Is rental property a good investment? It certainly is if you do it right.
Here’s what you need to know.
Expressing success mathematically
I’ve seen several formulas for success, but I follow the one-percent rule, because you can do it in your head. While there are more precise formulas out there, I prefer the simpler math since there’s less chance of error.
The rule is to make sure the property will rent for at least one percent of the purchase price. So if the house will rent for $1,000, you can pay $100,000 for it.
Of course, any house you buy is going to need some work, so unless you can immediately turn the house around–the most common scenario is that the house is already rented out to a reliable tenant who wants to stay and you can just take over the lease–you probably want to pay a bit less if you can, to allow yourself to make needed repairs.
Why those numbers work
But let’s look at the numbers. We’ll stick with the scenario of a $100,000 house renting for $1,000 a month, since it makes the numbers nice. Your down payment on the house will be $20,000 or perhaps $25,000. The payment on a 30-year mortgage, including property taxes and insurance, will be $500-$600. Banks see landlords as riskier than owner-occupants, so they have to make bigger down payments and get a higher interest rate. It’s low-risk if you do it right, but not all landlords do it right.
So your monthly profit after paying the mortgage is $400. But realistically, the tenant is paying the equity portion of the mortgage payment too, which, on average, is $222 a month on a $100,000 house. So even though you only see $400 go into your pocket, your monthly profit is $622. That works out to $7,464 per year.
Now, in an average year, you’ll spend about $1,000 making repairs. Some years it will be zero, but that year you have to replace an air conditioner, furnace, or roof makes up for those zeroes. Figure a profit of $6,464 per year. You can do some self-maintenance to make the air conditioner last a little longer. Making sure your tenant changes the furnace filter, or changing it yourself, makes the air conditioner and furnace last longer. If you don’t do that maintenance, the property loses value.
The initial investment was $20,000. A profit of $6,464 is a 32 percent return on investment. The average return on stocks is, depending on the rules you follow, under 12 percent.
I didn’t factor in the value of the house itself increasing. Most likely it will increase in value modestly over the years, but there will be times when the house will be vacant for a month or two and not producing income. That can offset the appreciation value.
Keep in mind the numbers work better when real estate prices are low. In 2016 they’re high, so finding real estate that allows you to follow the 1% rule may be difficult right now. That’s why people make unsolicited offers to buy property. Don’t overpay–wait for the numbers to work. If the numbers don’t work right now, pay down some debt.
Repairs and maintenance
Before we wrap this up, let’s talk repairs for a minute. From time to time you’ll have to replace things. I think architectural shingles make sense over conventional shingles because they last longer, so it can mean the difference between having to replace a roof once versus twice. But there’s no point in putting a high-end $20,000 kitchen in a rental. You won’t be able to rent a house out for $200 per month more because it has granite countertops and stainless steel appliances for the tenant to tear up. Put in used basic appliances, neutral-color laminate countertops, and basic fixtures. Paint it a nice neutral color that looks clean and stays looking clean. Look for stuff that doesn’t go out of style so you only have to replace it when it breaks. You’re not looking to win awards, just to make something that looks reasonably good with everything. Buy the cheapest reliable option you can find, which may mean $50 faucets instead of $40 faucets, but it protects your margins for that year that you end up having to replace an air conditioner.