.
The cap rate shows you how long it will take you to recoup your costs. You figure this out by dividing the house’s price by the net cash flow.
In this case:
The Price: $30,000
Annual Gross Income = $10,740 ($895/mo * 12 months)
A quick glance at those numbers tells you that the gross income will pay off the cost of the house in less than 3 years. In other words, I’m getting a 35 percent gross return. That’s a good sign!
But I don’t care about “gross” return. I’m concerned about “net” income, which means income after expenses. So let’s look at the costs.
Yearly Costs:
Advertising = $150 per year (or per lease term)
Trash = $396 per year ($33/mo)
Insurance = $1,100 per year, approximate
Property Tax = $1,200/year, approximate
Management = $1,074 per year ($89.50/month, or 10 percent of gross rent).
Repairs and Maintenance = There are two competing rules of thumb here. One rule of thumb says that 50 percent of your rental income goes to maintenance/repairs/management.
I don’t think that rule applies here, for two reasons.
#1: Rent and maintenance are “independent variables” – one can move without impacting the other.
#2: I’ve heard from many investors that the 50 Percent Rule tends to apply to apartment buildings, not single-family homes. (Apartment buildings have higher operating expenses, as they need to maintain common areas like the lobby, hallways, parking lot, facilities, etc.)
A different rule of thumb says that 1 percent of your purchase price will be the home’s annual maintenance cost. I’m suspicious of this rule, as well, because the purchase price and the maintenance costs are also “independent variables.”
The purchase price fluctuates based on the economy, the neighborhood and the school district performance. The maintenance costs are based on how long your roof will last. These two are unrelated.
But I’m willing to play ball. During the peak of the housing bubble, this house sold for $98,000.
Let’s take 1 percent of that, and assume the maintenance will cost $980 per year.
Yearly Costs = $4,900
Then add another 10 percent as a “safety margin” so that we have a conservative estimate.
Total Yearly Costs = $5,390
Now, subtract your Yearly Costs from your Gross Income, $10,740. This tells you the “net income,” which is your positive cash flow.
Cash Flow: $5,350 each year!! Wahoo!!
But wait! ANYTHING can have a positive cash flow if you buy it in cash. That doesn’t mean it’s a great investment.
So let’s take the final step and calculate the cap rate:
Cap Rate = Cash Flow / Price of House
Cap Rate = $5,350 / $30,000 = 0.178, which is a 17.8 percent return!! Happy dance!!
A 17.8 percent return is absolutely solid. At this rate, it will take me 5.6 years (100 / 17.8) to recoup the initial investment.
FAQ’s
Let me answer a few questions that I imagine this post is going to pose:
Q #1: Ouch. This sounds like a lot of math.
A: Technically, that’s not a question. But I get what you mean. As I said recently, I’m terrible at math.
Fortunately, this is all middle-school math. It ain’t calculus. And while it looks daunting, a few minutes of number-crunching can save you from a terrible investing decision (or push you into a great one!!)
Q #2: Wait a sec, I thought you did your own property management. Why are you subtracting the property management costs?
A: Yep, I do. But I need to make a profit AFTER paying myself. I can’t value my own time at $0, value someone else’s time at more than $0, and make a fair comparison between the two.
I pay a property manager. In this case, I hired myself to do that job. That’s not part of my return-on-investment, that’s a second job that I took on. (In other words, $5,350 is passive income; the additional $1,074 in my pocket is active income).
Q #3: Aren’t you forgetting the cost of yard work? And water bills?
A: The renter is expected to mow his own lawn and pay his own water bill! Whew! That’s because this is a single-family home, not a multi-unit building.
Q #4: Are you rewarding yourself with a flight to Austin now that you’ve found a renter? When you listed the house on the rental market, you said you’d reward yourself with a trip.
A: Why, thanks for remembering! Yes, I am! I leave on Wednesday. 🙂
UPDATE 2012: This post was updated on 10/18/2012 to reflect a less expensive property management fee — discovered after shopping around!
UPDATE 2015: I’ve started publishing monthly income reports. Check these out if you’re interested in seeing a more detailed snapshot of the entire rental property portfolio!
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The numbers look awesome! And it sounds like you’ve found a great renter. Double score. Have a great time in Austin!
I would like 10 of these and then I would trade them for a larger property (apartment building).
@krantcents – That would make for one heckuva blog post ….. 🙂
Hey Paula, are you planning to play by Monopoly’s rules of eventually trading in four homes for a hotel (or any other multi-unit dwelling)?
@CMonster – Definitely NOT a hotel! What a full-time job!! I don’t know if I’d sell these to buy a huge apartment building. It would consolidate all of my risk into one location, which I’m not a huge fan of doing. But if the numbers, the location and the timing is right, then maybe I would. I don’t think that’s the type of thing you can plan. We’ll have to just see how things pan out.
Great job! On the property, the numbers look great. I would love to see a follow up to this post, maybe at the 1 year anniversary breaking down the actual numbers. My numbers were much different than expected for my rental properties.
@YFS — That’s a good idea! What happened with your numbers? Do you have a post about it that I can read?
Paula, I blog about it monthly, in my income report. Essentially, my rent is never paid in full. The tenants rarely, pay their portion of the rent. I don’t even count on it anymore :-(. I only focus on the guaranteed section 8 portion of the rent now. By doing this, my cap rate dropped drastically to a paltry 10%. If the tenants paid their portions I would be in the 20% range. 10% isn’t bad, but I know it could be much higher if my tenants got their act together.
@YFS — That’s too bad, but I’m glad that you at least have some guaranteed rent coming in. As long as they don’t trash the place, things should be good. Plus, 10 percent is pretty good, especially for a property that requires zero time from you.
Congrats on the awesome deal and finding a good renter. I was looking into buying a rental property but my current situation and the numbers didn’t make sense for me right now. I’m glad things seem to be working out for you!
Wow! That is a ton of math! Did you know these numbers prior to renting? or was this really the first time you did the math?
@Evan — Haha, and I’m not a math-oriented person! Before we bought the house, we ran an analysis of the “best case,” “medium case” and “worst case” scenarios, plugging in all kinds of variables for the costs and the rent. The best case scenario imagined the lowest costs and highest rent; the worst case imagined the opposite. We do this for every house we consider, and we only make a move if the worst-case is something we could live with.
Fantastic work! Enjoy Austin, I have a great time every time I go!
Thanks Dollar D! Any recommendations?
Wow, I really can’t believe those numbers! I’ve never seen anything close to that good anywhere I’ve lived. The cheapest trailer in my town, which literally had a hole in the floor, still cost $65K, and you don’t own the land, it’s a pad rental.
@Anne – I feel fortunate to live so close to such good deals. If a person is interested in rentals, though, and doesn’t have great deals nearby, I’d encourage you to look further away. I know some people who own rentals in different states. One of the added bonuses of being a distance-landlord is that you’re forced to delegate the management, so you don’t get trapped in the “do” cycle!
@Anne,
I whole heartedly agree that you can have properties in other states where it is affordable. You must make sure you have a great property manager! They are worth their price in gold. Must be able to communicate with you on a regular basis.
I should probably write an article on this as I now have four property managers in three diff states.
Neema
That is an incredible deal! The down market sure has been good to you. Thanks for all the tips and math — it will make my own first income property purchase seem less daunting and more doable!
@Christa – I’ve found that investing can bring up a ton of emotions — excitement, fear — and doing the math is consoling. No matter what you’re feeling, you can always rely on the math to give you impartial advice. 🙂
Congratulations! I have had similar success in renting my properties. I too have had an approx 16% return. I love it when a real estate project comes full circle and you finally have a tenant!
@Sid – Congratulations on your great returns!!
I realize this post is old but I’ve just stumbled upon your blog today (via GRS) and have been reading intensely, very informative. Forgive me if you’ve covered this elsewhere and I haven’t read it yet, but why do you not include the myriad of tax deductions (depreciation, maintenance costs, travel expenses, etc.) for rental property into the cash flow calculations?
@Tom – Thank you so much. I’m happy to welcome GRS readers to this site. To answer your question: real estate investors use a variety of metrics to evaluate a rental property. “Cap rate” measures the cash flow, relative to the value of the property, but it ignores three factors: 1) debt service (mortgage), 2) tax implications (including building depreciation), and 3) property appreciation.
Why? Every investor’s tax consequences and debt terms/conditions will differ. Your taxes will change each year based on your income, based on the number of other properties you own, based on your marital status and number of dependents … etc. Your debt service may change throughout the life of the investment (e.g. you might have a mortgage with a 7-year balloon payment that you refinance in year 6). And property appreciation is tough to predict.
In other words, these three variables (taxes, debt and appreciation) fluctuate. That flux happens both among investors (Investor Joe will experience different tax consequences than Investor Sally) as well as within the lifetime of any particular investor.
By leaving those three variables out of the “cap rate” equation, an investor can make a simple, apples-to-apples comparison between Property A and Property B, to determine which one is the best buy.
Hi Paula,
Love you spirit of travel, adventure and real estate ventures, I feel like we are a kindered spirits! I love traveling all over the world too. I just purchased several units last year too and some I’m rehabbing. I have multi units, single family, duplex, fourplex in my portfolios. Love your details. I’m a realtor in Northern Virginia and got into real estate for the sole purpose of knowing how and what to do to purchase real estate. I was a Software Engineer for 23 years and finally switched over to something I love to do– real estate specifically rental properties.
It is nice to be able to talk to somone who had done this too. Maybe we can compare notes sometimes.
Thank you for writing these blogs.
Warmly,
Neema Nene
Hi Paula,
Love your website! I was referred by JIm at http://jlcollinsnh.com/.
I’m looking to buy my first rental property and have a couple quick questions:
Do you include debt service when calculating the cap rate?
Do you use an s-corp or llc for each property?
Is the net income taxed as capital gains or personal income?
Thanks for your help!
Chris
Hi Chris –
Thanks for joining the Rebellion! To answer your questions:
#1: Nope, you shouldn’t include debt servicing in cap rate calculations. Here’s why (check out this article).
#2: I use two LLC’s for my real estate business — so it’s not “one per property,” due to the administrative burden that would create, but they’re still protected under each LLC. I also carry an umbrella liability insurance policy.
#3: Rental property income is counted as Passive Income by the IRS. (The IRS classifies income in three ways: active, passive and portfolio income. Each carry a different treatment.) Check out this page for details.
Thanks!
You mentioned a cap rate of 17.8 % is solid. What would be an example of a average cap rate. Also do you think it is beneficial to have a real estate agent’s license to be a real estate investor. Thanks!
@Parag — If I’m investing in a stable market with high-quality tenants, I’d be happy with a cap rate of 7% or more. If I’m in a shakier market with higher vacancies and more tenant risk, I’d want a cap rate of 12% at a minimum.
You don’t need a license, especially if you’re a first-timer. Wait until you have one or two properties under your belt before you devote a few hundred hours to undergoing all that course material. If you’ve already invested in a handful of properties and you know from experience that you’re a “lifer,” then reconsider getting a license.
hi,
Your material is solid and extremely helpful. Thank you so much for putting in the time and energy in helping those less knowledgeable be able to process this information in small and easy sound bites! My question is, if you have a mortgage how do you process the math. Do you just calculate the mortgage interest into the expenses?
Thank you for your help!
Miriam
Great story. But how did you find a house to buy for less than $30,000? Was it dilapidated or something? Do you have a co-buyer and only your half was $30,000?
Aimee — Did you read Part I of the story, which I linked to at the beginning of the article? I explain how I found the property. Click the link and read the full story.
You can find houses across the Midwest and South that sell for less than $30,000. I grew up in Ohio, and in my childhood neighborhood, a couple blocks from where I was raised, there’s a home that’s currently on sale for $48,000.
Also, you can invest in rental properties anywhere across the U.S. You don’t need to invest in your own backyard. I’ve been living in Nevada since last year, and my 7 rental units are all located in Georgia. I hired a team that handles everything.
Hey Paula, great blog! I noticed that your main strategy is to purchase a home, fix it up, and offer it to a tenant that will pay on a monthly basis. I was just wondering if it would be better to use the same approach as you have, but instead of offering it for monthly rent you would possible earn tens of thousands by reselling the house and moving on to the next deal. Can you justify why renting would be better to accumulate wealth then reselling the house?
Best Regards,
Maks
I see Paula hasn’t answered yet, but here’s my take. It’s the difference between passive and active income. If you keep the house, you (and eventually, your heirs) have passive income for as long as you own the house. If you sell the house, you have to keep flipping more houses to keep the money coming in.
Wow thank you! Everyone explains how to do the various calculations, no one gives much advice on when to apply them! This makes it much clearer.
Wonderful blog!!!
* How much time went in between the time you got your real estate licence and starting to invest?
* Based on the the cost of the homes listed, they were NOT purchased in California. What state(s)
did you buy into?
Thank you.