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.
Couldn’t agree more. Its ridiculous to calculate your net income by subtracting what you pay for the mortgage (at least the principle part of the mortgage). That’s money you are paying yourself, not money you are losing. That money/principle will still be there when you decide to sell you house.
When you buy a bond no one says subtract the money you spend up front, your principle to calculate your income, because its expected you will get that back at the end. Why would a house be any different.
If Mr. Keys is relocating, he’s not going to be around to be his own property manager. That’s if he even wants to.
Maybe the 10% profit includes the buffer for vacancies? I had assumed that finding tenants is included in the property management fees, though.
Steve,
Good catch on the relocation thing. I didn’t think of that. In fairness I managed property 3000 miles and 3 time zones away. I’d be surprised if the property management fees include finding new tenants. Typically, I pay a month’s rent for that which is 1/12th or more than 8% right there… and they don’t manage a thing.
So in fairness, it really might be a close call. One thing I didn’t mention too much is leverage. That’s another thing that can play out well.
Hah! This is awesome :) You know, they asked me a ton of “What if…” questions a year ago, and I assumed they would never do anything with them. Thanks for finding this – I had no idea this existed!
This is one of the reasons I LOVE real estate, because there are generally few or no black and white answers. Clearly there are a lot of extra factors and assumptions to be made with a question like this, but I’ll share my reasoning here:
My assumption was that the loan was probably a 30 year loan, and probably taken out somewhat recently (the past 7 years) At around $200,000 mortgage, this puts the loan pay down at about $300 per month.
Yes, this is good, but the thing that changes the equation, for me, is CapEx – Capital Expenditures (those big ticket items that happen once a decade or so.) A new roof is $12,000, siding is $20k, etc. These things DO wear out over time, and need to be calculated as well. After all, let’s say you make $100 per month in cash flow on a deal, but 10 years into it you have to put on a new roof for $12,000. Your cash flow is now $0 for all 10 years. Ouch. I typically use the same number for CapEx as I do for repairs (maybe a little less), so using your numbers, we probably want to include another few hundred dollars a month, which almost cancels out the loan pay down. Now, maybe you could include CapEx in with the repair budget, which on a newer home might be possible, but if it’s an older home, I just don’t think so.
Furthermore, I think the 1% repair number is far too low. I mean, $2580 a year might be good for a newer home, but if the home is older, it’s going to need that PLUS a rehab every couple years due to tenants being difficult on properties. My typical tenant turnover on a house is around $5,000, and it happens every 2-3 years.
Finally, the other big thing I mentioned in the article is the capital gains tax. When you live in a house for 2 years, you pay $0 in capital gains. When you turn it into a rental, and lets say 5 years later you sell it – you have to pay long term capital gains tax on any profit, which can amount to a lot of money. So, of course there are a lot of assumptions here as well, but I think that does play into it quite a bit.
So, the house itself would become, in my opinion, a negative cash flow deal BUT yes, a person probably would SLOWLY build some equity and wealth over time due to the appreciation and loan pay down. I personally don’t think it’s worth it in this case, knowing the few facts that we have. I’d still take the money and put it into the next deal, even if it’s a primary residence. Not necessarily because the loan pay down Less risk, less headache. Even if they didn’t put the money down on their own primary, they could take that equity they have and invest it in a deal that would produce positive cash flow, not negative like this house.
But that’s just my opinion anyways :)
Brandon,
Thanks for coming by. I hope it made your day to see the mention in Money Magazine. I listened to you on Jim’s Microblogger podcast just a couple of weeks ago. Great stuff there.
I didn’t think of CapEx, probably for two reasons: 1) It hasn’t come up in my thimble of real estate investment reading 2) My properties are condos and the condo fees cover it (assuming no special assessments). That’s a good point that the 1% may be far too low, especially with tenants who aren’t necessarily going to love a place as if it was their primary residence. However, if you turnover a house every 2-3 years and it costs $5000 at the time, the $2580 a year would cover that and more (the “more” coming when you get three years out of a tenant). My thinking was that in Atlanta, the nice weather would mean less wear and tear than in other parts of the country.
It would be nice to have CapEx calculator or spreadsheet. I keep a list of appliances and such (flooring, kitchen cabinets, etc.) in the condos and try to predict when I’m going to need to replace something. Then I make sure to amortize it. So if I think a stove is going to last 10 years and cost me $600, I can view it as costing $60 a year. If the stove is 3 years old, I should have $180 set aside for a new one (plus obviously some extra for when things unexpectedly break). I don’t have anything for roof or siding since they are condos.
I think after the 6% selling costs there might not be much capital gains to take. Again, hard to say without the firm numbers, but it could be a case where the person is paying 0% of capital gains on $1000. I’d rather pay 15-20% on $100,000 down the line. However, I really don’t see any reason to sell at all. In my planning, the goal is to get it paid off and use the income to supplement my retirement income. If it becomes financially beneficial to sell, then I would do it, but that would be a situation where I’d be benefiting from a bubble-type situation.
Another thought is that perhaps the interest rate is lower on this place. If you were to sell it and buy another investment property, you’d probably get a much higher investment rate. I don’t know if putting it in your primary residence is a particular good deal in this low interest rate environment, but again that’s up to the person’s risk profile.
I realize that space is limited in a column like this for Money Magazine, but it would be interesting to see it covered in more detail.