So You Want to be a Landlord? Part II: How Do You Actually Make Money?

By Catherine Shaffer on 13 March 2008 (Updated 10 May 2009) 18 comments

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!

ARTICLE CONTINUES BELOW

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.

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Xin Lu's picture
Xin Lu

hmm. assuming a 5% increase per year on your property is very very optimistic in normal non-bubbly years. Your property depreciates as time goes on. I know the depreciation can be written off on the taxes, but I don't think I would ever buy a rental property if there isn't positive cash flow. Most landlords I know say the same thing. They make sure they have positive cashflow at an 80% to 90% occupancy rate. 

Guest's picture
Guest

I know you're "deliberately avoiding a full discussion of taxes", but the tax effect is actually one of the things that make renting so attractive.

If you manage your own property, you can take a loss of up to $25,000/year against your taxable income. If you're in a 25% tax bracket, that could be a savings of $6,250! And the golden part about that is that you don't have to spend the additional $25,000 to create the loss.

In your example, say your monthly net cash outflow is $507.37 (or $6,088 for the year). Now, assume your original basis in the property is $513,000. This means you would qualify for depreciation of about $19,000/yr (based on the basis of 513K divided by the depreciable life of the property, 27.5 yrs.)

So your total annual outlay is $6,088, but you actually reduce your taxes by $6,250 based on the $25,000 tax loss ($19,000 + $6,088). So the net effect is that you're paying $170 a year for your property. Sounds good to me!

Xin Lu's picture
Xin Lu

 

Hi Guest, you said: "In your example, say your monthly net cash outflow is $507.37 (or $6,088 for the year). Now, assume your original basis in the property is $513,000. This means you would qualify for depreciation of about $19,000/yr (based on the basis of 513K divided by the depreciable life of the property, 27.5 yrs.) "

erm.. in the original example the cost of the property is only 200,000. if your cost of the property is suddenly 513k you'd lose a lot more cash per month if you are still renting at the rate Catherine quoted.

I still think it is only worth it when the rent you can collect is more than what you pay out.

Catherine Shaffer's picture

You're right about the taxes, Guest. I am not meaning to discount the significance of the depreciation effect. It just needs a post all of its own. I think I need 1000 words just to explain what the cost basis is.

Xin: I happen to disagree with you about home prices, and believe that in many parts of the country, those who buy real estate in the near future will enjoy even better appreciation than five percent. Of course these are just my and your opinions, which is why I invited readers to plug in their own figures. Even if you have negative appreciation, you can still make money on rent if you buy and hold for the long term. I think it's important to keep an open mind about what various markets will do in the future. The only thing we really know is that we don't have a crystal ball. History has seen some spectacular increases in real estate value. Even with the extraordinarily bad economic conditions in my home state of Michigan (which I believe is leading the nation in foreclosures) and the loss of 3000 jobs from my home city of Ann Arbor due to the closure of a major employer, my home value (via recent comparables) is holding strong and nearly $50,000 more than what we paid for it seven years ago. I think that's amazing given all that has happened, and had fully expected to be upside down by now.

As to the question of positive cash flow, it really depends on what your business strategy is. If you are a part-time landlord with some other source of income, and you have one or two properties with negative monthly cash flow, you can still come out ahead at the end of the day, by, as Guest mentions, taking tax deductions from real estate "losses" against your regular income. If real estate investment is all you do, then of course you're going to have to find something with positive cash flow, or you won't have any income to take tax deductions *from*. LOL. Your friends are probably professional landlords and truly do need that cash flow. Even so, I wonder if they would benefit from adding some "losing" properties to their portfolio to mitigate their tax liability. (As we've seen, losers can be winners in the long run.)

Catherine Shaffer

Wise Bread Contributor

Guest's picture

Now, I did not mean to say at Paid Twice that ALL landlords are sleazes. Some are honest people who treat their tenants and their neighbors fairly. In my experience, however, the ones near me would find that description an uncomfortable fit.

The gentleman whom I described as cheating an elderly widow purchased the house two lots west of mine. It was immaculately and lovingly kept by its original owner and was in excellent condition. She apparently did not know a thing about finance -- he told her he would pay for the house "in cash," as though she would not be paid in full if she sold the house to someone else -- and she bought this idea with delight. He told her he would put one of his daughters in the house -- she was pleased to think a young person who would value the home as much as she had would be living there. He got the house for tens of thousands of dollars below its market value, pre-bubble but at a time when houses were selling at a healthy, normal pace.

The instant the papers were signed, the For Rent sign went up.

Around the corner from me, the same gentleman purchased another house, this one somewhat run-down. He signed his name to a document that is registered with the County Recorder's office in which he told the mortgager that he was purchasing the house so that he could move himself, his wife, and his elderly mother out of the house he actually occupied, because the house they were living in had a step in it (true--many of these houses have sunken living rooms), and they were afraid his mother would trip on it and fall.

Again, the instant the papers were signed, the For Rent sign went up.

All of the houses he purchased in this neighborhood were represented to lenders as residences that he or his immediate family members would occupy. These claims are available for anyone to see at the County Recorder's office.

At the old lady's house, he let the lawn die and cut down most of the trees. The house around the corner was allowed to devolve into a slum property. Typically, the first thing he'd do when he got his hands on a rental was to cut down all the trees, because he did not want to have to pay to water them and have them groomed. This is an older neighborhood whose established, mature landscaping is its main appeal. When you hack out the trees around one of these properties, you destroy much of its value.

He rented another house on a lease-to-own basis to a youngish woman who had never owned property. To one of the neighbors, he remarked that he was glad to have the opportunity to unload it on her because the pool was decrepit and likely would require some very expensive repairs. At this house, he cut two spectacular Aleppo pines out of the front yard. Not wanting to pay someone to remove the stumps, he killed the lawn and covered the front yard with gravel, mounding it over the three-foot-high stumps. Neighbors soon dubbed the place "the boob house," for reasons you can picture.

The selling price he worked into the lease-to-own contract was way, way above the house's market value. The woman's option to purchase came due at the height of the bubble -- just as the landlord was unloading his other properties at huge profits. Had the bubble not occurred, the amount the woman would have had to pay would still have been well above market value, but with the wildly inflated prices, she now was in a position to buy it for less than he could sell it for in the overheated market. He tried to negate the deal. She took him to court and won.

So here was a guy who indeed had no qualms about taking advantage of elderly women and naive young buyers. I'm sure he doesn't represent the entire "industry," if that's what it can be called. Neither, presumably, does the owner of the house across the street from me, who persists in bringing Hell's Angels and other unusual folks -- with all their noisy and sometimes threatening accouterments and pals -- into our middle-class neighborhood. But there they are.

Certainly, if you can buy a house cheaply, rent it for something close to the mortgage payments, KEEP the rent coming in (good luck!), and hang onto it without serious incident for a number of years, rental real estate can be a good investment. But the fact remains: a lot of rentals in a neighborhood do not help the area's property values. And since you can get 8 or 10 percent in a good mutual fund, unless you really enjoy hard work, guff from renters and neighbors, and visits from the police and the City's neighborhood improvement office, you might be better off to put your money in a low-expense mutual fund.

Xin Lu's picture
Xin Lu

"As to the question of positive cash flow, it really depends on what your business strategy is. If you are a part-time landlord with some other source of income, and you have one or two properties with negative monthly cash flow, you can still come out ahead at the end of the day, by, as Guest mentions, taking tax deductions from real estate "losses" against your regular income. If real estate investment is all you do, then of course you're going to have to find something with positive cash flow, or you won't have any income to take tax deductions *from*."

Well, this is certainly true. My parents rent a couple rooms out of their house and they don't really seem to be incurring any loss because they live there anyway. Yes, I do know professional landlords. My aunt is one of them, and taking negative cashflow is just not good business.

Funny about Money is also correct about mutual funds producing good returns without the hassle of dealing with renters and maintenance. I am more inclined to be lazy and buy mutual funds to make money.

Guest's picture
Meg

In most areas of the country owning ISN'T more expensive than renting, or not much more. For instance I live in Dallas where rents for a 1 bedroom Uptown are $900-$1500. I bought a 1 bedroom condo similar to one I would otherwise rent for $150,000. All costs - mortgage, tax, ins, and HOA total $1300. Right now I could probably only rent my unit for $1100, but my mortgage payment will stay fixed and rents will only go up, so eventually I plan to rent this place and at LEAST break even.

Better example - I just bought a duplex for $130,000. Mortgage (incl tax and ins) is $947/mo. One side pays rent of $700 and the other pays $750, so my total monthly income (assuming it's occupied) is $1450. Sure I have to pay for the lawn to be mowed and for the plumber to come by when there are clogs, et al, but a $500/mo cash flow cushion is a great thing to work with! In ADDITION I benefit from the market appreciation - which averages and is expected to be 4-5% in TX. Tax benefits like interest, depreciation, and maintenance deductions, etc. are a very important bonus. In fact my annual tax burden goes DOWN this year even though my income will increase from $55,000 (salary) to around $72000 (salary + rent income).

Guest's picture
Karsten

or you hve to play totto, but you must have luck :-D

Catherine Shaffer's picture

I didn't mean to single you out, Funny. That guy sounds like a real first class sleazeball. I have heard the "gullible old lady" theory in multiple places and no doubt it's a common scam, but I wanted to highlight how you can make money renting, honestly, in today's dollars with today's property values and mortgage rates.

There are certainly different investment options out there. The stock market, even mutual funds, can be risky. A lot of people find real estate investment more suitable, and remember I used as a case study an example of a house that rents for less than its monthly costs, and appreciates only modestly. We personally did much better on our rental. 

Catherine Shaffer

Wise Bread Contributor

Guest's picture
Freeby50

My father has done very well in rental property investments. Most of his strategy wasn't about cash flow but instead looking at the properties as a long term investement. Originally at least he never had a large cash flow on his properties. But after a few years go by the rents gradually increase and the mortgage stays the same. Because of this the cash flow situation gets better every year. Using the example in the post above if the rent is $1100 / mo the first year and rents go up just 4% annually then in 5 years the rent will be $1338 and in 10 years it will be $1628. All the while your morgtage payment is fixed. Then after 20-30 years his mortgages were paid off and he owned the properties outright. Now he has a good retirement income from them.

Jim R

Guest's picture

One of the most hated money saving strategies is to buy a property you can actually afford, even if that means moving somewhere where the living is cheaper.

The same is true for renting. We moved to a very inexpensive part of the country where houses are easily only a tenth of city house prices. That means that we've had no problem buying several of them, no mortgages, and renting them out for enough cash flow to sustain us in a low cost of living town.

People often say, "I can't move there. What jobs would there be?" If you find the right place, with the right strategy, and the right attitude which embraces the concept of "enough" for your daily living, this *is* all the job you need.

Guest's picture

On my blog I wrote a post called 'how much to spend on a house' ... suprisingly still one of the most popular pages on my site.

The issue is this ... for MOST people, owning their own home (despite the immediate buy/rent financial analysis) is the ONLY WAY THEY WILL GET RICH. But here's what they must do:

1. Buy their own home using as much deposit as they can muster, and only at mortgage payments that they can afford (while STILL saving at least 10% of their gross salary in 401k or elsewhere).

2. Every 3 - 5 years revaluing their house to check how much equity they have ... if their equity is > 20% of their Net Worth, they should refinance and use that equity to ...

3. Buy a rental property

4. Repeat until Rich (10 - 30 years)!

But, it ALL STARTS by owning your first home ...

Guest's picture
AKelly

I was in a seminar with a high net worth counselor who said that the best thing you can do is pay off your principal residence as soon as possible. Any thoughts on that? I currently do not have a mortgage on my principal residence with an appraised value of $400k.

Guest's picture
Guest

Does anyone know a good book that I can find that can provide easy to understand literature about purchasing rental property. My wife and I are interested in buying a rental home this year but really don't even know where to start. The property that we are interested in buying is a new condo with a price of 160,000-200,000. Any guidance from anyone. Thanks so much.

Guest's picture
William Garland

When considering investing in residential rental property please do not ignore the state's legal environment. Some states are very pro-tenant in their regulations and this can affect the profitability of owning properties. By contrast, in almost all states, commercial rental is relatively free of interference and courts will enforce the deal the parties make.

Guest's picture
Teresa

This is a great post. One thing most people do not take in to account when buying a rental property is property management fees. If you plan on hiring a property management company, say goodbye to any cash flow potential. I fully recommend being a do it yourself landlord. There are so many useful tools on the internet that help you to do this nowadays, that you really don't need a property management company. I highly recommend a site called www.rentalspacenetwork.com to advertise your properties and to take care of all of your applications, tenant screening and leasing. This is a fantastic site that eliminates paperwork hassles. I also recommend angieslist.com when you need a handyman. By using these two sites being a landlord has become much easier for me and I save 10% a month in property management fees allowing me to cash flow my rental properties.

Guest's picture
Guest

I agree with what Xin Lu says. When real real estate investors see a negative $500 per month cash flow on a $60K investment they do the logical thing: sit and and wait. I made an investment of $25K in March 2011 into a 3BR Townhome. When rented, I net $280 positive cash flow per month. That is more than 1% ROI monthly on what I invested. I manage my properties myself, but out of that $280 still comes repairs and vacancies. So, I hope to clear about $100/month in the first year or two.

5% assumption for appreciation is really optimistic and not just "barely keeping up with inflation." If you look over time, housing goes up at the same rate of inflation. Because it is still a little overvalued, even in 2011, I assume that over the next 10 years we will maybe have an average of 2% appreciation per year, and I don't assume I will be able to sell(or 1031 exchange) at a reasonable profit for 10 years. This forces me to find deals that pay me now. And the truth is, we can demand this in today's market. If San Diego today, I can find many properties that cash flow with only 10% down. There are certainly areas that still don't cash flow with 30% down. I avoid these areas, they haven't finished normalizing to the trend line yet.

There are FOUR pilars to making money in real estate. Know them well: Cash Flow, Appreciation, Depreciation/Tax Advantages, and Equity Build. Know them well! Good luck everyone!

Guest's picture
Guest

A comparison of the 9.9% property return to stock mutual fund returns is apples to oranges for the following important reasons that are often overlooked.

First, the property is a levered investment. Stock mutual funds are not. The leverage is 200/60, or 3.3x. The same leverage applied to a stock mutual fund investment would yield returns far superior to 9.9%. Something closer to 25% based on historic norms for the S&P 500 Index after borrowing costs.

Another way of looking at the effect of leverage is that it would only take a 15% decline in the property value to lose half of the investment ($30,000). It would take a 50% decline in the stock market to lose the same amount. Which has a higher probability?

Liquidity is also not addressed. An investment in a stock index mutual fund is very liquid; your dollars are available in one business day at negligible transaction costs. The property is highly illiquid. Selling the property may take months or longer, and the transaction costs (3%) would represent a 10% loss on your original $60,000. Ouch.

In summary, the 9.9% return does not compare "quite nicely" to stocks on a level playing field. In fact, the return on the property is woefully inadequate for a levered, illiquid investment. Higher returns are available elsewhere for significantly less overall risk, even ignoring deadbeat tenants, liability, etc. Apples to apples.