So you want to make money by investing but you are afraid of doing the numbers? My experience is that investing seldom requires math higher than what they teach in 7th grade.
One’s business knowledge is far more important than math skills.
I want to illustrate my point by calculating the rate of return on the money invested to buy my rental properties in North Texas.
I still have four rental properties from my previous life, although I am thinking about selling them this year. Not because the rate of return is anything inferior, but because I am spreading too thin and keeping them prevents me from doing something I really want to do, such as blogging for this site.
I bought the properties about 7 years ago, when I wanted to “manufacture” some capital gain (more on this topic in the future). As a conservative guy, I put down 20% for each of my properties. I guess I could have got away with putting down less money, but banks liked to see 20% before they approved the mortgages. So I have leverage my money 1 to 5, so to speak.
Now in my part of the world, landlords typically charge 1% of the value of the house as rent. For instance, if a house that costs $100K to buy will cost $1,000 per month to rent. There is no state law that dictates the 1%. It is just typical. If you are savvy and able to buy at bargain prices, obviously you can charge more than 1%. I was not particular lucky nor industrious, and I wanted to buy houses that were readily rentable so I did not look for the bargains except for one house (I will also write about that experience in the future).
Anyway, 1% per month is a good rule of thumb number. So each year I rake in about 12% of the house value as rent income. You may argue one has to reserve for vacancy period during which I do not have any rent income and you are right. But I have to start somewhere so for now, please allow me to use the 12% number. In the future, I will explain why assuming full occupancy is a pretty good idea.
Now, before I pocket that money, I have to pay property tax, mortgage interest, insurance, and maintenance.
Texas State is notorious for its high property tax rate, which keeps our property values low. In the city I bought the rental homes, property tax rate runs at about 2.3%.
Nowadays, everybody has refinanced their mortgage at a much lower rate, yet I am still paying 6% for my rental properties. This is mostly because I have been thinking about selling these units for a couple of years now. If I am selling the houses, it does not make sense for me to spend the money to refinance the mortgages.
Fortunately, I do not pay 6% of the house value as mortgage interest. Remember I paid 20% as down payment and borrowed 80%? Interest is charged only on the borrowed portion, so effectively I only pay 6%x80%=4.8% of the purchase price as mortgage interest.
Yes I do have to keep for insurances. As a matter of fact, there are two insurances, one that insures the house from burning down and the other insures the appliances inside the house from breaking down. The first one is mandatory by the bank and the later is voluntary. I carry the later one anyway because I want the tenant to have someone else to call when things break down. The two insurances combined costs about 1% of the purchase price of the house.
And finally, I need to maintain the house, painting and flooring, etc.. Here is where I take a break and assume zero expenses. For I figure, in long run, the value of the house will increase at the rate of inflation, and the money I put in maintenance can be recovered from the home price appreciation . The assumption is definitely not true in other markets where house prices tend to move up and down dramatically. But here at Texas, market movements tend to be mild and my assumption is pretty safe.
So what I got? Tax (2.3%) plus mortgage (4.8%) plus insurances (1%) equals 8.1%. Subtract these expenses from the rent income, I have 3.9% left. That is to say my rental property is returning 3.9% of the purchase price per year after expenses.
Remember I am 1 to 5 leveraged, so I need to multiply the rate of return (3.9%) by a factor of 5 and that gives me 19.5%.
And that is how much I get in return on my money invested, not considered above are the tax benefits of mortgage interest and depreciation expenses.
Close to 20% return on a passive activity as land-lording? All made possible because I use debts constructively.