So You Want to be a Landlord? Part II: How Do You Actually Make Money?
I know we're not completely done talking about risk in this series (see the first post here ), but Paid Twice, from I've Paid Twice For This Already asks an excellent question with regard to the rent vs. buy debate. Namely, if you can save more money by renting a house than buying, then what is your landlord doing?
So I ask my readers - how does this work? Anyone know how renting can be so much less expensive than buying, yet the home’s actual owners don’t lose piles of money?
You can read the whole post over at Someone Had to Buy the House You Rent.
The truth is that rents sometimes do not cover the monthly costs of owning the rental home, so how is it that these real estate gurus make their money? A lot of people think that it must involve unfair tactics, such as buying investment property at below-market rates from gullible elderly people, but there can't possibly be enough gullible elderly people to keep the whole industry going. Others think it must be because all of the property is fully paid for, or that it was financed for better terms than today's rates. However, economically speaking, rental rates in today's dollars have to somehow make sense with today's property values and interest rates. And remember that not all rental property is residential. There are a lot of investors out there buying office and industrial space to rent out. How does it all work?
What we need here is a calculator and the back of an envelope. The first thing we need to do is identify the two different sources of income from investment property. The first is equity appreciation. This is a primary strategy for some real estate investors, who target undervalued real estate, or real estate in areas likely to increase in value, and then buy and hold until they decide to sell. There are many types of rental property, and even in a down market like today's (or especially in a down market) you can make money this way.
The second income stream is rents. A lot of landlords buy up properties and hold onto them indefinitely, living off the rents, which will increase proportionate to the finance expenses of the property the longer you hold it. Although some landlords may focus on one strategy or the other, the truth is that both are in play for any given property.
Getting out the envelope, let's make some assumptions (and remember the back of our envelope is small, so we are not going to to be excessively detailed about this).
We are buying an investment property today for $200,000, with a $60,000 down payment (30%) and financing it for 6.75% for thirty years. The going rate for a mortgage on your primary residence today is 6.13%, so 6.75% should be about right for an investment property.
First, the monthly expenses.
- Monthly mortgage payment (principle and interest): $908.04
- Taxes and insurance (50 mills): $483.33
- Water utilities (typically renters don't pay for this themselves): $50
- Maintenance (sinking fund*): $166
- Total: $1607.37
The rent you can charge is determined both by market demand and costs. This particular house is a two bedroom, one bathroom starter home, and $1100/month is all you can get for it.
Your monthly cash flow for the house is -$507.37. Ouch!
Why would anyone do this? Well, let's look at things a different way, by checking out your profits.
First, there's your equity appreciation. Let's go with the doomsayers for now and assume you can barely keep up with inflation on your investment, so it's going to appreciate at a modest 5% per year. (Feel free to play around with different numbers on your own time.)
- Market value up 5%: $10,000
- Rent collected: $13,200
- Interest Payments: -$9450
- Property taxes and insurance: -$5800
- Maintenance: -$2000
- Net profit: $5950
That's a 9.9% annual return on your investment of a $60,000 down payment. Not bad!
Now, this doesn't "feel" like a profit to the landlord because much of it is tied up in unrealized capital gain, and the monthly payment includes principle, so some of the monthly "cost" is money he's paying toward his debt liability. In other words, the small principle payment ($1492.05 the first year) is not really "cost." That is money paid back to himself.
There are also income taxes on the $13,200 in rents to be considered. However, the IRS gives you a lot of deductions for owning rental property, including the ability to depreciate the entire property (the structure of the building, that is, not the land) and appliances or equipment you use for your rental business. For that reason, the effect on your bottom line at tax time could actually be to reduce your tax liability. (I am deliberately avoiding a full discussion of taxes here. That's another post.)
Although we could decrease that 9.9% annual return further by taking into account income tax, when looking at comparable investments, such as the stock market, it is customary not to deduct what you expect to pay in income or capital gains tax and so we won't do that here, but simply note that a 9.9% annual return compares quite nicely to what you can expect from stock market investments and mutual funds. Most people should be glad to get around 10% per year on any investment, before taxes, brokerage fees, and inflation.
And this is why landlords lord lands. It doesn't require dishonesty, just a healthy tolerance for risk (which we'll talk about next time) and occasional conflict. Oh, and about $60,000 cash.
*This assumes you are replacing your roof, furnace, and exterior paint or siding and windows every thirty years, and you are doing some miscellaneous repairs each year.