Why does landlording make money?

[kcy83]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment. For example: http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? You still have to pay for all maintenance and repairs, pay property taxes (which are more than for a primary residence), pay mortgage interest, possibly pay a management company, lose the opportunity cost on the home equity, pay income tax on the rental income... Could someone help me understand how you can come out ahead in this situation? Is it just that you have to live in an area where rental prices are high compared to home prices? It must work or people wouldn't be doing it!

Thanks for your insight.

[iamlindoro]

The home you live in is a terrible investment because *you* are paying the mortgage, and the only hope of return is appreciation.  A home you allow someone else to live in has a few distinct advantages:

* It need not have the amenities that you yourself demand in your home, and thus can be less expensive to "run."
* You can pick based on a numerical analysis of rents to purchase price, allowing you to select a home that covers all the costs and still provides a stock-market-beating cash ROI.  If this isn't possible in your market, buy somewhere where it is possible, factoring in the cost of property management if you don't wish to manage at a distance.
* You can use leverage/financing to put a minimal amount of cash down and immediately begin having someone pay the mortgage off, as well as providing reasonable cash flow beyond costs every month.

Compare House A and House B.  Both are 50K.  I am living in House A.  I am renting out House B.  I put 20% down on both.  Let's say rent on this unit is $1K a month and for the sake of argument, $250 in mortgage a month and $500 in various expenses to repair, pay taxes, insurance, etc.

House A 1 Month costs:
$250 Mortgage
$500 in Expenses
--------------------
-$750 a month (costs you money every month, only hope is appreciation)

House A 1 Month costs:
$250 Mortgage
$500 in Expenses
+$1000 in Rents
--------------------
$250 cash flow a month (plus you still have the 20% you put down equity, it's not "lost")

Let's say you bought your house all cash-- House A would still cost you $500 a month, but with the same cash you could buy 5 x House B and pocket $1250 a month.

ETA: I know that in both scenarios, you're at least accruing equity, but I'm ignoring that in this example.  If anything, it strengthens the argument as someone else adds to that equity in the rental scenario, and you add to it in the "own" scenario.

Above numbers are incredibly simplified, and just intended to illustrate the concepts.

Tl;DR: Your house is a bad investment because you're paying the mortgage and relying on appreciation to make anything.  A (good) rental is a good investment because someone else is paying the mortgage and costs, and you're still making money beyond that.

[forummm]

Owning your own house can be a good financial decision if it's cheaper than renting. Notice I didn't use the word "investment". It can be a profitable venture, but generally because your expenses were less than renting. There's also the bonus that the appreciation of the house (which tends to happen at about the same rate as inflation, but with very wide fluctuations in the short term) is typically highly leveraged appreciation (due to the mortgage). This of course hurts a lot when prices go down.

With a rental property, you're hoping to bring in more in rents than you pay out in expenses. So that's a profitable business right there. You also have the added benefit of long term appreciation, again which tends to match inflation. And again that appreciation is often from a very leveraged investment (a 75% LTV is 4:1 leverage).

[kcy83]

Thanks for your responses! They are very helpful. Quick question, in the top example, the rent is $1000 a month. Don't you owe income tax on that at your marginal rate? That would essentially knock out your gain.

Part of the reason this is confusing to me might be because I live in an area where the rent / property value ratio is a lot lower than your example. I think a $50,000 rental would rent for about $500 a month here, maybe less.

[gt7152b]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment. For example: http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? You still have to pay for all maintenance and repairs, pay property taxes (which are more than for a primary residence), pay mortgage interest, possibly pay a management company, lose the opportunity cost on the home equity, pay income tax on the rental income... Could someone help me understand how you can come out ahead in this situation? Is it just that you have to live in an area where rental prices are high compared to home prices? It must work or people wouldn't be doing it!

Thanks for your insight.

A house might be a terrible investment if you didn't need somewhere to live. If it's a good investment to be a landlord in your area and you'll be there long enough to average out the costs of realtors, maintenance, and repairs over several years then it should be a good investment to buy as your home as well. You might not be netting anything from tenant rent but you get to rent to yourself at a nice discount. The trap occurs when you buy a house that's much more than you need because you see the payment is so much less than rent on a reasonable place to live. People don't take into account all the other expenses and end up in lifestyle inflation without thinking it through. Buying a house is also much more emotional than finding a rental. Got to treat it like a rental with a big deposit and lifetime rent control. 

[sheepstache]

He's not saying it's always a bad idea economically to own your home, just that it's not an investment. Some people think of their home appreciation as being a good investment, but unless you sell the home, you never reap that gain. So people who calculated their home value as part of their retirement portfolio are screwed no matter how much it appreciates if they don't want to move.

[ShoulderThingThatGoesUp]

Thanks for your responses! They are very helpful. Quick question, in the top example, the rent is $1000 a month. Don't you owe income tax on that at your marginal rate? That would essentially knock out your gain.

Part of the reason this is confusing to me might be because I live in an area where the rent / property value ratio is a lot lower than your example. I think a $50,000 rental would rent for about $500 a month here, maybe less.

You owe income tax on your received rent minus expenses at your marginal rate (this may include mortgage principal, I'm not sure.)

[iamlindoro]

Thanks for your responses! They are very helpful. Quick question, in the top example, the rent is $1000 a month. Don't you owe income tax on that at your marginal rate? That would essentially knock out your gain.

All your expenses are deductible, AND you can depreciate the purchase price (all acquisition costs, actually, including closing costs) of the house over 27.5 years (though this depreciation can be "recaptured" if you ever sell, so many people choose to sell and immediately move the proceeds into another rental property in what's called a 1031 exchange).  You are taxed only on the net proceeds, not the gross rents.  In many cases, it's possible to use depreciation and expenses to avoid paying most or all of the taxes on the income.

Edit to add (simplified again, real life is more complicated!):  for the example above, you collect 12K a year in rents, and after expenses let's say you profit 4K (since you can't write off off the principal part of the mortgage).  Let's say you had a 50K acquisition cost on the house (throwing out closing costs).  You can depreciate $1818 a year.  So now you can only be taxed on just over $2K.  Let's say you pay 25-30% on that, so you only end up paying maybe $600 max on $4K in profit.  Again, keeping the taxes this low is contingent on not selling the property, or performing a 1031 exchange if you do, otherwise the depreciation will be recaptured (but you are still pretty profitable even when that happens).

Part of the reason this is confusing to me might be because I live in an area where the rent / property value ratio is a lot lower than your example. I think a $50,000 rental would rent for about $500 a month here, maybe less.

If this is the case, then don't buy rentals there.  Buy them somewhere else.  It's not as hard as it sounds.  :)

[arebelspy]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment. For example: http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

I love Jim's investment advice, but strongly disagree with his housing advice.  It very much depends on the numbers, and a blanket statement of "buying a house is a terrible investment" is just as wrong as a blanket statement of "renting is throwing your money away".

It depends on the numbers and situation.

There are certainly bad rentals where the owners lose money.  There are good ones where they make money.  You have to look at the numbers and see.

[thelionsmark]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment.

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? ... Could someone help me understand how you can come out ahead in this situation?

There's a huge difference between investment property and owning your home. Investment property needs to be treated like a business - you have revenues, expenses, marketing, maintenance, improvements, tax considerations, bookkeeping and more. As for owning your own home, that's an emotional decision, since it will almost always be a very risky business decision that would be avoided on it's stand-alone merits. Owning your home only pays you in 1 way.

Landlords of investment properties make money in 3 ways, in order of importance:
1. Capital Appreciation - the value of the property goes up
2. Equity growth - tenants are paying down the mortgage, increasing Landlord equity
3. Monthly cashflow - cash available when expenses are covered

Here's a trick you can use
The 1% rule is a quick rule of thumb when evaluating properties. The rule is "monthly rents must total at least 1% of the price paid for the property."
For instance, a $300,000 investment property will need $3,000 per month in rent to be cashflow positive.
(note: There are lots of exceptions to this rule. It is only useful for quick assessments.)

[money_bunny]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment.

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? ... Could someone help me understand how you can come out ahead in this situation?

There's a huge difference between investment property and owning your home. Investment property needs to be treated like a business - you have revenues, expenses, marketing, maintenance, improvements, tax considerations, bookkeeping and more. As for owning your own home, that's an emotional decision, since it will almost always be a very risky business decision that would be avoided on it's stand-alone merits. Owning your home only pays you in 1 way.

Landlords of investment properties make money in 3 ways, in order of importance:
1. Capital Appreciation - the value of the property goes up
2. Equity growth - tenants are paying down the mortgage, increasing Landlord equity
3. Monthly cashflow - cash available when expenses are covered

Here's a trick you can use
The 1% rule is a quick rule of thumb when evaluating properties. The rule is "monthly rents must total at least 1% of the price paid for the property."
For instance, a $300,000 investment property will need $3,000 per month in rent to be cashflow positive.
(note: There are lots of exceptions to this rule. It is only useful for quick assessments.)

Cashflow should be #1 on this list according to everything I have read and my own limited experience. It is both financially and psychologically draining to have to lose money on a property every month.

The other factor is that poorly performing real estate can get you the returns of bonds with much more risk, liability, non-liquidity, and work (Needs a reference here). ARebelSpy and I went over the numbers on a rental apartment I had. With some of the repairs coming up I was looking at 0 return years. It's under contract now to sell. It took me about 24 hours to paint and rehab things to bring in a buyer.

If you want to see that analysis google my posts here.

[supomglol]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment.

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? ... Could someone help me understand how you can come out ahead in this situation?

There's a huge difference between investment property and owning your home. Investment property needs to be treated like a business - you have revenues, expenses, marketing, maintenance, improvements, tax considerations, bookkeeping and more. As for owning your own home, that's an emotional decision, since it will almost always be a very risky business decision that would be avoided on it's stand-alone merits. Owning your home only pays you in 1 way.

Landlords of investment properties make money in 3 ways, in order of importance:
1. Capital Appreciation - the value of the property goes up
2. Equity growth - tenants are paying down the mortgage, increasing Landlord equity
3. Monthly cashflow - cash available when expenses are covered

Here's a trick you can use
The 1% rule is a quick rule of thumb when evaluating properties. The rule is "monthly rents must total at least 1% of the price paid for the property."
For instance, a $300,000 investment property will need $3,000 per month in rent to be cashflow positive.
(note: There are lots of exceptions to this rule. It is only useful for quick assessments.)

There is actually a 4th income:
Tax shelter. 

[zephyr911]

Question from a novice here... On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment. For example: http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

If it is better to rent then buy, how is it possible to make money owning a place a renting it out? You still have to pay for all maintenance and repairs, pay property taxes (which are more than for a primary residence), pay mortgage interest, possibly pay a management company, lose the opportunity cost on the home equity, pay income tax on the rental income... Could someone help me understand how you can come out ahead in this situation? Is it just that you have to live in an area where rental prices are high compared to home prices? It must work or people wouldn't be doing it!

Thanks for your insight.

Let's start with the primary residence case: I live in a 1144sf, 3BR, 2Ba house with a badass deck for entertainment, 2-car garage, and fenced yard for my dogs, in a walkable area. It cost $121,900, and the mortgage is $588 a month, of which about $200 is principal payments (not an actual cost). Thus, my interest, taxes, and insurance are ~$400. Let's be pessimistic and assume maintenance is equal to that $300/mo (typically it's less), bringing the total to $700/mo. A comparable apartment would run $800-1000 here, and even a decent 1BR would cost almost what we pay. I'm already winning without even factoring in the tax benefits.

If we had to leave town, or if we just felt like adding this house to the rental portfolio, we'd charge $900-1000 and profit a few thousand, but depreciation would roughly cancel out the taxable income. And single-family homes aren't even good cash-flow rentals compared to multifamilies. If we were really chasing FIRE above all else, we could buy a 4-plex, live in it, collect rent from 3 tenants, and still turn a profit. That is, *no* living costs, turning a profit, building equity using other people's money.

I'm a partner in an LLC that owns two duplexes in my town, and the returns average 10-15% after all costs. Leverage that with 80% investment loans at 5-6% and you can easily find total returns north of 20% with minimal tax exposure unless/until you sell a property. One year in, with all kinds of stupid mistakes and lessons learned, my $14k investment was worth about $17k, and the growth rate will only rise.

These numbers are unlikely in high cost-of-living areas, but they illustrate the kind of opportunities that landlording gives. Please do not extrapolate anything from that article... it is a hopelessly over-generalized piece of crap based on local conditions in some areas. If anything, read it and understand why it does not always work in every area for every attempt, so you can learn where and why it DOES work.

[zephyr911]

Landlords of investment properties make money in 3 ways, in order of importance:
1. Capital Appreciation - the value of the property goes up
2. Equity growth - tenants are paying down the mortgage, increasing Landlord equity
3. Monthly cashflow - cash available when expenses are covered

The relative importance of each of these is subject to debate.
For maximizing growth rate of a rental portfolio, I'd reverse them.
My procurement analysis focuses first on cash flow for reinvestment purposes, then looks at equity for possible cashouts in future years, and only then adds guesses about appreciation for the sake of a feel-good "total return" number. Appreciation is the hardest to predict and, like equity, expensive to access (usually a refi with potentially thousands in fees).

[CashFlowDiaries]

I agree that cash flow should be number 1 when assessing whether or not a rental will be a good investment. 

Here are actual numbers of the last rental I purchased.  You can see it is including calculations for estimated vacancy, repairs, property management, insurance, taxes, mortgage, hoa, everything!  If after all those numbers you are still coming out cash flow positive and a good ROI then you have yourself a winner.  In this case, im projecting over 20% returns and about $340 extra cash flow per month after all expenses.  not too shabby!

[aasdfadsf]

On most websites about FI, there usually exist solid arguments about why owning a home is a bad investment. For example: http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

If it is better to rent then buy, how is it possible to make money owning a place a renting it out?

It's not. If renting were always better than buying, then landlords would have to be philanthropists, because not only do they have to shoulder the costs of ownership, they have additional costs that owner-occupiers often don't (vacancies, vandalism, evictions, lawsuits, advertizing, management, etc.). It's the premise that's very wrong.

In the article you link to, the author fails to account for the imputed rent, which is where the majority of your ROI comes from in an owner-occupied house. This is a mistake roughly equivalent to claiming that a business is a terrible investment while not understanding that it generates income. As with a business, houses would be literally worthless if they did not generate income in the form of rents. In an owner-occupied house, you're both the renter and the landlord. If you weren't renting from yourself, you'd have to rent from someone else. The money you save by paying yourself instead of someone else is your imputed rent. 

Depending on the price-rent ratio, and assuming you didn't buy more house than you needed (i.e., you bought roughly the same value of house you would have rented), the imputed rent will generally give you anywhere from a 5-12% annual return on the value of the house, and it's tax-free to boot. From that of course you have to deduct a myriad of expenses, but in most cases it's a perfectly sound investment. It can be a bad investment due to circumstance, but it's not that way by its very nature.