By the end of this month, you’ll likely conclude that I get a lot of mileage out of Money Magazine. Today, I want to highlight a question from their Ask The Expert column from their August 2014 issue. Specifically the question is here:
I greatly respect Brandon Turner of Bigger Pockets and the community of real estate experts that he has built. In all honesty, my real estate knowledge and experience probably amounts to a drop compared to their combined silo (or tank, or whatever you store a ton of water in).
That said, I’m going to respectfully disagree with the conclusion that the reader sell.
I want to start off with the idea that a solid rental property generates at least a 10% return. From the article, this is presumed to be the case after mortgages, taxes, and insurance (or PITI), a property manager, maintenance, and vacancies.
Let’s try to analyze all the costs, shall we? We know that PITI is $1,100 from the article. That was easy.
Property management is a little more complicated. From Zillow property management ranges from 8-10% of the rent. That would be between $120 and $150 a month, so we’ll call it $135… a 9% number that was often cited in the discussion.
Up next… maintenance. According to this MSN article the maintenance should be about 1% of the property’s value. I don’t have the property value readily available. From the PITI, I can estimate it, but even that will be rough because I don’t know if it was refinanced or a 15 or 30-year mortgage. Nonetheless, the $1100 PITI number is between a couple of properties we own, so I will make a very rough of a home value of $258,000. This is actually probably high, but roll with me on this for a minute. The 1% maintenance fee on a home with this estimate would be $2580 a year or $215 a month. This “convenient” guess of mine “happens” to pair well with the property management number to total $350 a month. (I’m inclined to believe the maintenance would be less in a place like Atlanta than my experience in New England due to the harsh winters.)
We haven’t brought in vacancies and real estate fees to bring in new renters. These are very difficult to estimate. The article doesn’t attempt to. Furthermore, it doesn’t bring in the cost of enlisting an agent to help you find a renter (typically one-months fee). We’ll leave this as “outstanding expenses” for now.
We are at $1450 in expenses and only looking at $1500 in rent… and there are the outstanding expenses mentioned above. It looks like I should be agreeing with Brandon Turner, right?
Well there are other factors in favor of renting to keep in mind. When you are renting out a home, each month you are earning equity. As time goes on, each month you are getting more and equity as part of that PITI payment. It’s impossible for me to tell how much that is, but it might be around $400 a month, maybe more. That’s an extremely important and valuable variable to add to the mix. Imagine if he only had a two years left on a 15-year mortgage. Then he would be on the cusp of turning that PITI payment from $1,100 to maybe $300. That would make a huge difference right?
Here’s another thing… Isn’t it a little unrealistic to expect “at least a 10% return” that is almost complete passive (after hiring property management)? Would we put a mutual fund to this same high standard? In general, I don’t think we would. At a minimum, I think we can determine that hiring property management is something that varies from real estate investor to real estate investor. For example, we don’t have it. That alone gives a person a chance to use “sweat equity” to make another 9% a year more – enough to sway the calculation all by itself.
The article suggests selling. This may trigger 6% of the cost of the home in selling fees. It then suggests plowing the proceeds into the next home lowering the mortgage payment. Using a tool to calculate today’s interest rates:
you’d be getting only 4.5% return on that money. I believe in most cases that interest is tax-deductible, so it could be seen as even less valuable. It seems hypocritical to say that we need to make at least 10% for a rental, but we are okay with selling if that gives us the equivalent of a 4.5% return.
Finally, there’s the point of real estate being forced savings as I mentioned a few days ago. If Shane Keyes sells the home and uses the money towards his next home, he may be tempted to buy a bigger or better home. That’s fine if that’s a life decision he wants to make. However, in my opinion he may be better off financially having a stream of rental income to supplement his income after the PITI is paid down.