A 20% cash on cash annual return on a rental property? My eyes popped out when I saw the tweet from @marshal. That is too good to be true. Can it be true?
I realized I know nothing about real estate investing. Particularly rental property investing. So I started researching.
Rental Property Overview
According to pewresearch.com research, more U.S. households are headed by renters than at any point since at least 1965. 36.6% of households are renting their home. Combine that trend with the low-interest rate for a mortgage, it is a great time to invest in rental properties.
But buying a rental property comes with its own rewards and problems. Rewards include passive income and long-term capital appreciation. But not everyone can manage the property and deal with difficult tenants.
Pros and Cons of Owning a Rental Property
Owning a rental property involves a lot of work both during buying and while maintaining the property. Know what you are getting into before investing.
Pros
- Cash Flow – The rent you receive will pay off your monthly mortgage, taxes, insurance, and expenses. You will be left with some cash as a return on your investment.
- Property Value Appreciation – Your rental property will ideally appreciate in value over time.
- Tax benefits – As a property owner, you are eligible for tax benefits. You can deduct depreciation costs, property management expenses, and insurance, among other expenses.
- 1031 Exchange – You can avoid paying capital gains taxes when you sell your investment property. You have to reinvest the proceeds from the sale within certain time limits in a property of equal or greater value.
Cons
- Analyzing & closing the property – searching for properties, analyzing the neighbourhood, negotiating with the seller and closing the mortgage takes a lot of effort and time.
- Down payment for a mortgage – You should be ready to pay at least 20% of the property value as a down payment to get a mortgage on an investment property.
- Lack of Liquidity – Rental investment is not as liquid as stocks. You can not sell your property and get cash when you need it.
- Rising Taxes and Insurance Premiums – Taxes and insurance premiums may increase in the future
- Market decline – Housing markets could decline due to broader economic conditions. Also, the neighborhood you have invested in can lose its appeal which might depreciate the property value.
- Dealing with Difficult Tenants – Tenant problems are your responsibility 24/7/365. Flooded apartment? Complaining neighbors? You’ll get the call.
- Maintenance and Upkeep – Depending on the age of the property, you will have to fix or replace things to maintain the property in livable condition.
Now that we know pros and cons of owning a rental property, let’s look at the investment side of the rental property.
Calculating Return on Investment
There are three ways you can make money in rental property.
- Passive Income from Rental Savings
- Equity Gain
- Property Value Appreciation
The scope of this article is to show how we can calculate the passive income on a rental property. Let’s dive in.
Passive Income from Rental Savings
Passive income is one of the driving factors behind rental property investing. Passive income on a rental property is what’s left after all the expenses are paid. They call it the cash on cash return on investment. The expenses include your mortgage, tax, insurance, and the cost to repair and maintenance the property.
The best resource I found to calculate cash on cash ROI is Calculating Numbers on a Rental Property by bigger pockets. I simplified the calculation and created a spreadsheet for you.
I am going to take @marshal property for this calculation. The calculation is divided into four sections.
- Investment
- Income
- Expense
- Cash Yield
- Cash on Cash ROI
Step 1: Investment
This section covers the initial investment we make to buy the property. The three main investments are the down payment and closing cost for mortgage and the property remodeling cost after buying.
- Down Payment – Marshal tweet that the property value was $150,000 and he paid $42,000 down payment.
- Closing Cost – He did not mention what was paid for closing cost. I am approximately estimating the closing cost to be $3,000.
- Remodeling Cost – Because the property looks great, I am going to assume he did not do any remodeling after buying.
Total investment on the property is $45,000
Step 2: Income
The only income on the property will be the rental income. Marshal mentioned in the initial tweet that the rental is $1,695 for this property.
Total monthly income from the property is $1,695
Step 3: Expense
This section covers all the expenses paid to maintain the property. Some expenses are straight forward like mortgage, tax and insurance. But there other expenses like
- Mortgage – The monthly principal and interest paid as mortgage. He mentioned he is paying $818 for mortgage, tax and insurance. I approximately split it up between these categories and mortgage comes to $598
- Tax – Property tax paid to the county and state. In Missouri the tax is approximately 1% of the property value. Let’s assume the tax is $120
- Insurance – Home insurance is approximately $100.
- HOA – If it is a townhome or a property in a community, you will end up paying HOA fees. Because this is an independent property, there will be no HOA fees.
- Utilities(Water, Sewer, Electricity, Gas) – Marshal mentioned all the utilities are paid by the renters.
- Lawn Care / Snow Plowing – You will have to consider the lawn mowing fees or snow plowing cost. Let’s assume there will be neither for this property.
- Property Management – If you are planning to hire a property management company, you will end up paying 10% of the rent as fees to them. Even if you manage it by yourself, you need to add 10% as your fees for your time and effort.
- Vacancy Saving – General suggestion is to set aside 5% of your rental income to cover your cost during the months when the property is vacant.
- Repairs – Saving 5% of the income for common repairs like plumbing and electrical work is a good idea.
- CapEx – Depending on the age of the property, you will have to replace HVAC, roof and floor. It is advisable to set aside 5% of the income for these expensive replacements when it happens.
- Restoration Cost – You will come across bad tenants who will leave the property in bad shape. You will have to spend money to paint and restore it to good condition before you can rent it out. Set aside 5% to cover the restoration cost between tenants.
The total expense on this property comes to $1326.50
Step 4: Cash Flow
At this point we know what is the investment on the property, total income and the expense. To calculate the monthly cash flow, we have to subtract the expenses from the income.
Cash Flow = Income – Expense
Cash flow for this property comes to $368.50(1695.00 – 1326.50). And the annual cash flow is $4,422($368.50 * 12)
Step 5: Cash on Cash ROI
At this point we know what is the investment on the property and the cash flow. To calculate the Cash on Cash Return on Investment, we need to calculate the monthly cash flow.
Cash on Cash ROI = (Annual Cash Flow / Total Investment) * 100
Cash on Cash ROI on this property comes to 9.83%
The Cash on Cash ROI on this property is 9.83%
You might think 10% is not a great return. Remember the average annual return for the S&P 500 index from 1957 through 2018 is roughly 8%. You are beating the index by 2% with just the passive income. Remember that your property will also gain equity and appreciate in value.
Equity Gain
Over time the principle you pay off of your mortgage accumulates as your equity. In the example we looked into, Marshal will accumulate around $12,000 at the end of 5 years. In 10 years he would have accumulated $26,000.
Property value appreciation
Some people buy properties based only on the expectation of property value appreciation. Property value appreciation depends on the location you invest in. Property value will rise faster in metros than in smaller cities.
Together with passive income, equity gain, and property value appreciation, rental property investment seems to be a good investment option. Remember, you can also deduct the depreciation costs, property management expenses, and insurance, among other expenses from your tax returns.
There it is. Now you know what a rental property investment is all about. You can download and use the spreadsheet to calculate your Cash on Cash ROI while analysing rental properties.