There are numerous reasons why real estate can be a fantastic investment. Benefits include the generation of passive income that should increase with inflation over time, numerous tax benefits and access to cheap financing. All of that being said, not all properties are created equal, and it is important for investors to do their homework to separate the good deals from the bad.
At the time of this article, the 10-year U.S. Treasury is yielding 0.55% and mortgage rates are less than 3% for the best borrowers. Mortgage rates have been falling since the 1980’s, when they were as high as 18%. To illustrate the power of the falling mortgage rates, consider that a $200,000 mortgage with an 18% rate has approximately the same monthly payment as a $720,000 mortgage with a 3% rate. A 360% increase in the initial principal amount of the loan! It should come as no surprise that real estate appreciated meaningfully over the last 40 years.
As the tailwind of falling rates dissipates, investors will need to rely more heavily on cash flow to generate returns. In order to identify the highest returning properties, investors would be wise to calculate their pro-forma returns on each option.
Key Drivers of a Property’s Cash flow Potential
The dream scenario when buying a rental property is to have the rental income exceed all of the property’s expenses, including the mortgage payment, generating positive net cash flow. Not only do you get passive income that should increase over time, but your tenants are effectively paying down your mortgage for you!
Let’s review some key drivers of a property’s cash flow and walk through a simple example.
Income: Rent collections will make up a majority of your income, but could also include parking fees, pet surcharges and late fees. The level of rent you are able to charge will be driven by local market forces, such as supply and demand, income level and local economy.
Vacancy: Your property is likely to experience some turnover, which will leave it vacant for a period of time. Typically, 5-10% rental loss is assumed, but the local market conditions could dictate a higher or lower assumption.
Mortgage payment: The total mortgage payment will decrease your monthly cash flow, but the principal component increases your equity in the property. Your mortgage lender may require insurance and property taxes to be escrowed along with the mortgage payment. If not, you will still incur these expenses and should budget accordingly.
Property management fee: Assuming that you are not managing the property yourself, management fees generally range between 6-12% of rent. There may be additional fees for set up, advertising and leasing.
HOA Fee: Properties that are part of a homeowner’s association will charge an HOA fee. You should investigate what services, if any, the HOA provides, as it may offset another expense. The HOA may also have rules that could impact how you use the property, so it is important to understand the rules of the HOA prior to purchasing the property.
Utilities: Tenants typically pay for electric, internet and cable, but the property owner is usually on the hook for water, sewer and trash fees. Some of these expenses may be included in the HOA fee, if applicable.
Maintenance fees: Properties require varying degrees of upkeep. A single-family home requires much more maintenance than a high rise apartment. Older properties require more maintenance than newer properties. You will need to maintain the lawn, plow the driveway, service appliances, and occasionally, replace the roof, floor or hot water heater.
Cash flow Calculation Example
Once you have estimated all of your sources of income and expense, how do you put it all together? Let’s assume we are looking at a 2-bedroom townhouse. The asking price is $300,000 and we have approval from our mortgage lender at a rate of 3.5%. The lender requires a 20% down payment, totaling $60,000.
We are going to assume an 8% vacancy rate, because the rental market is balanced. We have identified a property manager that will manage the property, including leasing and advertising, for 8% of rent. We estimate property taxes and insurance to be just under 2% of the property value and maintenance expenses to be 8% of rent. Finally, there is a monthly HOA fee of $125 and the cost of utilities not paid by the tenant is $50 a month.
|– Management fee||($184)|
|– Mortgage payment||($1,078)|
|– Taxes and Insurance||($460)|
|– Repair & maintenance||($184)|
|– HOA fee||($125)|
|– Owner paid utilities||($50)|
|Monthly net cashflow||$35|
Base upon our analysis, the property should generate positive cash flow from inception, making it worthy of further consideration! Before making an offer, we should evaluate a few different properties to see if we can generate even more cash flow. Finally, we need to compare the return on investment to other investment options, such as stocks, bonds or alternative investments. Real estate can be a great investment option, but it is not the only choice!
Calculating Return on Investment
To calculate the return on investment (“ROI”) in the first year, we use the following formula:
ROI = (Net Profit + Appreciation) / Investment
To get the “Net Profit”, we need to annualize our monthly net cash flow and add back the principal portion of the mortgage payments, which is $4,606 in the first year. Then we add our expected “Appreciation” of 2% for the property (note that this is a paper profit until an actual sale occurs). Finally, our “Investment” is the down payment of $60,000 plus the $4,606 of principal paid towards the mortgage.
ROI = ($35*12 + $4,606 + $300,000*2%) / ($60,000 + $4,606)
ROI = 17.1%
If we assume no appreciation, the ROI falls to 7.8%, which is still respectable!
Pulling it all together, the resulting ROI in the first year is 17.1%. Considering equity returns are expected to be lower than their long-term average of 10% moving forward, this is a very attractive return. Furthermore, real estate has historically been less volatile than equities. Given the strong return and less volatile return profile, this property could be a great purchase for an investor with a reasonably long time horizon and no liquidity needs.
If you are considering the purchase of an investment property or would like to compare your returns to other investment options, please reach out to us and set up an introductory conversation.