It seems like such a difficult way to make a dollar. You have to buy a property, fix it up, figure out what rent to charge, find renters, deal with repairs, upkeep, late payments, complaints from the tenants, complaints from the neighbors, citations from the town, and also have a lawyer on standby in case an eviction is necessary. Then start again every time you get a new tenant.
On the other hand, in most cases you’ll receive monthly payments like clockwork, never hear a peep from your tenants, easily find new ones when necessary, and get a return on your investment that’s protected from interest rates and inflation, is almost risk free, and is higher than you can get from stocks or bonds unless you’re a hedge fund manager.
And if you ever decide you don’t want to be a landlord anymore, you can easily sell out at a higher price than you paid to begin with. Try doing that with a bond.
Dealing with the tenants is your problem, no getting around that, but let’s discuss some of the financial and strategic aspects of your investment.
First, on the tax front, not only are all your cash expenses – including broker fees and management fees – deductible for your federal taxes, so is the depreciation of your property. Calculated over 27.5 years on a straight-line basis, depreciation protects the first 3.6% of your annual return from taxes. With returns around 5 or 6 percent right now (2017), that’s a big deal. Calculation below.
Second, leverage. If you can borrow money at a lower interest rate than the return you otherwise get from the property, the return on the portion you provide is higher. Calculation below.
Third, what about rents? Do they swing like home prices? How much can you raise them? And what’s the right rent to be charging in the first place? Each property is different and so is each location, so it depends. You should go online and see what other landlords are asking for a similar property in the area. You can ask local brokers, but take their answer with a grain of salt – they’d rather get the commission at any rent rather than have you hold out for a higher one.
You can and should raise your rent every year. Inflation eats into your real revenue if you don’t keep pace. Rents don’t swing like home prices can; they rarely go down and usually rise a bit faster than inflation. If the neighborhood around your property changes, you can see rents rise even faster – and sometimes fall. This is one of the opportunities you have and one of the risks you take.
Fourth, and one of the biggest reasons people like to invest in rentals, what’s likely to happen with the value of your property down the road, when you consider selling it?
Two economic developments are in your favor right now. More and more people will be renting in the future, so the value of rental property in general will be rising. And the recession of 2008 brought home prices in many markets lower than they should be, so even after prices rose in the last few years, there now (2017) are still plenty of places where you can get a good deal.
Apartment buildings and homes split into multiple units also will benefit from strong demand over the next decade, but single-family homes will probably benefit the most – depending on which market they’re in – because a lot of people who can’t afford to buy a house still want to live in one.
A single-family rental on a piece of land in an attractive neighborhood gives you several options when you want to sell. It can be sold as an established rental, it can be sold as a single-family home, and it can be sold as a knock-down that a builder will level to put up a new one – most of the value in homes is in the land, not the structure. Because there has been very little home building since the 2008 recession, the value of single-family homes will increase at above-average rates over the next decade – if you’re in the right market.
Fifth, you do need to look strategically at the market where you intend to invest. Often that’s the market you know best – the one you live in – but also consider other markets with good potential. You can make a good investment in almost ANY market, but HOW you invest, what price you should pay, what time horizon you should consider, and what exit plan you need, will depend on the economic characteristics of the local market. No room to discuss that here, but see my article, “How To Develop A Localized Real Estate Investment Strategy”
Finally – and another cop-out – how much should you pay for your investment? Again, no room for that here, but see my article, “Price Your Rental Property Based On The Risks You Are Taking.”
The Depreciation Calculation
If you’re renting out a $100,000 property and your cash return is $5,000 per year, and your tax rate is 20% your after-tax cash income is $4,000 without depreciation. But after deducting $3,600 of depreciation your taxable income is only $1,400, your tax paid only $280, and your after-tax cash income is $4,720.
The Leverage Calculation
Lets say the pretax return on a $100,000 property is $6,000. At a 20% tax rate, the aftertax return is $4,800, a 4.8 percent return on your investment. But if you can borrow half the money at 4 percent, you can deduct $2,000 in interest from the pre-tax $6,000, pay 20% tax on $4,000, for an after-tax return of $3,200. Since your investment was only $50,000, your return is 6.4 percent.