Note To Self: Buy More Rental Property!
If there’s one thing I know I will regret 15 years from now, it’s not buying property over the next 12 months. Last Friday’s 7.6% YoY jump in existing home sales was a big shocker that helped propel the stock market to new highs. What’s exciting though, is that the property markets have lagged, creating what I think is a golden opportunity to pick up some rentals for one’s retirement.
If you look around the world, from the UK to Hong Kong, property prices have rebounded double digits this year. Yet, the US is slowly but surely coming out of price declines largely because of still massive consumer debt overhang. Volume growth generally always supersedes price growth. Who knows exactly when the property market will bottom, but what we do know is how to calculate simple math to make proper purchasing decisions.
Current borrowing rates (mortgages) for rental properties hovers between 5-7% for a 30-year fixed. Hence, that is your bogey. If you can get a rental yield of at least 5-7%, your rental property starts looking interesting. Obviously, the higher the rental yield the better. To calculate a rental yield, you simply divide the total annual rent buy your considered purchase price.
Real Example in War Torn Vallejo, California. Bankruptcy Central.
Home Price: $250,000 3 bedroom, 2 bathroom house that once went for $500,000.
Current Monthly Rent: $1,500 based on 10 comps on Craigslist’s rental section.
Rental Yield: $1,500 X 12 = $18,000 / $250,000 = 7.2%.
Mortgage Rate: 6% on $250,000 if you unrealistically put no money down = $1,250 for a positive spread of $250/month.
The issues with this example is you have about $3,000/yr in property tax to pay, unknown operating expenses, and the risk of not finding a tenant for the full 12 months. However, the upside is that your mortgage isn’t going to be the full $250,000 because you will put some money down and have less monthly payments as a result, and you have the opportunity to ride the eventual asset price recovery.
Another way to look at rental property is through an all cash offer. If you have $250,000 in cash lying around earning 3%/yr, would you be willing to earn a 4.2% premium (7.2% rental yield minus 3%) to be a landlord? Some will say yes, some will say no way and demand more. This is what we talk about when we refer to “Equity Risk Premium” in the stock market.
Whenever you look at property, you must consider the realistic rental yield to make sure you are paying a fair price. And just in case you run into financial turmoil, you should be safe to know your costs will be covered. Where you start making millions is when you start a fund, raise money, buy hundreds of properties, leverage, and then sell off a portion of your fund to shareholders. Some call this a Real Estate Investment Trust (REIT). However, let’s just start small and build the empire one unit at a time!
Rental property investments come down to simple math and income production. At an extreme, even if the $250,000 house lost another $200,000 in value, but is still renting for $18,000/yr, that’s all that matters in the meantime. Yes, eventually rents will come down, but what is going on now is massive financial panic and implosion by individuals who bit off more than they could chew. Asset values have declined much greater than the decline in rents, and normalization will eventually occur. In the mean time, you should just collect the rental income and patiently wait for the right time to exit.
Happy Hunting!
Financial Samurai – “Slicing Through Money’s Mysteries”
Follow me on Twitter @FinancialSamurai
I agree about picking up some rentals for cheap now. It’s important to take advantage of the weak hands who are selling now. The maximum of buy high sell low escapes many people.
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I agree picking up a rental property would be great. I think those of us in a strong position to do so can still wait a little longer. Although, the month over month sales increased 7% the supply actually increased more, so we’re still adding backlog. Once the rush of first time home buyers ends in November housing will take another leg down IMO.
-Gen Y Investor
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admin Reply:
August 24th, 2009 at 7:28 pm
Hey Gen Y – I don’t think the property market will run away from us by any means, but I honestly don’t believe things will get much worse. Simple math is dictating a healthy positive carry now on many properties in hard hit areas. I just spent 3 hours taking a look at some properties today, and I must say, I’m quite interested.
I wish they’d get even cheaper, but i’m not sure. My favorite time to buy is during the height of winter holidays. Anybody listing then is amazingly desperate.
Best, FS
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Well, well, well… “S&P index shows home prices rose 3 percent in 2nd qtr, the first quarterly gain since 2006″ today 8/25.” I hope I’m not too late.
Rest, RB
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Wish I had the cash to do this. As a college student just trying to get by week to week and month to month, I just don’t have hte finances for a rental property (let alone any property!) but if I had the cash to invest I’d pull the trigger fast!
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I will definitely be buying more property this year. It is the biggest no brainer of our lifetimes right here, right now! People are still scared. Perfect time.
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Primary and secondary home sales are rebounding strong. You’ve got something here RB. I’m just too old already, so no need.
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My take on the UK property “rebound” is it’s actually a dead cat bounce. The time to buy for those who can afford to do so (myself excluded unfortunately) will be mid-2010 or so.
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One of my friends bought 3 homes that had peaked at 500k. they were REOs, listed for 250k. he offered 125k cash, no contingencies close in 3 days, put 20k to fix them up and is renting them for 2000/mo.
These were in hispanic neighborhoods of San Diego.
But the data that the press is reporting about home prices increasing is probably misleading.
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admin Reply:
October 13th, 2009 at 6:58 am
LOD – Wow, sounds lik a healthy 20% annual rental yield! Smart fella. I think it’ll work out well for him, as not only will he just collect the cash flow, he’ll probably see some equity appreciation over time. Thnx for sharing your example!! FS
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FS,
What are your assumptions about getting a year-round tenant?
And what if the tenant loses their job and cannot pay?
Not trying to be negative, just want to know what your risk analysis says about this.
-Mike
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admin Reply:
October 18th, 2009 at 7:10 am
Howdie Mike – Very good question, and something I could probably dedicate an entire post to. I think in a nutshell, a landlord should always bake in 1 month of non occupancy for your reasons i.e 91% occupancy. It all depends on your location and your asking price.
Something will always rent out, if you lower the price enough. Say you get $2,000/month and lose 1 month a year for whatever reason. If you want to stop losing that one month, just take $2,000/12 = $167 and market your price accordingly.
Realistically, you aren’t always going to have only 11 months a year in occupancy since people generally stay longer than 1 year at a time. There are all types of incentives landlords can give. I think I will dedicate another post to this question. Thnx! FS
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I think your basic analysis is ok, but you are missing a few fundamental pieces. First, if you have a 100% mortgage at 6% on $250,000, you are correct that your interest payment for that mortgage will be $1,250 per month, but unless you have an interest only mortgage, you will be paying $1,500 (30 yr fixed w/ amort). Second, you mention taxes but you don’t include insurance or maintenance on the property. I think 0.5% to 1% of the value of the home is a good estimate for maintenance (an additional $100 to $200 per month), and then insurance could be another $1,000, or another $83 per month (depending on your location). All in, now you are looking at almost $1,800 per month, which is higher than your monthly rental income.
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admin Reply:
January 7th, 2010 at 3:46 pm
Brian – You’re right about not including all the expenses. In areas of high demand, the problem is… it rarely works that one will be cash flow positive immediately after the first year or two, otherwise everybody would buy, and then it really wouldn’t work!
Thanks for sharing your commentary.
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You strategy is an excellent one and now and in the near future are excellent times to execute. Mortgage rates are at a historic low, property values are extremely attractive, rental demand is on the rise as more and more people sell/lose their homes and while market figures vary region to region and can be somewhat inaccurate I think we are at the bottom. Forecasts are that we are going to stay at the bottom for several more years (notably recent NAR analysis), but the wise investor might do well to consider that prices probably won’t go much lower but interest rates are likely to rise and the income lost while waiting suggest now is a great time to invest. The most successful investors always buy when fear rules and others are selling. Here in south Orange County California the beach cities real estate opportunities are remarkable and this type of property will always be desirable, with short term vacation rental possibilities another option to consider as part of your rental holdings. If you’d like I can set you up with a personal website to search the local MLS and receive updates of Hot Buys. Thanks Samurai good piece.
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