Carefully selected, appropriately maintained and properly managed rental properties can provide three things all investors look for: 1) income, 2) capital appreciation and 3) tax advantages. In fact, in more ways than you may realize, real estate investing mirrors investing in stocks and bonds.
For both, your goals are short-term income and longer-term capital gains. When you invest in real estate, your short-term income comes from rent, instead of from quarterly dividends or interest payments. And your capital gains come from the price of the property you own going up, rather than stock price growth.
That is not to say there aren’t big differences. (And that’s not to say that your portfolio should include only stock market assets or only real estate. Research shows that varied portfolios are much better over time.) Stock market investing is often much more passive. It may also be less time and research intensive than real estate investing.
I have found, however, that taking a more active investing approach reaps higher rewards. For me, it’s just more satisfying to own tangible properties than shares of stock that show up as numbers on a monthly statement.
Choosing a Property
Many people “fall into” owning a rental property. They get married, move in together and, rather than selling the extra home, decide to rent it out. Or they inherit a home from their parents and rent it out instead of immediately selling it.
Often these are not ideal rental property situations for a few reasons. The main reason is that the numbers don’t work. And that is because planning is always better than falling into almost any life situation.
If you would not buy the property as an investment for the specific purposes of rental income and/or capital appreciation, it probably won’t turn out to be a great real estate investment.
Let’s say you are not in one of these situations. Instead, you would like to buy and rent a property as an investment.
Yield Is Better Than Location
What makes a good investment rental property? You might have heard that real estate investing is all about “location, location, location.” And that’s certainly true with rental real estate investing. You want a rental that’s right for a large pool of reliable tenants who can afford the rent and are looking for housing.
As important as location is, it’s just as easy to lose money on a property in a great location as it is to lose money on a property in the dregs of town. The location alone is just one part of being successful.
The key thing is that the numbers work. You want to make sure your property is cash-flow positive. You need to precisely calculate rent revenue and expenses. This is called your “net rental yield.”
What Is Net Rental Yield?
At its simplest, the net rental yield is the real estate version of the ROI (return on investment) you would look to achieve on any investment. It is calculated as follows:
Net Rental Yield = (Net Rental Income ÷ Total Property Cost) x 100
You need to calculate, or very precise estimate, your total property cost and your net rental income to arrive at your net rental yield. So what goes into those numbers?
Here are the details of one of my properties that have been rented for nearly a year now:
|Cedar Barn Way Property Details|
|TOTAL PROPERTY COST||$139,269|
|Annual taxes and insurance||$1,625|
|NET RENTAL INCOME||$16,488|
|NET RENTAL YIELD||11.8%|
Your total property costs need to include all out-of-pocket expenses to get the property move-in ready for tenants. That would be your purchase price, closing costs, financing costs if you took out a loan, the cost of rental licensing and fees, and advertising costs. All costs need to be counted.
Likewise, you need to know your annual rental income and all your costs to come up with the difference. That is your Net Rental Income.
Typical costs come from upkeep, property management fees, taxes, insurance, vacancy expenses (budgeting for months when the property may not be rented) and monthly utilities (if your lease doesn’t state that the tenants pay those). Make sure to total rental income less all the expenses of keeping your asset and producing that income.
Avoid Rookie Mistakes
Being surprised by unbudgeted costs is a novice mistake. In the case of this property, you will notice that I budgeted for vacancy and upkeep. But I didn’t incur either of these costs in year one because 1) the tenants were screened with care and signed a one-year lease and 2) new appliances with warranties were placed in the property as part of the rehab process.
So my net rental yield for this property was 11.8%. (Annual Rental Income of $16,488 ÷ Total Property Cost of $139,269.)
What’s nice about knowing your net rental yield is that it lets you weigh properties against each other. Then you can find the better deal before buying. It even lets you compare your estimated real estate returns against the expected return of other investment choices like stocks and bonds.
What About Appreciation?
For years, many thought that properties only went up in value. The housing collapse of 2008–2010 brought a dose of reality to that thinking. But even in that bubble, there were residential properties across the nation that held their value and even appreciated.
Properties chosen with care hold a real value that does not go away.
The prospect for capital appreciation is a big part of my property selection process, but I don’t count on it to make my numbers work. Markets are fickle and prices go up and down. And if you think about it, the market price of residential property matters only when you want to sell it.
Of course, I watch the changing market values as I would any other investment so I know if it makes more sense to continue to rent or sell for gains. This Cedar Barn Way property was bought below market value because it was a foreclosure and needed work.
So far it seems like a good investment. Today, comparable properties in the area are selling for around $185,000. If I decided to sell and could get that selling price and deducted 8% for selling costs, my profit would be approximately $30,000. Not my best deal so far, but not a bad return on an investment of $140,000.
Rental real estate also has some tax advantages that other investment choices lack. This article starts to show you to how real estate investing achieves two of the three things every investor looks forward to achieving. The third is tax advantages. Real estate investing has a unique tax advantage. You can learn more here.