Determining Return on Rental Property

[popntx]

I bought a rent house investment property way back in 1984 for $62,000 and have never had an issue keeping it rented. The mortgage was paid off over 10 years ago, so I've had a healthy positive cash flow for several years of about $10K per year after all expenses (property taxes, insurance, management fees, etc.). The house is currently worth about $250K. Prior to the mortgage being paid off, I had a slight positive cash flow most years. I've always considered this to be a long term, if not permanent investment that is now paying off with some decent supplemental income in my retirement.

In retrospect, I probably would have done much better just taking the $62K and put it in a stock index fund, but that's water under the bridge. I have no desire to go back and spend the time and effort to calculate the return I actually have made over the years on that $62K.

However, I do think it's important to understand the return I am currently getting on this property versus what I could get via other investments (for example CD's, or a balanced stock/bond portfolio). Again, I have no intention to sell the house, but could be convinced to do so if there is a compelling reason.

I think the answer is as simple as taking the cash flow each year divided by the estimated value of the property for that year (what I could get if I sold it and invested it elsewhere). For example, for 2018 if my positive cash flow is $10K and the value of the house is $250K, then my return is 4%. Note all numbers are before taxes. Not great, but not bad. Of course, the numbers get worse if I have vacancies or major expenses come up.

So, does my logic make sense? Are there other variables that I need to take into consideration?

 

[SumDay]

Vanguard Index Funds and ETF's won't call you when the toilet overflows.

 

[pb4uski]

.... So, does my logic make sense? Are there other variables that I need to take into consideration?

The change in the value of the property during the period.

So expanding on your example, is the value of the property at the beginning of the year is $250k, it cash flows for $10k and the value at the end of the year is $255k, then the pre-tax return is 6% ($15k/$250k)..... just like if you have a stock portfolio that is $250k at the beginning of the year, pays $1k in dividends and is worth $255k at the end of the year.

 

[RetireBy90]

I believe you have the basic idea. Property investors call it cap rate. However, in considering the property and other investments, consider what you would net from a sale of the property. Consider taxes on your gain, depreciation recapture and commissions. You may only net say $200K which would give you a 5% cap rate.

Also consider the risk between property and other investments, any expected expenses such as my roof is 15 years old or bathroom needs to be updated.

And then there is the rise in value addressed above.

Guess you could consider the $10K income like a dividend and in least in value like a stock price increase.
Just my thoughts which are worth exactly what you paid for them :’)

 

[popntx]

Thanks for the excellent feedback. The property is in a desirable area and has been steadily going up in value over the last 10 years, so that definitely is a factor to consider and contributes to the overall return. And the property has been fully depreciated, so the net gain after taxes, depreciation recapture and commissions will certainly impact the net I would receive after selling.

As far as toilets overflowing, that's what I pay the property management company for dealing with.

 

[calmloki]

We are selling a little rental place right now. Depreciation recapture and capital gains tax and real estate commission and closing costs are going to cut deeply into the sale price. We bought in 2001 for $77k, added a roof and multiple paint jobs in and out, various flooring and appliances, all that normal rental stuff. Looking for $229k right now and may get to keep $140-150k after all is done. OTOH, it kicked maybe $10/year while being rented out and we paid it off long ago. I'll be surprised and impressed if the stock market does as well for us with the amount we will be left.

I use what the tax man calls "real market value" as the property value - it seems way too low until you figure in the taxes and other costs of sale - then it seems high. Still, better than me pulling numbers out of a hat.

 

[brucethebroker]

In retrospect, I probably would have done much better just taking the $62K and put it in a stock index fund, but that's water under the bridge. I have no desire to go back and spend the time and effort to calculate the return I actually have made over the years on that $62K.

You may be missing an important point. How much did you put down all those years back, and how much did you spend fixing it up before finding a renter? Personally, I use that as my true "basis-not the purchase price.

I previously owned a rental house I purchased for $100k. I put 10k down and another $3k in fix ups to rent it out. After that, the renters paid the mortgage & repairs (and I made profit and tax deductions) for over 20 years until I paid off a small remainder on the mortgage.

Sure, I could count $100k as money I should have put into stocks, but I NEVER had that 100k until I sold the property. Certainly did not have it to invest 20+ years ago. My true "basis" was only $13k. Could I have done better with the $13k in the stock market? Most likely, no. Not to mention that I might have been tempted to buy a new car or take a vacation with it.

 

[brucethebroker]

BTW, I use return on current market value of the house (net of expenses to sell the house-figure on 7-8%). My net rents seemed to run in the 6.5 to 7% during most years-including during the Great Recession. Add in the value of depreciation deductions and potential appreciation and that is a pretty nice return.

 

[Starsky]

While it's tempting to look at market returns over such a sustained bull market and compare them to my real estate returns; it quickly becomes an apples to oranges comparison. I think real estate is a great compliment to stocks because it offers disconnected diversification from Wall Street; and can be a great backstop when the market isn't working in your favor.

I've always thought of my singe-family rentals as my hands-off small business that generates income month-after-month, and occasionally requires some maintenance and investment to keep running smoothly. The lower ROI is offset somewhat by depreciation and property appreciation - and by the fact that I can earn retirement income without depleting the real value of the property. It is a great security feature, in contrast to having to sell my stock assets to fund my retirement. And rent doesn't care whether the market is up, down or flat.

For me, tax-deferred stocks/ETFs was my long-term investment strategy to accumulate accessible savings. [About 25% of our invested assets are held in IRAs] Stocks are much easier to manage than real estate for lots of reasons, but the market doesn't always work when you need it to. The average market return over the last 50 years is just below 10%, but it has been very erratic. I have friends who live 100% on income from their stocks, and unpredictable times like now can be wildly stressful for them.

For me, I would consider the rental property cap rate to be higher than an annuity, but lower than investing in stocks for income [typically]. Given that, a 4-6% return seems fair. It could be better, but time has a lot to do with it. [Depreciation is a great tax benefit, and not having it could make a big difference in your calculus.] Some (maybe a lot) of the ROI could also be a function of the unrealized property appreciation over the years.

I see the same thing. Since the value of my rentals has gone up a lot since I bought them, my ROI based on the properties' market value has diminished significantly. OTOH, ROI as a function of invested capital only gets better every year as rents go up.

The good news is that on your balance sheet, the unrealized property value appreciation is no different than the unrealized capital gains in your stock portfolio.

The bad news is that it is relatively hard to switch investments in real estate. The transaction costs can be significant, and it can be hard to find other properties in the same market with better ROI. I got lucky a couple of years ago and exchanged an older property that needed lots of maintenance for a newer, cheaper property further out of town that was bigger and had a much better ROI. I do foresee more portfolio management like this in the future to help maintain the best returns - and maybe pull a little cash out.

I'm [hopefully] too far away from the final dirt nap to have a handle on when our rental properties will become more of a burden than an asset. I expect that there will come a time when the utility of the unrealized cash will be greater than the value of the steady monthly rental income, but right now that's a long way off.

 

[popntx]

The change in the value of the property during the period.

So expanding on your example, is the value of the property at the beginning of the year is $250k, it cash flows for $10k and the value at the end of the year is $255k, then the pre-tax return is 6% ($15k/$250k)..... just like if you have a stock portfolio that is $250k at the beginning of the year, pays $1k in dividends and is worth $255k at the end of the year.

I can't believe I didn't think to take increasing property values into consideration when determining my total return. My house is in an "up and coming" area in a city with an already very hot real estate market. Over the last 5 years, property values have increased an average of 10% per year according to tax appraisals (I know, not the most accurate measurement). Nevertheless, increasing property values have been a bigger contributor to total return than positive cash flow from rental income over the last few years. Of course the increased property value isn't realized unless/until you sell, and higher property values correlates in higher taxes, but fortunately the strong real estate market is resulting in the ability to raise rents over time as well. All-in-all, I am happy with this investment.

 

[jetpack]

I happily sold my rental property a few years ago. The calls to fix things and the worries of leaky roofs and pipes were just too much for me. The property itself did great and I think it's a wonderful investment for people in their competitive years. Once you retire, it's so much easier to sit back and not worry.

 

[Filetmerlot]

I sold my rental on Friday. The tenants were fine. They kept the place nice and relatively clean. There were just too many reasons why I felt we should sell:

1. It was just too much like having a second job.

2. last year I had the hot water heater and furnace go out in the unit which cost about $8500.

3. since we bought it in 2013 condo fees went up from about $259 to $400

4. I don't have it in me to raise rent every year. The difference between the rent we charge in 2013 and the rent now was only 13%. Similar units went for 20% higher for rent.

5. The property went up in value by about 80% from our purchase price to our sell price.


Using an old analogy - if you had $x (property value) sitting on the table would you buy the property again? I would answer no, so therefore we decided to sell. I'm happy just using the Bogle approach and buying index funds and letting other people be landlords.

 

[Cobra9777]

Our AA includes 15% real estate, which consists of one rental house plus a REIT ETF.

For the rental, I track value change plus pretax net cashflow. We focus on cashflow, so I ignore depreciation; and I use pretax figures since I want to merge this into other pretax returns for overall portfolio tracking. I know the rental income has a tax advantage due to depreciation, but it also has recapture down the road. So for performance tracking, I just ignore all that and focus on pretax cashflow plus value change for consistency with other types of investments. I also use a normalized variant of this metric to determine when and how much to increase the monthly rent.

I don't really compare rental returns to stocks or bonds. Long term, I sort-of expect that returns will be better than bonds but below stocks. It's an intentional alternative asset class that I like to hold for stability, reliable cashflow, and the tax advantage. The tradeoff is a little bit of work now and then. We have long-term, stable tenants so usually it's just a matter of doing some light maintenance myself, or coordinating with skilled trades for repairs I can't do myself.

This is very manageable for us right now. But still, DW and I are inclined to sell when/if the current tenants leave, depending on market conditions at the time. We'll likely use the proceeds to increase our REIT ETF and keep real estate at 15% in the AA.

 

[pb4uski]

I guess that technically our retirement portfolio includes a rental property since we bought our winter condo using money from our retirement portfolio but I don't include it in my thinking of what our retirement portfolio is.

Since we bought it a few years ago it has appreciated a little. The main benefit is that we get to use it for 6 month a year... if I take the opportunity cost of money at 5% plus our annual operating costs it is about $18k a year and I don't think that we could rent that condo for $18k a year or even for a seasonal rental of $18k for the 6 prime months, but it might be pretty close.

 

[Huston55]

I guess that technically our retirement portfolio includes a rental property since we bought our winter condo using money from our retirement portfolio but I don't include it in my thinking of what our retirement portfolio is.

Since we bought it a few years ago it has appreciated a little. The main benefit is that we get to use it for 6 month a year... if I take the opportunity cost of money at 5% plus our annual operating costs it is about $18k a year and I don't think that we could rent that condo for $18k a year or even for a seasonal rental of $18k for the 6 prime months, but it might be pretty close.

PB-

Do you rent your vaca condo when not using it?

 

[pb4uski]

No... the months that we use it are the highest demand months and the months that we don't use it there is minimal demand.... not to mention the hassles involved.

We do know of some folks who own property in the Myrtle Beach area that from what I have been told has high demand from May-Sept and Oct-Apr is nice weather but can be cool with occasional cold spells... the rentals from the high demand months pretty much carries the property so their net cost to use it in the off-season is quite affordable.

OTOH, my understanding is that rent in that area in the off-season is also very affordable.

 

[Cobra9777]

I guess that technically our retirement portfolio includes a rental property since we bought our winter condo using money from our retirement portfolio but I don't include it in my thinking of what our retirement portfolio is.

Since we bought it a few years ago it has appreciated a little. The main benefit is that we get to use it for 6 month a year... if I take the opportunity cost of money at 5% plus our annual operating costs it is about $18k a year and I don't think that we could rent that condo for $18k a year or even for a seasonal rental of $18k for the 6 prime months, but it might be pretty close.

Our main home is 4500 sqft on 2.2 acres. Way too big for the two of us, but we're still enjoying it for now. We definitely plan to downsize at some point. I estimate that there will be $250-300K net proceeds after downsizing. That figure is included in my retirement spreadsheet at an estimated date in the future.

I've often thought that for AA purposes, perhaps I should also include that figure in my current portfolio as an investment in real estate. If so, that may influence how much other real estate I want exposure to. But for now, I just include it in net worth, not in the actual portfolio or AA. In part, this is because we might actually use the funds when we downsize to get a really nice place, location-wise. Evidently, DW and I have different definitions of "downsizing."

 

[Offgrid Organic Farmer]

I bought a rent house investment property way back in 1984 for $62,000 and ...

The mortgage was paid off over 10 years ago

You did not spend $62k to buy this property.

You likely spent around $4k in closing costs, and from that time on, the mortgage was serviced by rental income.

 

[BeachOrCity]

You did not spend $62k to buy this property.



You likely spent around $4k in closing costs, and from that time on, the mortgage was serviced by rental income.

This^

Real estate works because of MODEST leverage. You make ur money when u buy. Be patient and buy right and be willing to put the time in and it can do incredibly well.

Speculate on appreciation, be lazy, outsource by hiring a property manager and watch your returns shrivle.

 

[pb4uski]

You did not spend $62k to buy this property.

You likely spent around $4k in closing costs, and from that time on, the mortgage was serviced by rental income.

Nonsense.

The OP put money down and incurred debt in exchange for the property... total money down and debt incurred was $62k. No different than if he had written out a check for $62k.

Under either cash or financing option the OP was entitled to collect rent by virtue of owning the property.

The difference being that if he bought the property for cash he could have pocketed the rent but since he financed it he has to use some of the rent payments to service the debt.

 

[Offgrid Organic Farmer]

During my career, I owned four different apartment complexes. Each in a different state/nation. In total, I may have spent $20k out of my own pocket in buying these properties.

How much Net Worth I gained as rental income paid down the mortgages, was substantial.

 

[pb4uski]

But alas, it wasn't all so great, was it?

http://www.early-retirement.org/for...-purpose-in-firecalc-91614-4.html#post2039026

 

[Offgrid Organic Farmer]

But alas, it wasn't all so great, was it?

I walked away with a large chunk of cash in my pocket, and I never paid taxes on that profit.

I saw one bump in the road.

Overall that was not bad.

 

[pb4uski]

I walked away with a large chunk of cash in my pocket, and I never paid taxes on that profit. ..

If you had a "large chunk of cash in my pocket" as you claim how come you wrote that "our savings was gone"?

What profit was it that you never paid taxes on?

If the property sucked your savings dry and the bank foreclosed and took the property it is hard to see how you profited.

 

[Offgrid Organic Farmer]

I have explained this a few times before. Not sure why you want to dig about so much.

Between 1990 and 2002, we sold some of our properties and used the profits buy down the mortgage on our last remaining property.

In 2005 we refinanced our last remaining apartments and used that cash to buy our farm [I paid cash, no mortgage]. That cash was all the profits that we had made from all our complexes.

In 2008 we lost all of our tenants due to the Recession and the lay-offs in that city. And we began servicing the mortgage using our savings.

In 2009 we ran out of savings.

Do you want to hear it again, maybe in a different language next time?