3 Ways to Check that a Rental Property is a Good Investment

16

The purchase of a house is the largest investment we typically ever make. It would sure be a good idea that it’s also a good investment. But how do you calculate the yield on a house?

Since my last post on the All You Can Eat Mortgage, my wife and I have been seriously looking into buying a house. It’s kept us super busy, but we found one!

A Lucky Purchase

We had been talking about it for several months but we didn’t have a deadline. Until we realized our lease was expiring, that we couldn’t negotiate anything with the new management and that our jobs had moved to another office 45min away.

We were on a quest to buy a house, with the main criteria being that it needs to be a good investment. We have checked dozens and dozens of properties online and made a top 3 to visit with our realtor on Saturday, 2 weeks ago. We didn’t find anything convincing, so we set another visit on Monday for the next top 3. Nothing convincing either, until we see that house that was in the neighborhood, for sale, but for some reason was not on our list.

We visit it the same evening, loved it, we had found our house.

There was good space, good light, the interior was completely remodeled and the exterior was in the process of being refreshed and repainted by the HOA. Incidentally, as we were talking outside the house, we met a lady walking her dog. She was very friendly, we started talking and after a few minutes told us she happened to be the president of the HOA. A timely and very valuable encounter.

We made a lower offer than the list price, they countered within our range and we agreed. The deal was done on Saturday, exactly 7 days after starting our search. The property was ready to move-in in less than 30 days, which was perfect for us.

Most importantly, the property had to be a good investment so I looked at ways to evaluate the Return On Investment of Real-Estate.

Find out the ROI of your Home

Without much specifics, I had a mental check-list that would qualify a property as a good investment. It helped us identify good neighborhoods, then identify several houses and eventually set criteria for the ones to visit.

Our criteria were the following:

  1. Asset Value : With little doubt, the property would keep its value, or appreciate, over the next 10 years.
  2. Rentability : It can be rented out from day 1 would our jobs decide to send us for an assignment overseas.
  3. Cashflow : The rent would at least cover the cost of mortgage, insurance and HOA and would ideally generate a profit,
  4. ROI : The return on investment should be higher than the 2% we could get on bonds.

There are 3 types of ratios that we used to evaluate the ROI of a real-estate investment.

We have used the first 2 during our search and the last one before closing the mortgage, to make us comfortable with our decision.

They each have their pros and cons and I found they are useful at different times of the house hunting process.

#1 ROI for Real-Estate : the Gross Yield

The Gross Yield is the easiest indicator to calculate because it has only 2 variables : the asset cost and the yearly rental income it can generate.

Gross Yield

The Asset Cost is the cash cost of the asset (eg. 200k$) and the Yearly Income from the Asset represents 12 months of rent, before tax and expenses, that is what the renter would pay (eg. 1500$).

In that example, the Gross Yield would be :

Income      = 1500 * 12 = 18,000$
Asset Cost  = 200,000$
Gross Yield = 18,000$ / 200,000$ * 100
Gross Yield = 9%

The method is the similar to that is used to calculate the yield of stocks. For example AT&T has a yield of 5.6% because the yearly dividend is 1.88$ for a stock that costs 32.21$. However the Gross Yield for a real-estate investment isn’t accurate enough to compare it with other asset classes such as equities.

The Gross Yield was key for me to do back-of-the-enveloppe estimates of what can generate promising returns, while browsing through many many properties online.

Pros:

  • It’s quick and simple,
  • Can be mentally calculated,
  • Serves as a good first rentability estimation pass.

 

Cons:

  • It doesn’t take into account real-estate specific costs,
  • It works only for a cash purchase,
  • Should be used only to compare other real-estate investments.

To get an idea of how Gross Yields vary in the US, you can refer to this 2013 study by Bankrate. Yields were around 10% in Houston and 7% in NYC. Detroit was leading with 22% while San Francisco was trailing with 5% (appreciation might be a bigger factor in SF).

#2 ROI for Real-Estate : the Net Yield

While the Gross Yield is great to do a rough estimate of which neighborhood to invest in for example, the Net Yield helped us identify which properties will generate the desired return on investment.

The Net Yield is more accurate because it takes into consideration real-estate specifics costs such as real-estate taxes, maintenance and HOA, or the Direct Costs related to owning the asset.

Net Yield

In our above example with a property that costs 200k$ and can rent for 1500$, the Yearly Direct Costs would be real-estate taxes (3000$), yearly maintenance costs like plumbing and electrical repairs (1000$) and the HOA (2500$) if there’s any.

In that example, the Net Yield would be:

Income      = 1500 * 12 = 18,000$
Direct Costs= 6,500$
   Taxes       = 3,000$
   Repairs     = 1,000$
   HOA         = 2,500$
Asset Cost  = 200,000$
Net Yield   = (18,000 - 6,500) / 200,000 * 100
Net Yield   = 5.75%

The Net Yield, while slightly more complex, is also more precise and can be used to compare equities and real-estate investments. In our example, this property would generate a yield comparable to the AT&T stock (5.75% vs 5.6%).

Pros:

  • Gives a more realistic yield calculation,
  • Can be used to compare real-estate investment (in cash) with other asset classes, 

Cons:

  • Requires specifics costs of the property evaluated
  • Works only for a cash purchase.

#3 ROI for Real-Estate: Cash-on-Cash return

You might have noticed that the main shortcoming of the Gross and Net Yield is the assumption that the purchase is made cash. For most of us, buying a house cash just isn’t an option and we take a mortgage from the bank. This has a cost and a duration that needs to be brought into the equation.

The Cash-on-Cash returns looks at the return generated by the asset based on the amount of equity invested in the asset and not its actual purchase cost.

Cash on Cash return

Let’s take our previous example of a 200k$ property that rents for 1500$ / month and let’s say it has been purchased with a 4% loan over 30 years. The first year’s loan cost will be 6349$ while 2818$ will go towards equity. The 20% downpayment, or 40k$, will also go towards equity.

Income         = 1500 * 12 = 18,000$
Direct Costs   = 6,500$
   Taxes          = 3,000$
   Repairs        = 1,000$
   HOA            = 2,500$
Borrowing Costs= 6,349$ (1st year)
Equity in Asset= 42,818$ (1st year)
   Downpayment    = 20% * 200,000 = 40,000
CC Return     = (18,000 - 6,500 - 6,349) / 42,818 * 100
CC Return     = 12%

Since we are using a mortgage, the net income at the end of the year is lower than with a cash purchase (5,151$ vs 11,500$) but the amount invested is also much lower (42,818$ vs 200,000$), which makes for a higher return.

The first year will generate a profit of 5,151$ for an initial investment of 43k$, or 12%.

As the owner builds equity in the property, the equity amount increases, which decreases the return. After a few years, the rent might increase as well, which would increase the yield. The calculation isn’t fixed in time and will vary every year throughout the life of the mortgage but the yield will likely be the highest on the 1st year.

Once the property is paid in full, the Cash-on-Cash return becomes the Net Yield.

(18000 – 6500 – 0) / 200000 = 5.75%

Once the house is paid in full, after 30 years, the actual amount charged for rent is likely to have significantly increased. So would have the costs. The Cash-on-Cash return would need to be adjusted every year for changes in income, costs and equity.

Pros:

  • Gives the most accurate representation of return on investment,
  • Can be used to compare leveraged real-estate investments with other asset classes,

Cons:

  • Requires specifics costs of the property evaluated
  • Changes every year to account for inflation and rent variations.

These last 2 weeks have been insanely busy but I’ve been forced to learn a lot about real-estate and this has been fascinating! It’s definitely an asset class that I wasn’t familiar with before and I can see the appeal of investing in a tangible asset.

How about you? 
Have you had a positive experience in Real-Estate investing? 
If you have rental properties, what types of returns are you looking for to invest?
If you currently pay a mortgage, have you calculated what the ROI of your house would be if you rented it out?

-Nick

Get Free Email Updates!

Enjoyed this article? Join our Financial Independence newsletter.

I will never give away, trade or sell your email address. You can unsubscribe at any time.

16 COMMENTS

  1. Congrats! Your house look beautiful. It looks like it’s in the upscale neighborhood.

    I’ve only bought 2 properties so far. As of now they are both bringing me positive cashflow. I consider that as a blessing.

    However, I might have a hard time selling both of them if I decide to sell, as they are multifamily property. Most people don’t like the idea of having to “deal with people” 🙂 We will cross that road when we get there.

    • Hey Vivianne, thanks!
      I feel bad because I didn’t post a picture of the actual house, I was afraid that it could jinx a deal that isn’t closed yet. But I can tell you it’s at least as nice as this one 🙂
      This is great that you have 2 properties that are cash-flow positive, this is great passive income.
      Or at least I hope your tenants aren’t too much work to make it worthy!

      • I had a feeling that you might not post your own home, I live in the east coast, a lot of houses look like this one. It’s kind of cool just to go look at open house sometimes. 🙂

        Having a rental is like having a second job. For now, I’m okay with the time and the commitment. If it get to be too much, I might consider contracting out.

  2. Nice find on the house! When we were looking, we ended up finding the house we ultimately bought as well. Our second realtor was really good though, just the same. He had lots of similar properties, but you can’t win them all.
    Great analysis on home investment. I guess I’ve never thought of a home as an investment, since we were covered through our companies both times we bought. the first, was a loss, as we bought in the Summer of ’08 right at the peak of the real estate boom, and right before the crash. However, we were covered within 10% from our company, and ultimately still came out ahead compared with renting.
    This house we wanted to be more protected with and make sure it was “re-sellable” and priced fairly, and I think we did alright. We have a great location, great space and nice sized yard that still doesn’t have a pool in it, so there is actually room to run around. At the least we should break even, but I think we will fare much better than our last home, regardless.

    We probably won’t do renting as an income, because it just doesn’t fit our agenda. I keep bringing it up, but it just might not be for us.

    • Hi Mr. SSC – the benefits your company gives you on the purchase of a house sound a lot like what mine would offer if we hadn’t rented earlier. Maybe those are the O&G benefits.
      It’s awesome that you found a great house to live in on your 2nd purchase, I think the “re-sellability” is an important factor for piece of mind. Because the real-estate transaction costs are so high (broker’s fees, move in/out,…), and because sometimes selling is not easy like in 2008, we wanted to have the option to rent-it out in addition to being re-sellable (we were greedy).
      In many areas of Houston, home prices have doubled since 2011 and reached levels that are still (mostly) reasonable.
      If you have bought a few years back, you might be able to recoup more than what you lost in 2008!

      • Yeah, we had friends that ran into that situation with relocating. Actually, they were trying to buy before they moved so that they could gain those benefits. They knew they’d be moving in a year, but as renters they didn’t qualify for the home buying parts of relocation unless they were current homeowners, so they bought a house. Crazy stuff.
        We’ve been in our house here about 2.5 years now. prices in our area are steady, and may have increased some, but I think we have a great location that should help when we go to sell, hopefully in a couple of years. Fingers crossed…

        • Ah, these O&G folks, they have so much money they buy a house just to get more benefits 🙂
          We found something in the Energy Corridor, prices have almost doubled in the last 3 years as the area as developed. There are several developments still ongoing, we’ll see how that impacts real-estate prices and rents.
          To keep an eye on prices, I’d recommend checking Zillow as they keep an history of all sales (good to check the trend) and HAR for the completeness of their database for what’s currently on the market.
          If oil prices go up as they predict end of 2017, you might be in a good position to sell. And if possible try to sell in the summer, there’s a lot more demand between may and september, when schools go on summer vacations (and buyers are ready to move-in).

  3. Congrats on finding a house that’s right for you!

    We own one rental property, and our calculations were a bit different from the norm because we bought it specifically to rent it to a loved one who we need would be a reliable and long-term renter. The easiest thing to forget to calculate (we know this because we forgot!) is the income tax you owe on the rental income. You get to write off the mortgage interest and insurance, and you get to depreciate the property, but you still owe tax on the rest of the rent you collect. While we’re still working and are in a relatively high bracket, that’s a pretty big chunk of tax that means our property is currently a net loss. That will change once we quit in two years, because our tax rate will plummet — then we’ll basically break even. And once the mortgage is paid off on the rental in 14 years, then it will actually make us money. So it’s definitely a long-term investment! We know our experience isn’t typical, but there’s a lot to think about when buying a rental property.

    • Hi ONL!
      A long term renter whom you are familiar with is a great renter! I’ve read a few stories how people had to deal with new renters every 12 months, deal with evictions, collections, … and this is definitely something we all want to avoid.
      But the way I look at it, it’s also a way to learn, so there’s always something positive to it.
      Taxes are indeed something we need to keep in mind and now that my wife and I are married, I think we’ve been ‘upgraded’ to a higher tax bracket. I’ll need to check that, thanks for the reminder!

    • Wow, impressive! For such an appreciation, I’d have sold in no time. Unless the rent I could have collected increased by the same ratio, that would have been a money mine 🙂

Leave a Reply