Author Topic: School me on my rental property understanding..  (Read 6403 times)

cbr shadow

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School me on my rental property understanding..
« on: June 26, 2014, 12:21:01 PM »
There's something that I don't understand about rental properties.  I would think that if the rental covers your mortgage payment that it would always be worth having as a rental rather than selling.  Based on what I've read here that is not always correct.

Example A)
If I have a $1400 mortgage payment and I'm getting $1500 for renting out the house, in what case would this not be worth it to keep as a rental property?  Common belief is that your mortgage payment is being paid for you and you're builidng equity by paying off the house with someone else's money.
Of course there are other things to consider like: vacancy, repairs, etc.

Example B - my real-life situation)
I have a $1900 mortgage payment on a $210k house (15-yr loan @ 3.75%, taxes/insurance included) and can get $1600/month renting it out.  So every month I have to pay $300 towards the mortgage, but each payment $900 goes toward paying principal.  So my $300 pays off $900 of principal.  What am I missing here?

Thanks for any insight,
Ryan

arebelspy

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Re: School me on my rental property understanding..
« Reply #1 on: June 26, 2014, 12:31:51 PM »
There's something that I don't understand about rental properties.  I would think that if the rental covers your mortgage payment that it would always be worth having as a rental rather than selling.  Based on what I've read here that is not always correct.

Example A)
If I have a $1400 mortgage payment and I'm getting $1500 for renting out the house, in what case would this not be worth it to keep as a rental property?  Common belief is that your mortgage payment is being paid for you and you're builidng equity by paying off the house with someone else's money.
Of course there are other things to consider like: vacancy, repairs, etc.

Example B - my real-life situation)
I have a $1900 mortgage payment on a $210k house (15-yr loan @ 3.75%, taxes/insurance included) and can get $1600/month renting it out.  So every month I have to pay $300 towards the mortgage, but each payment $900 goes toward paying principal.  So my $300 pays off $900 of principal.  What am I missing here?

Thanks for any insight,
Ryan

You're missing the part that I bolded.

You just glossed over that like it was nothing.  :D

EDIT: To add to that, what happens when it's empty for a month?  You're suddenly 1500 in the hole.  Then you have to pay for the turnover costs (paint and carpet).  There's another few hundred to few thousand.  Then something breaks.

Then there's the capital expenses: long term stuff that just wears out, that you should put money aside for every month.  Think: roof, water heater, HVAC, etc.

You also owe the property manager somewhere in the neighborhood of $1500-2000/yr.  Unless you're managing it yourself, in which case you should pay yourself a fair wage.  Unless you like managing properties and having a side gig where you get paid.. nothing.  "Whee, I own this property and spend time managing it and make no money on it" doesn't sound like something I'd ever say.

There's more costs as well, but those are some major ones you're just skipping over by doing "gross rent - PITI."
« Last Edit: June 26, 2014, 12:36:58 PM by arebelspy »
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waltworks

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Re: School me on my rental property understanding..
« Reply #2 on: June 26, 2014, 12:44:54 PM »
I'll echo Arebelspy - with some vague numbers you can use to start guessing what your real outcome will be:
-10% vacancy (so your $1600/mo is now $1440)
-1.5%/year for maintenance (call it $300/mo, so you're at $1140). Could be much, much more, could be less if the house is really new and well built. You will always have to do flooring, paint, roof, etc at some point. Appliances will break, pipes will burst, etc. You can go a year with almost no costs and then get hit for $6k worth of roof repairs the next.
-Increased insurance costs and/or legal fees (let's say you get really lucky and this is only $20 a month or something over the course of many years, so now $1120)
-Management costs - without getting into a discussion of how to treat managing the property yourself (I think of it as a job for which you should pay yourself, or at least subtract the value of your time) this will cost you, say, 8% of your gross rent, $130/mo. So now you're at $990.

Your mortgage is $1900, your actual income is $990, so you're at negative $910 cash flow. If you want to include the principal paydown in the calculation, you're only losing $10/month, but losing $10/month on a $210k investment sucks.

-W


johnhenry

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Re: School me on my rental property understanding..
« Reply #3 on: June 26, 2014, 02:09:04 PM »
Here are a couple spreadsheets loaded with data from Example B in your post.  I  had to make a few estimates and guesses, then I added in estimated repairs in an amount that would be accurate for the 50% rule.

Assumptions were:
-20% down
-$1500 closing costs
- value of 90/10 for structure vs land
- no accelerated depreciation on internal items
- non-mortgage portion of loan payment split evenly between taxes/insurance (this won't change bottom line, only allocation of expenses)
- added token amount of $50 to claim for travel expenses
- no rehab costs
- interest vs. principal calculated based on first year of loan (will change each year obviously)
- assumed no vacancy (but did add enough estimated expenses (repairs) so that 50% rule applies

One spreadsheet is meant to analyze the investment property.

The other will show what your income statement for the property would look like if the estimates were accurate.

Let me know if I plugged something in wrong...


GrayGhost

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Re: School me on my rental property understanding..
« Reply #4 on: June 26, 2014, 02:10:26 PM »
Apart from what's already been said, here's something to consider--why deal with the trouble and bother of owning a property that's giving you a low (or negative!) return on your hard-earned dollars, when you can cash out and buy into a few index funds instead?

The sum total of work you'll need to do to see ~7% returns a year on your dollars is a few clicks, compared to the endless hassle of dealing with turnovers, repairs, nonpayment of rent, et cetera.

In other words, why lose $300 a month--assuming no repairs, assuming no vacancies--and deal with the day-to-day issues of landlording, when you actually make money on average, for essentially no work?

Sure, you can bet on appreciation, but I'd recommend against that unless you understand the local market and have a good reason to believe that your property will appreciate by a lot. Remember that average home appreciation is something like 1% a year over inflation. In contrast, average stock market performance is about 7% a year, and you have to do hardly any work to capture those numbers.

cbr shadow

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Re: School me on my rental property understanding..
« Reply #5 on: June 26, 2014, 02:50:28 PM »
I appreciate everyone taking the time to respond.

More on Example B)
If we sold right now we'd probably break even or owe a small amount after fees, according to my Realtor. 
In that case, selling doesn't have the benefit of being able to invest any initial cash from built equity.

As for knowing the market, my Realtor seems to believe now is not the time to sell and that if we hung on to the property for two years we'd be happy with the value at that point.  I realize she can't tell the future, but I'd think she's more in tune w/ the housing market than most.


waltworks

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Re: School me on my rental property understanding..
« Reply #6 on: June 26, 2014, 03:17:55 PM »
You can obviously gamble on appreciation, but if it doesn't happen you're even worse off, eh? This might be a classic sunk costs fallacy problem where it's losing you money but you feel like you have to stick with it because of the all the time/effort/money/love you put in.

I'd sell it and hope to walk away clean.

-W

arebelspy

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Re: School me on my rental property understanding..
« Reply #7 on: June 26, 2014, 06:15:59 PM »
I appreciate everyone taking the time to respond.

More on Example B)
If we sold right now we'd probably break even or owe a small amount after fees, according to my Realtor. 
In that case, selling doesn't have the benefit of being able to invest any initial cash from built equity.

As for knowing the market, my Realtor seems to believe now is not the time to sell and that if we hung on to the property for two years we'd be happy with the value at that point.  I realize she can't tell the future, but I'd think she's more in tune w/ the housing market than most.

Breaking even to get out of a cash flow negative property sounds pretty wonderful.

And yes, you may see appreciation, or not.  Most likely you will see some, but if you took that -9k or whatever it is for the cash flow annually and invested that over the next few years, how much will you have instead?

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jmoney

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Re: School me on my rental property understanding..
« Reply #8 on: June 26, 2014, 07:11:54 PM »
Where do you live and is it a market that's going up? It's probably better to sell it but if you must keep it (for ego or other wise) look into a land contract where you can assign the repairs, property tax and insurance to the tenant. It probably will make you cashflow slightly but you have to do the math. Look at it this way:

Consider a sales commission of 6% of 210 k if you put it on the market = $12.6 k. I assume you owe ~$190 k.

So if you sold it yourself on land contract for $210 k with $10 k down that would put the commission in your pocket upfront and you're legally ok because you're not upside down. You can't owe your lender (aka your bank) more than your land contract buyer owes you. Really $10 k down is only 5% on a $210 k home which is very reasonable for someone and would give you several months of negative cashflow upfront. You may try to bump the price higher and ask for more down because you offer financing if you are in a good market.

Obvious risk is tenant could trash the place. Obvious benefit is $10 k (or whatever above you can get) down payment upfront plus any principal paydown if the tenant backs out. You also want to check about land contracts where you invest. I love them because in Ohio if a land contract goes bad the process is similar to eviction and the house is back to you in ~45 days very quickly and cheaply. Some states require full foreclosure for land contracts which I would not do this in.

You can probably also push the rent and sales price higher to help justify a small loss. Maybe you can get $1700 -1750 on land contract instead of $1600? That puts your loss at only $100-150 per month and if you combine that with the $10 k upfront your are break even or ahead for quite some time.

Can you lower your property tax or insurance? I appeal property tax every year and save thousands.

Here is one reason why I don't like banks and here is the real value in you holding the financing already. How many points and closing costs did you pay when you bought your home? Factor those into your break even at this "pending sale closing" you are probably in the hole for sure based on your first post. Lets say you paid $7500 in closing costs. You can save a land contract buyer from paying $7500 to a bank by giving them financing and thus you are able to sell for more. There is something for you both to gain and don't feel bad upcharging when selling on land contract if you can get it.

Last, depending on when you got this loan, how much you put down, and your interest rate compared to today's rates you might be able to offer someone the same terms you pay - thus the same "rent" as your mortgage. Just advertise the opposite way. Not $1900 per month, but $210 k house 15 year loan at your% interest rate owner will sell on land contract. Or advertise $1600 rent and have the land contract say tenant pays insurance and property tax. People will pay more than rent if they can own and you can make some money along the way.

waltworks

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Re: School me on my rental property understanding..
« Reply #9 on: June 26, 2014, 07:24:28 PM »
This sounds like an incredibly convoluted FSBO. Which, if you're a RE semipro, might be worth it, but otherwise is probably a terrible idea IMO.

-W

123flip

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Re: School me on my rental property understanding..
« Reply #10 on: June 27, 2014, 06:43:57 AM »
As for knowing the market, my Realtor seems to believe now is not the time to sell and that if we hung on to the property for two years we'd be happy with the value at that point.  I realize she can't tell the future, but I'd think she's more in tune w/ the housing market than most.

Real estate agents are not economists, and if anything, they likely have a more skewed view on the real estate market than an average person.  In fact, I bet if you ask the typical agent in any typical market where they think the market will go over the next 5 years, the bulk of them will tell you that real estate will appreciate a good bit.  And I'm sure they believe it.

But, if you look at the numbers, over the past 100 years, real estate appreciation (as a whole across the US) has essentially tracked inflation.  While anything can happen in the future, if I had to make a prediction, I'd predict that what will happen over the next couple years is the same as what has happened over the past 100 years -- the market will appreciate modestly and in line with inflation.  So, while your house may be worth a few percent more in a couple years, in "real dollars" it will more likely be worth about the same as today.

Unless you have some macro-economic insight into the economy as a whole, or you have some knowledge of your market specifically that should impact employment, population, desirability, etc., I wouldn't try to forecast where the market will go and I certainly wouldn't listen to real estate agents who try to do it. 

Based on the information you've provided so far, I'd recommend selling to break even and be thrilled to not spend $$$ every month on a cash flow negative investment.

Just my $.02...

Fishingmn

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Re: School me on my rental property understanding..
« Reply #11 on: June 27, 2014, 06:49:58 AM »
I'm a Realtor.

Do I think real estate will appreciate on average over time - yes.  Just like I think the stock market will have positive growth over the long term.

Unfortunately, I was not given a crystal ball upon getting my license that will allow me to predict short term economic statistics.

Gerard

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Re: School me on my rental property understanding..
« Reply #12 on: June 28, 2014, 07:14:17 AM »
I'm a Realtor. [...]
Unfortunately, I was not given a crystal ball upon getting my license that will allow me to predict short term economic statistics.

You are awesome. Could you please share this realization with your colleagues?

(No, I'm not being sarcastic!)

Thespoof

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Re: School me on my rental property understanding..
« Reply #13 on: June 28, 2014, 11:54:49 AM »
The one thing I can't wrap my head around about real estate is all this talk about cash flow and such. Sure, havering a couple hundred bucks a month in positive cash flow is peachy but why does everyone seem to ignore the fact that some one else is paying for the property! So what if I have to put in a few bucks here and there. Eventually the $300,000 house will be paid for and I own it for pennies. Other people paid the lion's share. I now own a property that cost me squat in the grand scheme of things. Leveraging other people's money is the cat's ass here. I never see anyone talking about the fact that other people are substantially paying the property off regardless of cash flow, returns, yadda yadda. Even if I have to pay a couple hundred bucks a month, where can I own a house worth several hundred thousand dollars for a couple hundred bucks a month generally speaking? Am I missing something?

arebelspy

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Re: School me on my rental property understanding..
« Reply #14 on: June 28, 2014, 12:07:24 PM »
The one thing I can't wrap my head around about real estate is all this talk about cash flow and such. Sure, havering a couple hundred bucks a month in positive cash flow is peachy but why does everyone seem to ignore the fact that some one else is paying for the property! So what if I have to put in a few bucks here and there. Eventually the $300,000 house will be paid for and I own it for pennies. Other people paid the lion's share. I now own a property that cost me squat in the grand scheme of things. Leveraging other people's money is the cat's ass here. I never see anyone talking about the fact that other people are substantially paying the property off regardless of cash flow, returns, yadda yadda. Even if I have to pay a couple hundred bucks a month, where can I own a house worth several hundred thousand dollars for a couple hundred bucks a month generally speaking? Am I missing something?

Let me tackle that, and I think you'll understand why cash flow is more important than that.

First reason: Because that won't happen for 30 years.  I'm retiring in two.

The principal pay down adds to my returns, sure, but it's not funds I can access without jumping through some hoops or selling the property.

Yes, we do count principal pay down in returns, obviously.  But it's not worth a negative cash flow investment for that - then the tenants AREN'T buying the house for you, you are, with your negative cash flow.  Focus first on the cash flow, and you'll get the house paid off as well.

Let's look at some numbers.  Say, for example, I buy a 100k property, rent it out for 1500/mo.  Put 25% down, 5% mortgage.

Gross rent: 1500
Expenses (50% rule for a rough example is good enough): 750
P&I (75k loan, 5%, 30 year): 403

Monthly cash flow: $347.

Cash on cash return (25k down, and assume 5k closing/repairs, for 30k invested total): 13.9%

We're also getting appreciation (at the rate of inflation), most likely.  And we have that principal pay down you mention.  How much is it?  Well, it's about $90 for the first few months.

My cash flow is nearly four times that much.  Sure, that principal amount rises due to amortization, but so does my cash flow as rents rise.

Why don't we mention it much?  Well, it's just not as important.  It sounds impressive "they're buying a house for you!!"

And don't get me wrong, it's nice.  But when you look at the reality of the numbers, of course we're going to focus on cash flow when we get that now, not in 30 years, when it shows up in our bank instead of having to refi or sell to access it, and when it's 4x as much as principal pay down is.

So yeah, eventually you own a house.  Neat.  You also collected 4x as much as that house is worth in rents along the way.  That's what makes me more excited.  :)

And since the principal paydown will happen either way, might as well focus on getting the cash flow, because (believe it or not), that won't happen either way - some people buy cash flow negative properties.  So focus on making sure you get that cash flow, and you'll own the house anyways on top of it.

Does that answer your question?  :)
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Rezdent

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Re: School me on my rental property understanding..
« Reply #15 on: June 28, 2014, 12:17:50 PM »
The one thing I can't wrap my head around about real estate is all this talk about cash flow and such. Sure, havering a couple hundred bucks a month in positive cash flow is peachy but why does everyone seem to ignore the fact that some one else is paying for the property! So what if I have to put in a few bucks here and there. Eventually the $300,000 house will be paid for and I own it for pennies. Other people paid the lion's share. I now own a property that cost me squat in the grand scheme of things. Leveraging other people's money is the cat's ass here. I never see anyone talking about the fact that other people are substantially paying the property off regardless of cash flow, returns, yadda yadda. Even if I have to pay a couple hundred bucks a month, where can I own a house worth several hundred thousand dollars for a couple hundred bucks a month generally speaking? Am I missing something?
What I see missing:
Running costs that you are on the hook for
No return for risk: house could devalue, tenants or nature could damage/destroy
Opportunity costs: you could be earning money on the money you are putting into the house

And lastly - yes you would potentially own a house worth lots of money.  YOU don't get the use of that house - the tenants get that.  That moves a rental house into a different realm - from a home to an investment.  Would you pay $300/month for an equivalent investment account that appears to only earn at the rate of inflation?

NoCreativity

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Re: School me on my rental property understanding..
« Reply #16 on: February 10, 2016, 03:34:26 PM »
old post, I get it, just trying to learn more about rentals / real estate.

Isn't the idea that the investment in a non-liquid asset such as this will be somewhat of delayed benefit, possibly to children / spouse if managed correctly? So the immediate cash flow situation could really be a wash, although I understand why you would not want to "own" a property with a negative cash flow situation....


SwordGuy

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Re: School me on my rental property understanding..
« Reply #17 on: February 10, 2016, 05:53:00 PM »
old post, I get it, just trying to learn more about rentals / real estate.

Isn't the idea that the investment in a non-liquid asset such as this will be somewhat of delayed benefit, possibly to children / spouse if managed correctly? So the immediate cash flow situation could really be a wash, although I understand why you would not want to "own" a property with a negative cash flow situation....

No.  Get that idea out of your head.  It's bad.

Example: You die early.  Your heirs can't afford to make the negative cash flow payments anymore, so they sell it for pennies on the dollar to get free of it.   Oh, you got extra insurance for that?  Congrats!  You are even MORE cash flow negative!

You could instead use the negative cashflow to invest with and get actual assets that don't cost you money to keep.   And that bring in extra cash that can be used to buy even more assets that bring in extra cash.  That's what compounding returns do for you.

arebelspy

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Re: School me on my rental property understanding..
« Reply #18 on: February 10, 2016, 10:53:21 PM »
old post, I get it, just trying to learn more about rentals / real estate.

Isn't the idea that the investment in a non-liquid asset such as this will be somewhat of delayed benefit, possibly to children / spouse if managed correctly? So the immediate cash flow situation could really be a wash, although I understand why you would not want to "own" a property with a negative cash flow situation....

No.  Get that idea out of your head.  It's bad.

+1.

Here's the thing:  You choose where to invest your money.  Why invest it in a "meh" investment that will upgrade to "okay" decades down the road?  When you could choose a good investment now that, via compounding, is ridiculously amazing decades down the road via compounding?

Even if you want to leave to heirs, investing in something good now, rather than something meh now, will leave much more.
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Re: School me on my rental property understanding..
« Reply #19 on: February 11, 2016, 09:53:38 AM »
I'm a Realtor. [...]
Unfortunately, I was not given a crystal ball upon getting my license that will allow me to predict short term economic statistics.

You are awesome. Could you please share this realization with your colleagues?

(No, I'm not being sarcastic!)

Yeah, Zillow is supposed to do that.
But around here we let our mortgage originators do it.

--fellow Realtard

zephyr911

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Re: School me on my rental property understanding..
« Reply #20 on: February 11, 2016, 10:11:53 AM »
old post, I get it, just trying to learn more about rentals / real estate.

Isn't the idea that the investment in a non-liquid asset such as this will be somewhat of delayed benefit, possibly to children / spouse if managed correctly? So the immediate cash flow situation could really be a wash, although I understand why you would not want to "own" a property with a negative cash flow situation....
This has been alluded to above, but here's more math: $300/mo into an index fund earning real returns of 7% is $51,900 after a decade, and you can pull it out any time you need it.

I'm currently getting $1200/mo on my former residence, with a $905 payment, and even that is super-marginal - as in, I'm just debating when, not if, to take the $5-10K hit on the sale. Even on a 4yo home with minimal upkeep, just keeping it clean and occupied erases most cash flow, and one major component failure would wipe out an entire year's equity accumulation or more.

We now look for about 40% of rent to cover debt service. That way, we can allocate 40-50% for the costs discussed above and still have cash to reinvest. And preferably, it's at least a duplex. Not only do they pull higher cap rates, but the odds of 0% occupancy are much lower. Cash flow now, AND a paid-off asset later. Don't count on a $300 monthly loss to earn $900 payable someday... count on five figures out of pocket and net $0 after equity build.