I’m yet to learn a more powerful way to build wealth and passive income than Rental Properties.
There are so many strategies in Real Estate that you can deploy that it’s a bit overwhelming when starting.
Today I’d suggest you tone down the noise around Fix and Flips, Commercial Real Estate, Wholesaling, Mortage Notes or any other strategy and focus on the tried-and-truth Rental Properties.
Let’s drill down why Rental Properties have the potential to generate 20%+ returns.
Let’s go deep in numbers, understand what so special about them, and how to make money with rental properties.
How the essential math works?
The math behind rental properties is quite simple.
All Income - All Expenses = Your Results
Your results can be positive or negative. Every investment comes with risks, but if you do your homework right, you’re most likely to see profits than losses.
But “All Income” and “All Expenses” are still too vague. You surely know there are much more items inside these variables, and that’s exactly where we’ll go next.
What are the different Rental Property Income Streams?
Of course, the biggest one is rent. After all, this is a rental property. You find a good tenant, sign a lease, and receive the rent.
This is also by far the most satisfying thing in rental properties. Getting my first check in my mailbox – more likely a direct deposit to my bank account nowadays – materialized the whole rental property investing concept to me.
When I got that first check and realized every month I’d be getting that money, it gave me a perspective on how attainable financial freedom could be.
But I’m getting ahead of myself.
Since we’re talking about rental property income, here are a few other revenue streams that might apply to your investment.
Have you ever missed a lease payment? I have.
Not because I didn’t have the money ready, just because my landlord only used checks, and I forgot to hand him the check that month. Result: $30 bucks late fee!
It sucks when tenants don’t pay on time, but it’s not always a sign of financial problems.
While I’d rather have on-time payments than this extra income, this is one income that might show up in your account.
Just make sure it’s a one-time thing. If it becomes a revenue stream, happening every month, you might need to reevaluate your tenants.
Pet Rent and Fees
Providing pet-friendly housing can be a great benefit to you. While you should be already accounting for extra cash in your tenant’s security deposit, investors can also establish additional pet rent and non-refundable one-time fees.
Coin-operated washer and dryers, additional storage rental, an extra garage parking spot, these are all examples of extra income streams that rental properties can produce.
What are Rental Property Expenses?
It’s easier to think of expenses as two categories: fixed and variable.
Fixed expenses are the ones you know beforehand, or can estimate very accurately, how much they cost.
Variable expenses you know they will happen one time or another, but not exactly when or how much.
When analyzing your investment you can quickly calculate the fixed ones, and then estimate the variables according to your level of comfort. Let’s talk about this some more.
If you’re using mortgage, that will be your biggest expense. If you invest right, this can be a good expense to have. It allows you to use other people’s money and leverage your whole investment.
Let’s not forget that leverage can work both ways, although I personally believe the risk-reward for Rental Properties is spectacular and the reason I’m using mortgages for all my investments. More on this later.
But there are the top fixed expenses to take into consideration:
- Mortgage payments
- Annual Property Taxes
- Property Manager
- Home Owners Association Fee
These expenses take care of things that are not exactly under your control, but you can prepare for them beforehand.
For instance, your house is not going to be rented 100% of the time. We account for that via vacancy rate.
The house components won’t endure centuries too. They have a limited lifespan so you will need to have some extra expenses on repairing roof, HVAC systems, water heater, etc… These are called capital expenditures.
Can we make money?
Taking into consideration all income possibilities and all expenses, the answer to this question is somewhat objective.
If your incomes are greater than your expenses, you will make money. If not, you don’t.
By now you should be forming your own feeling for whether you’ll make money or not, based on your experience and where you live.
If you’re like me, living in Bay Area’s San Mateo County, where median house is $1.1M (~$4,000 mortgage), and median rent is $4,000, you might quickly realize that this can be a challenge.
But these areas are the exception, not the norm. The everyday investor like you and me can leverage all the other markets in the country that do work!
Dallas has median house in $145,000 range (~$512 mortgage) and median rent at $1,342. Can it make money? From this macro analysis it surely looks very promising, right? To better answer the question you need to look at individual properties, but spoiler alert, yes Dallas works great!
A real-life example of Rental Property Investing
Numbers don’t lie. I remember when I first start looking for Rental Properties as an investment. I was skeptical of everything and everyone.
Being a geek investor, I know that I need to resort to numbers. Also, books, articles and experience investors warned me about all the different expenses and things I had to consider in my investment analysis. For instance, you need to include vacancy rate in your calculations, since your house won’t be rented 100% of the time.
The good news is there are dozens of calculators out there created by expert investors to help us out.
I don’t like Excel too much. I prefer Google Drive Spreadsheets since the files are always online and in sync with my devices.
So what I did was to distil a bunch of spreadsheets into my own. I’ll be using it for this calculator and providing it to you as well. Let’s get to it.
The investment opportunity
This is a real opportunity that my agent passed on to me, and I only omit the address here.
Address: 12321 Cashflow Dr. Houston, TX 332211
Stats: 3 beds, 2 baths, 1460 sqft
List Price: $155,000
Offer Price: $150,000
Tax Rate 2.43%
HOA $180 year
Expected Rent: $1620
With experience, you’ll notice out of the bat that this looks promising. A quick indicator is the rent/price ratio. In this case, it’s greater than 1%, which is good!
$1620/$150,000 = 1.08%
I’m going to take all the numbers and plugin into my spreadsheet. What’s actually going on there and all the calculations are something I’ll be sharing in another post.
- It takes $35,650 to buy this property. That’s my cash outlay.
- This rental property has the potential to produce $340+ in monthly cash flow. After the mortgage is paid, that will be $940+.
- Taking my cash outlay and the cash flow, this house provides 11.57% of Cash-on-Cash return on the first year.
(Pause for a moment and reflect on that.)
It’s a great return! Ok, there’s more.
My tenant is paying for my mortgage, so I’m building equity. The first year is the year where I least build equity, but it already accounts for $1936. I won’t be actually putting my hands in that money just yet, but if I were, it would be extra $161 per month.
(Another pause to realize equity buildup is an extra return.)
On top of that, house prices tend to appreciate within each year. So there’s also property appreciation. A mere 4% increase – the long-term average for real estate – is another return on top of everything else.
Because I’m leveraging my investment with a mortgage – I only put 20% down to control 100% of the house – it really is a 4% * 5 = 20%. I don’t quite look at appreciation, but it’s certainly a great bonus!
Bottom line: this house has the potential to produce $340+ in cash flow per month for a total return of 17% in year 1. All it took you was the work to set all this up and the $35,650.
Is it worth the time and work to get this up and running?
For me, absolutely yes!
Do notice that I’m talking year 1 here, but actually, when investing in rental properties, we try to keep at least a 5-year view.
One year alone is not enough time to protect you from bad things like big expenses. For instance, I had to replace an entire HVAC system in the first year. A $6,000 expense. Ouch!
But on a five-year horizon things are stable enough, and any bumps on the road get smoothen out. On our simple calculation, on the fifth year, we can expect a 20.71% total return.
If you just got started in real estate, these numbers will probably surprise you. I personally got so skeptical that I had to check and re-check the math, and I do encourage you to do the same!
I’m regularly tuning the formulas and adjusting expectations, but this spreadsheet has taken me quite far already.
Also, I don’t want to give you the sensation that all are roses and money will pour down very easily if you invest in Real Estate.
My goal here was to show you that it is possible, and back any claims with actual numbers.
I get really frustrated when people say “Rental Market returns 4% and so Stocks Are better” because they are completely missing the point.
The least thing I care about in Rental Properties is appreciation. I care about cash flow!
I want to see all my income being greater that expenses and then some. I want to see $200, $300 every month in positive cash flow. I want to see the potential for 8, 9, 10% of Cash-on-Cash return out of the gate on the first year.
Follow us and download the spreadsheet
I hope this article has clarified to you all the different ways to make money with Rentals.
I know there’re a few empty spaces to be filled, so I’ll be providing some more info on the next few weeks.
At the very least Rental Properties can be an important ally in your portfolio for passive income and diversification. At best, it will be your main engine for financial independence and wealth creation.
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