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Assessing The Returns You Can Expect From Owning Real Estate

Diversification across asset classes is part of any sensible financial plan.  This means that you don’t just invest in a wide variety of different stocks, but in a variety of different things like stocks, bonds and tangible assets which includes Real Estate.  One of the purest forms of Real Estate investment is buying a residential property and renting it out.  This can be a very rewarding and lucrative investment option and one with returns that are not closely correlated to stock or bond market performance, so perfect for increasing portfolio diversity!

budgets, retirement planner and personal finance blog
Done right, owning rental property
can be a great investment.

This kind of investment is however, more involved than buying some stock from a brokerage.  It is really best looked at like a hybrid investment/small business and can take a little time in addition to money.  Oversights can easily cause a potentially sound investment concept to result in significant losses.  How involved?  Well that gets us to your first major decision…whether or not to use a management company.  This has a big impact on how much of your time and expertise will be required and also on the returns you can expect.

After that the key steps to estimating returns are selecting a property, estimating rent and budgeting for the full range of expenses you can expect to incur to estimate net returns.

Property Management Services

If you hire a management company in the USA, you’ll probably end up giving them somewhere in the neighborhood of 75% of a month’s rent to find and secure a lease with a tenant, then 8% of the rent each month thereafter.  This varies of course by region and company.  In return, you generally get the following services:

  • Finding and signing leases with tenants.
  • Serving as the tenant’s point of contact.  They don’t need to know or care who you are.
  • Managing maintenance.  This means taking calls (whenever they might come) from tenants and arranging repairs to the property when they are needed.  It includes clean up and upgrades between renters.  A good company will have relationships with all the right contractors and handymen on staff.
  • Dealing with tenant legal issues, like the rare eviction.
  • Tax reporting.  Expect a nice summary at the end of each year with all fees paid and maintenance costs incurred.

What they generally will not do:

  • Cover the cost of repairs and maintenance.  They will bill you, so this should be in your budgets.
  • Contact you for every expenditure.  Most management firms will want pre-approval to maintain the property as needed, contacting you for major repairs only.
  • Assume any liabilities.  You will need to maintain insurance on the property, including liability insurance in the event a tenant sues you should they get hurt on the property.

Purchase a Property Suited to Renting

Just about any residential property can be rented, but there are a few things to consider beyond simply finding a house that you feel is nice enough to be desirable…

  • Energy efficiency is important to most renters as they pay the utility bills.  Windows, energy efficient toilets and efficient cooling in hotter locales are high impact upgrades.
  • In most places the “sweet spot” for a rental house is something that is an incremental upgrade from an apartment as this is the most common kind of home renter.  Think 1300-1800sf 3 BR.
  • Multi-family houses (usually duplexes or quads) can deliver higher rent at the same purchase price when compared to single family homes, but maintenance costs and turnover (even per unit) also tend to be higher.
  • Owning a rental house in a neighborhood with a Homeowners Association (HOA), especially a mandatory one  (like a master planned community) can create additional considerations and costs for you.  There will often be monthly fees.  It puts a greater onus on you to stay firmly on top of maintenance including things like lawn maintenance (in a strict HOA it may be best to bundle a lawn service into the rent).  You also may have to consider that things that tenants do that might violate HOA rules could cause you to incur fines.  In some HOAs this can include things as simple as parking on the street or even in the driveway for too long, or leaving trash bins at the curb beyond a certain period after trash is picked up.  Make sure you know the rules before renting or buying a rental property in a neighborhood with a HOA.

Estimate the Rent

If you have a property manager, they take care of this for you, but you still need an estimate before you buy a property to determine if it might be a good investment.  The first step will be to assess what going rates are for properties like the one you are considering. Often you can hire a local realtor for a fixed fee to run a comparative analysis for you. This makes it easy to estimate a reasonable rate to charge based on the wide range of data points they can access in the Multiple Listing Service (MLS) database that they have access to and you don’t.  Alternately, you can cull  through classifieds, craigslist, zillow and other publicly accessible services to get a sense of the market.  If you are renting a condo, apartment rental rates can be a good indicator as well.

Once you know the “going rate” you can tweak yours based on the relative condition of the property, any location advantages or disadvantages and terms you are seeking (e.g. you will charge a premium for a month to month rental and typically offer a discount for a multi-year lease).  Try to be objective, you won’t come out ahead striving to secure too high of a rent, vacancy (as you will discover when you estimate returns) is one of your highest costs and largest risks.

Estimate Net Returns

When you first look at almost any rental house, it looks great.  For example a house that you buy for $150K-$200K might easily command $1000 to $1500 a month in rent.  That’s 10% return a year on the purchase price just on income and before you account for any appreciation in value!

Not so fast though, there are a lot of expenses to account for.  Among the most important ones, you will almost always need to include the following:

  • Management Fees (if you hire a property manager)
  • Monthly Mortgage Payment (if you have one)
  • Annual Property Taxes and Property and Liability Insurance (if you don’t have a mortgage)
  • Vacancies.  Factor in at least a month per year vacancy for the purpose of estimation.
  • Maintenance. A reasonable estimate is 1% per year of the property’s value, depending on market and condition/age of the house.
  • Cost of Finding and Signing Tenants (to management company or realtor, or advertising costs, credit check and legal fees if you do it yourself)
  • HOA/Condo Association Fees

If you buy with care, you will generally find that you can net a decent positive return in the form of income after these expenses. This return can reasonably be expected to keep pace with inflation as both rental income and expenses will increase accordingly over time.

Beyond income, there is the consideration of capital appreciation.  Eventually when you sell the property, you can usually expect some gains, again more or less in line with inflation, with a great deal of variation based on location.  In our Financial Planning Software you would account for income and capital appreciation in different places, and we have a wizard to help you out.

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