Make the math of rental real estate add up for you
Q: What do you think about owning single family home rental real estate vs. investing in the stock market?
A: I have seen several families do well with rental real estate, but only by owning several properties over many years (if not decades). As rents increase, positive cash flow often occurs while the mortgage is being paid off by tenants. But the math is tough, especially in the beginning years.
Here’s an example.
A client family asked about renting out a home they were moving out of. The home was worth about $400,000 and they had about $200,000 left on the mortgage. Their monthly cost for the mortgage, property tax and insurance was estimated at $3,000 a month and they felt they could rent the property for $3,500 a month. We also noted that the fact that they had a mortgage technically meant having less of their money tied up, providing leverage for gains. However, leverage works both ways. A loss of one quarter of the value of the house would drop their equity by one half.
I remarked that owning this property and putting in the time and work over many years might pay off, but that it would not really make any money for them in the first few years. The only two ways to make money would be the build in equity with each mortgage payment, and the possibility that the house increased in value.
On the expense side, we discussed that their equity of $200,000 sitting in the house had an opportunity cost-i.e., it could be invested elsewhere and presumably make money there. Even if we looked at a low expectations 3% return-that would mean $6,000 a year.
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They also should consider an allowance for the property being empty for some period of time and at least acknowledge the risk and cost of a “bad” tenant. The property will have scheduled/expected maintenance (hot water heater, A/C unit, roof, etc.) and unscheduled maintenance and repairs.
So, we discussed that they were investing in a highly illiquid product that carried unseen risks as well (house prices can certainly drop) for perhaps no net income for several years. Presumably and hopefully, rents increase enough in future years to produce net income while the mortgage balance is also dropping. We observed that most of our client families that had elected to own one or two properties often remarked to us that it was “not worth it.”
Residential real estate historically appreciates roughly at the rate of historic inflation (two to three percent per year). The U,S, stock market historically appreciates at double this rate for the last 70 years, and is a truly “passive” investment.
I’d conclude with the belief that rental real estate can be a good investment-but that it requires patience, time and work. The most successful real estate investors I’ve seen usually slowly acquire several (or many) properties over a period of years, and do not count on real estate price appreciation to provide most of their gains.
Steven Podnos is a fee-only financial planner in Central Florida. He can be reached at Steven@wealthcarellc.com and at www.WealthCareLLC.com.
This article originally appeared on Florida Today: Make the math of rental real estate add up for you
