Back HomeBuild Wealth and Passive Income With Rental Properties
November 29th, 2010 by keithandkinseyMany of you have asked questions about our rental properties. Why do we own rental properties? How much income do the really make? Is it really worth the hassle? How do you decide what makes a good rental property? I’ll give you a general overview now and try to cover specific topics with more detail in future blogs.
I like rental properties because they generate passive income. In other words, the income from them is almost automatic rather than trading hours for income like you do at your job. I’ll admit, we aren’t completely hands-off with our income properties. We still manage 3 out of 4 properties, the 4th is completely passive (a management company manages and maintains it for us). Even the properties we manage require far less time per dollar than our full time jobs. I’ll admit, there is some hassle factor in these self-managed properties, although I believe it’s well worth it in the end. The goal for us with rental properties is to build long term wealth rather than short term gains. There are ways to get short term profits in real estate, I’ll focus on the wealth building factor for now. We target long term wealth building with rental properties through the use of cash flow, principal pay down, appreciation, and tax savings. All of these combined ultimately help to grow our net worth.
Cash flow
Simply put, cash flow is the difference between the income and expenses of a property. For example one of our properties looks like this:
Expenses Income
Mortgage payment: $1005 Unit 1: $1035
Tax Payment: $413 Unit 2: $1010
Insurance Payment: $65
Avg Vacancy Loss $102
Avg Maintenance $200
Total Expenses: $1785 Total Income: $2045
The difference between income and expenses is $260. Note the vacancy loss is an averaged number assuming 1 of the 2 units is vacant for 1 month per year. Also the average maintenance cost is a number that is planned to cover long term expenses such as a furnace replacement or repairs during a tenant turnover. In reality, when the property is full and maintenance free, you can add $302 to the cash flow. I recommend setting this money aside in savings because you will need for a larger maintenance item in the future. As you can see, the monthly profit really isn’t that great. You’ll see by the end of this blog it’s well worth owning in the long term. The most important thing in this whole blog is: you absolutely must choose a property that has positive cash flow. I admittedly screwed this rule up on the first property I bought, but I’ve learned a lot in 10 years (the first property still worked out okay though). The lack of cash flow is why so many rental property owners ended up in foreclosure in this down market. They were banking on short term appreciation, and it didn’t happen. A good rule of thumb is put 25% down and find a property with a purchase price of less than 10 times it’s gross annual rent. This will almost always result in good positive cash flow. There are still ways to purchase rental property with 0% down, but that’s a riskier approach to be discussed in another time.
Principal Pay Down
In the above example you can see that our tenants pay the entire mortgage on this property. Naturally, each month when we make our mortgage payment, part of that payment is applied towards the principal of the loan. Take a look at any amortization calculator online and you’ll see that the amount applied towards principal increases each month. Currently on month 25 of our loan $216 goes towards the principal. This year with principal pay down by just paying minimum payments covered by the income we receive from the tenants we’ll gain $2542 in equity.
Appreciation
Several years ago people looked at real estate as if it always went up in value. Well, this is where they got into trouble. Properties were being bought with the assumption that they would always appreciate at a rate of 5-10% a year. Well, as we’ve all learned by the recent down turn we can’t always count on that. So, I look for a property to make sense assuming no appreciation, and I consider appreciation an added benefit if it happens. Historically Southern Wisconsin has averaged 4.02% per year of appreciation over the last 30 years (including the last couple of down years), which would double a property’s value in about 17.5 years. Based on this historical average a $100,000 house would be worth $326,216 in 30 years when the mortgage is paid off. Again, don’t count on this. If history repeats itself, it’s an added bonus in owning real estate.
Tax Savings
I’ll save the details on this for your tax advisor, but here’s a quick summary on this example property. For tax purposes, this property is going to show $5662 of income. However, the IRS allows you to depreciate residential rental property on a 27.5 year schedule. With this depreciation we will be allowed to deduct $5,700 making the property show a $38 loss on our tax return. Note – you do have to reclaim this depreciation when you sell a property, unless you do a tax deferred exchange (a later topic). This will save us about $855 in taxes per year. This is something I don’t factor in when purchasing and analyzing property because you never know when the government could change the tax laws. For now, it’s a nice added bonus.
Long Term Summary
As you can see we aren’t getting rich off of this property in the short term. However, lets look at what happens if we were to hold the property for 30 years. The purchase price was $217,000. 28 years from now the mortgage will be paid off and we’ll be sitting on a property worth $719,000 assuming 4% appreciation (again no guarantee). We will have collected $93,600 in positive cash flow, this isn’t even factoring the probability that rents will go up over time. We will have saved $25,650 in taxes. Subtracting the original down payment, this is a grand total of $784,000 more wealth than if we had never bought this property. Now lets play devils advocate and assume a highly unlikely worst case scenario that the property never gains a dime in value and the government change the tax laws to provide no benefit to us what so ever. We will still be sitting on a property purchased for us by our tenants along with the cash flow through out the years. So, we would still be $256,350 better off. The best part is, at that point the property is paid for and the cash flow becomes $1265 per month (not adjusted for inflation). This is just one property, imagine what you could do if you bought several along the way. What does a person do with this extra wealth and income? Have a little fun, invest in your future, retire without depending on the government, and give to those less fortunate. Now do you understand why we like rental property???
Great article! When using your calculation estimate of less than 10x the AGI, how is the down payment calculated into this? Or, are you simply calculating total annual gross rents multiplied by 10?
By putting down 25%, or in your example about $55M, this would decrease your mortgage creating a variance between expense and rental income. Would you suggest saving/setting aside this amount showing less of a profit year over year? An estimate yearly profit is $4M, which puts the total cash equity at 13 years before you would recoup your cash. I think the time line is a bit lengthy.
I’m a new investor in RE and seeking to learn more about formulas, timeline, processes, property evaluation and so on. Any news letters/articles, books, articles that you recommend would be highly appreciated. Thanks!
Dan, I like to keep things simple and safe. There are many investors out there that look for high cash on cash returns based on using as much leverage (debt) as possible. I use to be one of those guys, but I’ve taken a more conservative less risky approach lately. The less money you put down, the better the return on your investment, but the less cashflow, and the more risk you have.
I personally am a long term investor, and invest for wealth building rather than for recouping my cash in a short time frame. To build wealth, a slow steady, conservative, cashflowing method has worked for me.
I’ll admit, I did purchase one property with no money down and another with only 5% down. Both of these should have been my best performing properties based on percentage of return. In all honesty, these have been my worst performing properties. That’s part of the reason I changed my approach.
The 10x rule of thumb was simply based on 10 times gross annual rent. This plus 25% down almost always equates to good cashflow.
The most important formula is income vs expenses. If you plan for positive cashflow with conservative numbers, you will certainly build wealth over time.
I’ll try to post some more about formulas and resources in the future. One of my upcoming blogs will likely be a list of my favorite real estate investing podcasts. There’s some great info out there.
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