UNDERSTANDING HOW RENTAL INCOME REAL ESTATE CAN GENERATE PROFITS
I was trying to reason through some of the new-age investment advice regarding rental income real estate. Investing in real estate was the key to riches starting in the 1970’s, especially so for the brain-drains who emigrated their countries for the US.
Most of the advice which you read about these days, whether online or in books, is focusing on rental income properties. These are single family homes or condos which are rented to individuals. The specific advice regarding these investments is that they should be cash-flow positive.
DEFINING A CASH-FLOW POSITIVE INVESTMENT
A cash-flow positive investment is one which puts money in your pockets throughout most of the investment period. Specifically, if you are renting out a home then the income from rent not only covers the expenses of the property but also leaves you with a profit by end of the year.
If you are renting a home for $1,000/month and have $500/month of expenses then you have a $500/month of positive cash-flow. Fairly self-explanatory, right?
So the question I want to answer with this post is whether the investment would still be worthwhile if you broke even, for example, $1k/month of income and $1k/month of expenses.
The expenses, of course, would be everything from HOA dues, property tax, property management fees, vacancies, property turnover between tenants, and repairs, etc.
CAPITALIZATION RATE & CASH-FLOW
Again, going back to the current advice regarding rental income properties, it’s considered a weak investment if you have a capitalization rate of <8-10%. Let’s define this cap rate and understand how the 8-10% number is calculated.
Okay, so think of capitalization rate as a return on investment that’s more standardized. For example, in our home above where we are making $500/month after expenses, we are earning $6,000 for the year. If we divide this number by the price we paid for the home (let’s say $150k) then we come up with capitalization rate.
In the above example, the cap rate is 4% ($6,000/$150,000=0.04). This is considered abysmal among investors.
The point of this post is to talk a little about what constitutes a good investment and whether we should let capitalization rate determine the value of our investments.
3 BASIC Methods TO INCREASE WEALTH THROUGH REAL ESTATE
Residential rental income is ubiquitous and fairly easy to understand. There are a lot of great resources for the novice investor to predict the common unforeseen expenses of a house which is rented out in order to roughly calculate whether a specific investment is a good investment or not.
For the title, I chose increase wealth instead of saying “earn income” because there the point of investing is to increase our wealth, it’s not always about seeing cash in our pocket.
Yes, we talked about this. Whatever money you are left with at the end of the month, that’s your cash-flow, your income, it’s the return on your investment.
This certainly is the most popular form of real estate investing. It’s a sweet situation when you get to pocket money every 1st of the month.
You earn a few thousand for the year, pay off all the various expenses of the property and then are left with some income. You get to write off some depreciation which is the cost basis of the property divided over 27.5 years. In a $500k property, it would be ~$18k/year.
In order for cash-flow to be real, there must be some actual dollars left over after paying for expenses at the end of a calendar period. Whatever method you use to increase the rental income and decrease the property expenses, will tip the scales in favor of a positive cash-flow.
2. APPRECIATION OF ASSET
A real estate asset could earn some money in rent or it might be a property that you intend to flip. Though each of these is its own unique investment method, they can be combined.
In hot markets such as SF or NY and now Portland, one might have a piece of property that is being rented out which drastically appreciates in value. Even though the main mode of income is through rent, there could be a much greater form of income through appreciation of the asset.
The investor can then decide to sell the property to lock in a profit or perhaps hold onto the property even longer, speculating that it’s going to go up even further.
3. INVESTMENT DEBT PAYOFF
How about a negative cash-flow? If my property expenses are higher than my rental income then I would have to put money into this investment out of my own pockets.
I may not profit though the cash-flow method (#1) but there is still money coming in to pay off my mortgage on the property assuming, of course, I didn’t buy the investment in cash.
This is perhaps the more hotly contended aspect of real estate investment. The question being, is it okay to have to pay a little every month in order to have a rental income property? That’s what we’re getting into in this post.
For the record, a couple of years ago, I wrote a post talking about how many doctors were horribly positioned in real estate because they often were breaking even on their rental income properties.
Back then, being the young ignorant buck that I was, I didn’t take into consideration that doctors often bought nicer investment homes, in more desirable neighborhoods which position them nicely to have an asset that will likely appreciate (method #2, from above) while having renters pay down the mortgage (#3).
CASH-FLOW OF A PAID OFF PROPERTY
There are a lot of factors when considering a paid-off property, let’s review them here, it will help the would-be investor make better decisions. It’s a much bigger gamble to put up all of your own money into a real estate investment deal rather than using mostly the bank’s money.
In the next few paragraphs I would like to talk about a scenario in which you might take a sum of cash and pay for a rental income property entirely – for example, paying for a $250k house and then figuring out the value of the income earned from it, the return on investment (ROI).
The reason I emphasize value is that there are certain overheads involved when paying for a property in cash that’s different from carrying a mortgage. And just because we are earning, for example, $1,000/month from that property, it doesn’t mean that it’s a worthwhile investment, not without considering all the other alternatives.
Another abstract way of making my point would be to use an example of a chef who spends $50,000 to buy a food truck…
- then spends another $50k over the next few months to build it up
- spends 14 hours per day working at this business
- leaves their job as a chef to start this business
- nets $3,000/month after paying their overhead
- sells the truck for $75k after 10 years of running it
This example might help make my point below because this person tied up $50k which could have been earning a return in another investment.
They left their job and replaced their income with an income from their own business. And that person now spent perhaps more time running this business, which is a time value which must be considered.
Let’s now talk about the various factors to consider when buying a real estate in cash in order to convert it to a rental income property.
FACTORS AT PLAY:
- how much your money could earn if it wasn’t tied up in the home
- ongoing expenses to manage the property
- tax benefits of a rental income property
- time commitment
- the psychologic value of owning a rental income property
- resale value of the home once sold
1. OPPORTUNITY COST
Opportunity cost is the term used to refer to the money you have tied up in the house and how much that money could earn invested elsewhere.
If you paid down 20%, well, then that 20% could be used in other ways to earn an income – that must be considered and factored into the actual value of an investment.
In the case of buying a home in cash, if you pay $250k from your savings then you must consider what that $250k could have earned in a similar investment.
So what would be a similar investment? I would say a mutual fund REIT would come close or perhaps even an index fund or a CD.
For $250k, it would be safe to assume a rate of return of around 1% above inflation based on current market trends. That would be somewhere in the 3-4% range.
After 10 years, the $250k should, therefore, be at least worth $370,000 if invested in the real estate in order to consider it a “wise” investment.
2. ONGOING EXPENSES
We can’t just consider property taxes and HOA dues when it comes to overhead in such a business venture. Tenants will wear out the carpets, faucets, outlets, sinks, paint and doors. Mother nature will wear out the roof and doors, the siding and the driveway.
Appliances may need replacing within 1-2 days especially when it comes to things like a broken refrigerator or a dead washer/dryer.
Emergency expenses such as a burst pipe or a leaking drain require a phone call to a 24/7 plumber. If the A/C or heater dies or there is an issue with a gas leak, this must be addressed right away because it’s a business you are running. Your tenant can’t live without such amenities.
3. TAX BENEFITS OF A RENTAL INCOME
The first 2 points were a little negative, let’s talk about the positive. There are tax benefits when investing in rental income. Depreciation is the low hanging fruit and writing off expenses against the rental income is the next point.
Depreciating The Home On Taxes
Any asset which is used to generate income in a business can meet criteria for depreciation. You can review this on the IRS website. A certain percentage, somewhere in the 3.5% range, can be written off against your taxes for approximately 27 years of owning/renting the unit.
Deducting Expenses Against The Income
Next, if you spend $3k to fix water damage in the bathroom then you can deduct that from the total income you made for the year. However, it’s not free money.
If you made $10k on the property for the year and would owe taxes on that $10k, you would now only owe taxes on $7k because you deducted the $3k you spent on the moldy wall repair.
So, did you save $3k? No, you saved only $625 on taxes. Instead of paying, let’s say, 25% on $10k, you ended up paying 25% on $7k.
I think understanding this point is really helpful. Too often, people blurt out things like “It’s all good, I’ll write it off on my taxes!” Understanding what this phrase means is important – it’s certainly misleading because you aren’t writing it off but only saving a percentage of the expenditure by listing it on your taxes.
4. TIME COMMITMENT
This is one of my favorite factors to consider. It has become that much more important now that I have been able to enjoy authentic freedom; the freedom to have my entire day to myself without anyone telling me what I gotta do.
It’s also that much more important because physicians are uniquely different in that they earn a very high hourly wage. Trading this hourly income for working on real estate must return a higher return on time invested compared to practicing medicine unless there is an alternative purpose – such as diversification, or in the case of someone who wants to get out of medicine, etc.
Let’s work with some examples. I, for example, invest the majority of my money in index funds and I anticipate to get a ROI (return on investment) of around 3-5% in the long run.
If I, instead, use my investments to do some day-trading then perhaps I could expect a return closer to 15-20%. This would require several hours of work every single day. We won’t address the higher risk here because, technically, that should be equivalent due to the extra time spent (so I’ve heard).
Would it be worthwhile for me to get 5x higher returns by spending several hours a day extra? In my case, no. I would then be taking on a part-time work and lose the passivity of my index funds.
In order to acquire a rental income property I would have to:
- deal with a bank
- get a pre-approval letter
- deal with a realtor
- shop around
- signs contracts
- submit paystubs
- renovate the property to make it tenant-proof
- advertise for a tenant
- exchange keys
- make payments
- spend time learning how to manage such an investment
- deal with tenant issues
- work with contractors and gardeners
- I would have to turn the property over between tenants
- replace broken shit
- list the property at the end of my landlording career and once again deal with a buyer and realtor
Apparently, people online can bypass all this, somehow, or fail to mention it, or it’s so easy to them that they don’t consider it work. I, too, view my index fund investing quite brainless, when in fact, it required a lot of education up-front and requires me to have a coach (financial adviser) to guide me through it.
5. PSYCHOLOGIC VALUE OF OWNING A RENTAL INCOME
There is something sexy about owning a rental income property. We know of many who have made millions on it, often through the news networks.
I personally don’t know anyone who has lived a lavish lifestyle by way of being a real estate investor, at least not early in their life.
A buddy of mine who was 60, who frequented the same urgent cares in our moonlighting endeavors, had multiple properties in San Diego and Hawaii. He was always doing some work, on some property, traveling and dealing with situations. I’m not saying this is bad – just that he was 60 and moonlighting with me.
I know of 2 individuals who are successfully invested in real estate well past $10 million. However, it took them decades to build this up and the going was not easy.
Neither of these individuals had a graduate education. I think acquiring a medical degree is enough fucking work, putting time and effort into a whole new business venture could easily burn a person out.
Both of these individuals, also, made their money at other primary careers and funneled some of their income into investing in real estate and building up their portfolio.
Yet, the allure of home ownership remains. It’s perpetuated by media and contagious success stories. I rarely read about the horror stories, especially not on websites which are teaching a brother how to invest in rental income.
Finally, some ventures might click with you in a way that’s hard to describe. A person with a student loan debt at 1.5% might be better off paying that thing off as slow as possible. Yet, paying it off immediately might offer the best psychologic profit to that person (me, I’m that dude).
If you think that real estate might be your jam then start immersing yourself in it without necessarily jumping into it buck nekked. Shadow someone who does this. Turn a home you’d otherwise sell into a rental income or work for a property management company part time.
6. RESALE VALUE OF THE PROPERTY
In this final section, let’s talk about selling the property once you complete your reign as a landlord.
Remember that depreciation that was so juicy, saving you several thousand dollars every year? Well, if you end up profiting on the sale of the home, then you owe taxes on the difference of tax depreciation and asset appreciation.
This is called depreciation recapture which to me is like having to stop your urine stream midflow… worst feeling ever because even if you resume it, it’s just not the same!
SOME ACTUAL EXAMPLES
Let’s talk turkey, words don’t really capture the concept of a business all too well. I’m gonna give 3 examples of homes based on the math and research which I’ve done and dissect them down.
$900K WALNUT CREEK, CA HOME
If you bought a $900k home in Walnut Creek, Ca and rented it out for $3,500/month then you would have a potential capitalization rate of 2.6% if it is paid off.
It would require $180k of a down payment and you would spend $700/mo on taxes, $70/month on insurance. There would be about a 1% annual property maintenance cost (~$8k) and assume losing 1 month per year on average due to unoccupancy when turning over the rental.
That would leave you with $1,800/month profit if the property is paid off.
If it’s not paid off, and you rented it for $3,500/month then you would have the above payment minus your tax savings. I’m too lazy to do the detailed math and there are income factors which I don’t care to hash out, but with my rough math, it actually might be worthwhile. You would be taking advantage of method #2 and #3 from earlier in the post. Your asset would likely appreciate (#1) since it’s the city of Walnut Creek and you would have a tenant paying off your mortgage (#2).
The capitalization rate doesn’t take into account the opportunity cost of the 20% you put down. That money could have been invested in stocks or even used to buy a rental income property in cash. I’m repeating myself, but the point is worthwhile to keep thinking about.
$250K CONDO IN PORTLAND, OR
If I buy a condo in Portland, instead, for $250k and rent it out for $1,300/month then I would have a capitalization rate of 3.5%.
I would have a basic overhead of $1,544/month if I put down 20% and I would have another $3,000/year on property maintenance and unoccupancy.
The opportunity cost of the $50k would be different because the chance of the condo appreciating as much as a single family home is lower. And I would expect that my $50k would be worth at least $70k after 10 years of being invested in the property.
Now, if I paid for this property in cash, I would have around $9,000 per year of expenses to maintain this rental income property and I would take in around $16,000/year – that’s a net profit of ~$7,000/year or $580/month.
All of a sudden, we are dealing with an opportunity cost for $250,000 which should earn me at the very least $7,000/year if invested in lower-risk and lower-cost mutual funds.
Do you see how similar these two potential investments are becoming? Now, you’d have to sit down and figure out how much the depreciation tax savings will save you versus the index funds. You’d have to factor in the time needed to run a real estate business or the cost of hiring a management company.
Finally, you’d have to guesstimate which investment will fare better long-term. Will your mutual fund appreciate more in value and be safer or will the piece of real estate appreciate more and provide a safer long-term return.
$250K HOME IN ELK GROVE, CA
Now, you might be thinking that the condo has the HOA, so of course it’s not gonna make as much. You might think that if you bought a single family home instead in another cheaper city then you might be better off. Let’s look and see.
The $250k home, if financed with 20% down, would cost you $1,254/month just to cover P&I, insurance, and Taxes.
A home should have little higher maintenance costs annually but won’t have the HOA. You’re responsibe for foundation and exterior and roofing in a single family home.
The resale value might be better but it might be tougher to rent, depending on the neighborhood.
If you bought a cheap home in a wealthy neighborhood, well, it might not rent well because most families might afford to buy.
If you buy an average priced home in a poor neighborhood then you may not be able to rent it because fewer people can afford the rent. There might be higher risk of job loss which means longer unoccupancy or more frequent tenant turnover – all adding to the property maintenance costs.
What about rent? Well, the homes in EG are currently renting for around $1,500-1,700 when they are in fairly decent shape. However, the homes going for $250k, generally need around $20-50k of renovations to make it a viable rental.
BACK TO THE MAIN QUESTION, CASH-FLOW POSITIVITY
I wrote a lot and haven’t yet answered the question I posed at the beginning of this post. Does a property have to be cash-flow positive in order to be a viable investment?
No, it doesn’t. I proved the point, from my perspective, by demonstrating the 3 key concepts in which a rental income property can make us money: 1.cash flow, 2.appreciation, 3.debt payoff.
If you live in an area from a long enough time then you will feel it out and know what pockets in your neighborhood will make for good investments. If you are moving constantly then you may have a bit less insight unless you are insanely keen on such matters.
If I buy a home that breaks even after paying for all its overhead, I might still benefit because the asset might appreciate or because I can leverage some of the tax deductions such as the depreciation which we discussed.
WHAT ABOUT A NEGATIVE CASH-FLOW?
How about you buy a place, put down 20%, rent it out for $3k/month and end up having to pay $1k/month out of pocket to carry the property?
Is this carrying cost worth the investment? I would say, rarely. Remember, we have to account for the opportunity cost of that 20% as well.
In order for a negative cash-flow property to make for a good investmet then you must heavily speculate on the future appreciation of that asset.
Such is the game played by very savvy investors who invest in land, either in cash or through a bank loan. They will hold on to this land for decades until the right time comes to sell it. That carrying cost may or may not turn them a profit in the end. But if they do this with enough properties, losing money on 80% of them but profiting immensely on 20%, then they will likely come out ahea.