I first got fascinated by financial markets after reading the book The Big Short by Michael Lewis about the ’08 financial crisis (I have since tried to read everything he has ever written…the books are amazing). The intricacies of our financial system and the way that global events, governments, businesses, and people come together to affect change that has such a large impact on so many (positively and negatively) is something worth trying to understand. Because the mortgage crisis was such a defining experience in my introduction to finance, I have naturally had an innate fascination with real estate.
Today, I want to talk about the economics of owning rental properties. Rental income has been one of the most consistent themes in the portfolios of well-known figures in the financial independence community over the past decade (pre-2008 as well, but I was ~12 then so I wasn’t paying much attention before that). This is not particularly surprising, as the recovery in the housing market after the ’08 mortgage crisis has been absolutely incredible.
There are many reasons that real estate is a valuable addition to your portfolio, it provides great diversification, is an inflation hedge, has favorable supply / demand economics, etc.…but the reason it has been so insanely valuable for everyone that has invested over the last 12 or so years is that it is one of the most direct ways that individuals utilize leverage (borrow money) in their portfolios. When people buy a home, they usually put 20%-25% or less down up front and take a loan for the rest. If your property appreciates 10% and you only put down 20% of the value, you have realized a 50% return (we’ll get into the renting part of the equation later). Of course there is a lot of downside here as people found out in ’08, if your property goes down in value, you are on the hook for all the losses as you will have to pay back the loan. Don’t worry if you don’t fully follow, I’m going to get into the nuts and bolts later.
One caveat – As part of my ‘keep it simple’ philosophy with investing I have not personally invested in any individual rental properties to-date (although I have considered it many…many times), and instead use real estate crowdfunding platforms like Fundrise which pool your money with other investors and invest across a variety of properties and manage them for you. Recently their focus has been on rental income in sunbelt states, which fits perfectly with my view of the real estate market at the moment.
That being said, my mom is both a real estate investor and realtor (and CFO and many other very impressive things) so I have gotten a firsthand look at the process of investing in a rental property and how the economics shake out.
Economics of buying rental properties
When you buy a rental property, you are looking for two things:
- Appreciation on your property: This just means you want the value of the property to increase. At a macro level, you want to look for cities / states where you expect the population to grow increasing the demand for houses, and at the micro level you want to find pockets within those cities / states that you think will appreciate more than others. You usually want to find areas that haven’t already experienced that appreciation in value, but you expect to continue to get more valuable because of future construction activity, etc. Investing in your local area can give you an edge here because you will know the area very well.
- Rental income: If you are renting out a property, you want to be cashflow positive and generate income from the rent you are charging. That means you want to find a place where the costs of the mortgage payment, property taxes, maintenance, etc. are less than the rent you can get from the property.
The following are the primary puts and takes when evaluating your monthly rental economics:
Income:
- (+) Rental income: The monthly rent paid by your renter or renters
- (*) Expected utilization: You usually want to factor in some time when your property does not have a renter (in between renters, etc.)
Expense:
- (-) Mortgage payment: This is dependent on the price you purchased the property at and the interest rate you got your loan at
- (-) Property tax: Depends on the county, but the average annual rate in my county is ~1% of the assessed home value (so on a $250K house you would pay $2,500 / year or $208 / month)
- (-) Expected maintenance: You will want to factor in some maintenance items that will inevitably come up and factor that into your monthly expected expenses
- (-) Homeowners Association Fees: This is a frequently forgotten one, but many neighborhoods / condos have high homeowners’ association fees. These are fees you pay each month just for living there. Excluding some absurd outliers, on the expensive end I have seen ~$300-350 / month for this in Atlanta
- (-) Insurance: You need homeowners’ insurance to cover this new property (and maybe additional insurance if you are a landlord)
- (-) Admin fees for managing the property: There can be a variety of added costs from hiring a property manager (can cost up to 1 month of rent) to setting up an LLC to hold the rental properties to managing your taxes. You should bake all these in when evaluating a deal
One rule of thumb when trying to find a property that may have attractive rental economics is if the expected monthly rent is more than 0.75% of the value of the property. That means for a $250K house, you want to make ~$1,875 in rent per month. You likely won’t find that kind of rent in areas that are already in high demand because property values will be too high. In fact, it is getting hard to find those rental yields even far out of cities given the amount of money flooding into the housing market. Home prices rose something like 11-12% in January ’21 because the supply of houses for sale was at a record low. Regardless, be picky about buying a rental property. You make money in these kinds of deals by buying at the right price and can lose a lot by getting swept up in the market.
First, let’s just talk about rental income. The following is an example for a $300K house that you can rent out for $2,250 / month:
$3,200-$5,500 in annual cash flow on an investment where you put down $60K is not a bad return on investment for the level of risk you are taking.
But that’s not all (!), you’ll have several added benefits to this:
- You get returns from any appreciation in the value of your property
- The rent is helping you build equity in the house which will increase the amount you get back if you sell it
- There are many tax advantages to owning property
- There are significant scale benefits to renting
Appreciation
Let’s say your property appreciates to $360K after 5 years. That is ~20% of appreciation or a 3.7% annual increase in value. However, you only invested $60K into the property, so that $60K increase in value is a 100% increase in your investment.
Let’s look at an example of what this would imply for your year 1 return. Assuming the same purchase as the prior example, if your property appreciated 3% in the first year, you would have an unrealized gain of 20-24% including rental income and appreciation:
Building Equity
Even if you made $0 in net cashflow and the property stayed the same value, you would make money on the deal. Because part of the rent you collect is used to pay back the loan to the bank, after the length of the loan you would own the entire property. So you can invest $60K and at the termination of the loan you would own the full property, which was worth $300K when you purchased it
These can meaningfully improve the return profiles of rental properties!
If the leveraged return profile itself wasn’t enough to get you excited about rental properties, here are some other interesting things that might interest you.
Tax advantages
I am not a tax advisor, so don’t take my word on face here, but there are many ways to optimize your taxes when you own rental properties:
- You can deduct the interest that you pay from your rental income to decrease your tax liability
- You can deduct ‘depreciation’ to push off when you have to pay taxes on a property. For tax purposes a property has a useful life of 27.5 years, so you can deduct 1/27.5 of the property value each year from your rental income for tax purposes. You will have to pay a reconciliation on this when you eventually sell the property, but it lets you push off your taxes
- You should form an LLC if you plan on buying multiple rental properties and you can lump all your associated expenses in here and also deduct those from your rental income
As a result, many people who own rental properties can show essentially $0 in income from them and pay limited amounts of tax on their returns.
Scale benefits
There are a variety of scale benefits with renting out properties – from lowering admin costs, grouping insurance, increasing your average utilization, etc. On top of that you gain a lot of experience in the process and learn what works and what doesn’t in various investments. For these reasons alone, I think it is valuable to have a long time horizon when thinking of getting involved with rental properties.
My view on rental income and real estate today
To say the least the real estate market (at least for rental economics) is doing well right now. Home prices skyrocketed in January ’21 (up ~11% on average) – demand is through the roof as people look for more space as a result of COVID and inventories are very low / construction materials cost is very high.
A low interest rate environment as a result of the last year of stimulus made borrowing extremely cheap. Remember our mortgage payment row up above? If interest rates drop, banks charge less for you to take a loan, so for the same house price, your mortgage payment gets lower. This makes the economics of renting even more attractive.
I am not going to try and predict the housing market / interest rates going forward, but I can tell you what I’m paying attention to going forwards:
- Interest rates / inflation: If inflation expectations continue to increase & the Fed starts raising rates faster than expected, mortgage rates will go up, and house prices will come down. The bright side as a renter is if you are cash flow positive on your rental income and interest rates go up, you don’t have to sell your property. Rent prices should actually do well, because it will be harder for people to purchase a home since interest rates are higher / credit is tighter, which should result in more renters. That being said, you never want to see the value of your properties come down (even if they are unrealized losses)
- Remote work trends: COVID & remote work pushed a lot of people out of major cities and into larger homes in cities like Atlanta, Dallas, Denver, etc. These demographic movements have propped up a lot of prices in those areas and companies are taking notice and testing out office locations outside of their traditional hubs (e.g., Microsoft / Google bringing jobs to Atlanta, Investment Banks opening / promoting offices in Miami, etc.). I want to see how sticky these trends are or if things somewhat reverse after everyone is vaccinated
How you can invest
There are 3 primary ways to invest in rental properties:
Directly purchase an individual property and rent it out
- Pros: You will take part in all the upside I discussed above and can use your knowledge of a specific area to invest in underpriced homes. Most larger funds will be looking at buying more expensive commercial properties or groups of houses so individual properties may be undervalued (although institutional investors are beginning to look at single-family homes as well)
- Cons: This requires the largest time & capital investment by far. It is by no means a walk in the park and you take on plenty of risk when you do this
Invest in a crowdfunded real estate platform like Fundrise or Crowdstreet
- Pros: You can invest with limited capital (~$500 minimum for Fundrise), you get access to the upside with rental properties / real estate investing without the massive effort required to do it yourself, and you are diversified across a wide variety of funds
- Cons: Your upside is usually slightly more limited than with the DIY method (and there are management fees you pay), you have less control over what you are invested in (especially with Fundrise), and you have limited liquidity (can be fees associated with selling before 5 years)
Invest in a publicly traded REIT
- Pros: Similar pros as with crowdfunded real estate, but more liquidity when you want to sell out. Additional cons that make this a less attractive option in my opinion
- Cons: Similar cons to crowdfunded real estate, and also tend to trade very correlated with the stock market due to their publicly traded nature (meaning less value in diversification), not all of the money is necessarily invested in real estate, and you have very little insight into what you are invested in
Whatever you pick, I hope this post has convinced you that real estate is worth looking into for your portfolio!
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