Not Rich Yet | Managing higher incomes

May/10

18

The math behind buying a rental property

We are currently considering buying a rental property as an investment. It turns out, there are many different ways to “skin that cat”.

But how do they all compare?

So I ran some IRR (internal rate of return) calculations for them. The IRR essentially tells me what the expected return on my investment will be. Investing in a rental is no different than investing in a CD or a stock – you expect to earn a positive return on your investment.

Here are the facts

We would pay roughly $200k for the property, and get a gross rental income of about $1700 per month. The gross “cap rate” of the property would be about 10%, the net cap rate of the property would be about 5.5%. This means that we would have an annual gross income on the property that equals 10% of the purchase price and after accounting for all expenses except for mortgage costs, an annual income of 5.5% of the purchase price.

Further then property would be cash flow positive on a monthly basis – the rental income would (slightly) exceed my mortgage payments, taxes, insurance and expected maintenance costs.  Sounds great, right? I buy a property and the tenants pay my monthly bills while my equity grows.

But there is a catch. I still need to make a down payment (no more zero down payments in today’s market).

So what is the return or IRR I earn on the down payment investment?

Base case

Lets assume I buy the property with a 20% down payment, and I own the property for 10 years after which I sell it. I assume that the property value increases every year by 2% (roughly with inflation), and rent increase each year 1% (slightly slower than inflation).

Under that base case, I would earn an IRR of 9.6%.

Not bad, right? Better than what I would get if invested in a CD. But hold on, isn’t this riskier than a CD? Shouldn’t I be getting a higher return to make a riskier investment worthwhile?

Value evolution

So what happens if the value of the property doesn’t evolve the way I assumed and doesn’t grow with 2% as assumed in the base case? Lets keep everything else equal and change that assumption.

  • 2% p.a. value growth (base case): IRR = 9.6%
  • 5% (market peaks): IRR = 15.8%
  • 1% (slower growth): IRR = 7.2%
  • 0% (flat market): IRR = 4.4%
  • -2% (market declines slowly): IRR = -3.1%
  • -3% (market takes a beating): IRR = -9.1%

Ouch! So if the real estate market grows or does well I get a nice or even very nice return. But if the market stays flat or starts declining I very quickly have less attractive and even negative returns.  I better be sure the market doesn’t tank!

Rent evolution

So what happens if rents don’t evolve the way I assumed and don’t grow with 1% as assumed in the base case? Lets keep everything else equal and change that assumption.

  • 1% p.a. rent growth (base case): IRR = 9.6%
  • 3% (rents grow quickly): IRR = 10.3%
  • 0% (rents flat): IRR = 9.1%
  • -2% (rents decline): IRR = 8.1%

Okay, so rent growth has some influence on my return but all in all it doesn’t move the needle much. My IRR is still reasonable even if rents start to decline  a bit.

Down payment

So what happens if I plunk down more or less of a down payment compared to the 20% in the base case? Lets keep everything else equal and change that assumption.

  • 20% down (base case): IRR = 9.6%
  • 0% down (no money down – not realistic): IRR = 17.0%
  • 10% down (hard to get for investment deals): IRR = 11.7%
  • 25% down (being required more and more for investment deals): 9.0%

Wow, this really illustrates why 0% down was so lucrative back in the old days.  You could nearly double your IRR by not putting anything down. In essence your renters would pay everything for you and you wouldn’t have to invest a thing but reap a big return when you sell.

Buying it out right

So many people like to pay-off their rental properties quickly, and then think they have a wonderful investment. That is a lot like putting 100% down or just paying cash. What is the IRR then?

  • 100% down (pay cash): IRR = 6.0%

So all else being equal, if you pay for cash for the property, your return on investment is a low 6%, nearly half of what you what have gotten with 20% down and a third of what you would have gotten with 0% down.

Summary

Frankly, from my perspective, the risk posed by fluctuations in property value are quite substantial.  So I would want to see an investment return of at least 9%. That means I should pay no more than 25% down, and not pay off my mortgage early. In addition, I should try to make sure I am able to increase rents over time.

I am still mulling this one over and will keep you updated as it evolves.

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6 comments

  • Welcome Carnival of Personal Finance Readers · Not Rich Yet · May 24, 2010 at 13:34

    [...] The math behind buying a rental property More sponsors Disclaimer Anything published on NotRichYet.com is for information and entertainment purposes only and does not constitute specific advice. NotRichYet.com is intended to provide general information only and does not attempt to give you advice that relates to your specific circumstances. [...]

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  • Under contract! · Not Rich Yet · May 25, 2010 at 06:21

    [...] So we just signed the contract to buy the rental property I mentioned in my post The math behind buying a rental property! [...]

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  • Hope to Prosper · May 25, 2010 at 12:06

    Awesome analysis. I am considering the same thing, but holding the property for retirement income. Unfortunately, it’s nearly impossible to rent a house that will even close to break-even where I live. And, I don’t want to buy out of the area, because I intend to do most of the maintenance myself. So, I am waiting it out to see if they drop more.

    Reply

  • AJC · May 29, 2010 at 04:09

    Jake – excellent analysis; 9%+ returns from RE are much better than CD’s and not far off stocks, with far less volatility (recent years aside!) … can you lock in your interest rate?

    Also, what type of area is this in? Major metro?

    Reply

    • Admin comment by Jake · May 29, 2010 at 11:24

      Thanks AJ. Yes, I locked in the interest rate – it is a sub-urb of one of the larger (but not super size) metros in the midwest.

      Reply

  • Carnival of Personal Finance #258 – Cities at Night | FinanceMoz.com · June 7, 2010 at 13:30

    [...] from Not Rich Yet presents The math behind buying a rental property, and says, “This shows some interesting math behind buying rental properties. Most people [...]

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