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 Post subject: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 9:59 am 

Joined: Fri May 04, 2012 2:23 pm
Posts: 810
You see it all over the blogs. And people think "owning" a rental is the Cat's Meow. I've always looked at it like a second job and I can never get the numbers to work. Of course, if I could get the numbers to work, it may be lucrative. So, let's talk numbers.

I've done an analysis with the following assumptions:

-$250k investment
-$1000/month rent
-10% operating costs + 1 month's rent (to represent the amount of time the place is vacant), on average
-25% marginal tax rate
-2.5% avg rate of inflation
-30% Land value
-4% discount rate (this should capture the cost to borrow money and the opportunity cost of leaving it invested in the boring stock market)


So, I did a 30 analysis (years 0 - 29). I depreciated the home on a 27 year schedule (I know it is technically 27.5 yrs). The home's value raised with the rate of inflation (may or may not be a good assumption). After 30 fun years of landlording, the home is sold, depreciation is recaptured and proceeds are taxed at LTCG.

The numbers pooped out:

-$418k discounted NPV
-$607k undiscounted NPV
-1.67 discounted ROI
-2.42 undiscounted ROI

So, these numbers are hardly anything to get exciting about. If my assumptions are correct.

I would first like to ask the community if they see any flaws analysis method? I figure most people, if they put $50k down on place would calculate ROI based on that, and not the entire $250k invested. And perhaps the analysis should reflect that since an avg joe/jane couldn't borrow another 80% to invest in the stock market, but let's discuss that and I plan to eventually put that analysis together as well.

I know home values and rents vary market to market. Tax rates vary as well. I will generate type curves if the analysis above seems reasonable.

Thoughts?

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 Post subject: Re: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 10:36 am 
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I think your analysis is generally reasonable but without seeing the specifics it is difficult to comment much further.

I will say that I think your 1.67% ROI is in addition to the assumed 4%. In otherwords, it is the premium you get for your investment.

There can also be additional tax benefits that you are not considering. If you actively manage the property in accordance with IRS rules you can write off a $25000 paper loss every year against ordinary income. If you are in the 30% bracket then that is worth about $7500 a year after taxes. It's enough to be factored in. The source of this benefit is essentially the depreciation.

There might also be ways to recapture the depreciation later tax free.

All-in-all I think your conclusion that being a landlord is not the path to guaranteed prosperity is generally correct. But it can be worthwhile in situations where the math works out.

We own a vacation property that we rent out. We roughly break even on a cash basis but get a net tax benefit every year plus we get to use the property for free for a month or two a year so it works out to be beneficial.


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 Post subject: Re: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 5:50 pm 

Joined: Fri May 04, 2012 2:23 pm
Posts: 810
I disagree that the depreciation can be "recaptured" tax free. You can exchange and exchange, but eventually, someone will have to pay the capital gains and decpreciation recapture.

I will look into the "paper loss". Is there a specific pub I should look at it? Is this referring to providing "other" services to tenets?

I also left off property taxes...

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 Post subject: Re: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 6:08 pm 

Joined: Wed Nov 12, 2008 9:47 am
Posts: 172
Location: FL
What you have calculated out may be correct. But 1k rent on a 250k investment sounds terrible to me. My duplex cost me 175k and I pull $2,200 a month out of it in rent. That was the only thing that really stood out to me.


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 Post subject: Re: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 7:43 pm 

Joined: Thu Dec 30, 2010 4:59 pm
Posts: 62
Location: San Diego, CA
nossorc wrote:
What you have calculated out may be correct. But 1k rent on a 250k investment sounds terrible to me. My duplex cost me 175k and I pull $2,200 a month out of it in rent. That was the only thing that really stood out to me.


I agree that 1k rent of a 250k investment is most likely too low of an assumption. In my neighborhood the 250k place (down the street) would easily rent for $1,300 a month after HOA dues.

Area dependent of course, but you might also want to consider a duplex, triplex, or quad. Anything 4 units or under is not considered a commercial property. There seems to be an absolute floor on rental prices in most areas (just an observation) and many of these multi-family homes are near there. For example I just randomly pulled up this example: http://www.realtor.com/realestateandhomes-detail/2203-Landmark-Ct_Arlington_TX_76013_M85319-87676 These particular units are renting for $540 a month or $2160 a month if all of them were rented at the same time. Assuming a 25% margin of safety, that's 1,620 a month.

Too good to be true? Maybe. I have no experience buying or selling rental property.

Bichon Frise wrote:
-10% operating costs + 1 month's rent (to represent the amount of time the place is vacant), on average


What are your assumptions on operating costs? I believe that I have read somewhere that a safe margin of error when estimating the amount of time the rental will be vacant is 20%. This may or may not be in line with your estimate depending on your operating costs.

Bichon Frise wrote:
I would first like to ask the community if they see any flaws analysis method? I figure most people, if they put $50k down on place would calculate ROI based on that, and not the entire $250k invested.


I believe to calculate your ROI you need to add your down payment amount, maintenance costs, principal and interest. Basically any money you put into the place. At the end of the 30 year term it will be much more than the 250k acquisition price. Earlier in the term it will be much less, but always more than the 50k down payment.


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 Post subject: Re: Economics of Rental Property
PostPosted: Mon Aug 20, 2012 8:57 pm 

Joined: Fri May 04, 2012 2:23 pm
Posts: 810
yeah, I plan to develop some type curves with an investment:rent ratio. I agree, that may be terrible, but it will be interesting to note how sensitive that ratio is.

Operating costs are for things like new carpet, fresh paint, general maintenance etc. 10% of rent is probably too low.

The ROI number does include rent, costs, taxes, interest etc. Instead of calculating based on down payment, it was calculated based on the entire investment, "salvage" value, then discounted with a factor to account for the cost of capital (debt and baseline earnings). 1.67 is not an annual return, rather a factor of growth over the entire investment period. In other words, you don't even double your investment over 30 years.

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 Post subject: Re: Economics of Rental Property
PostPosted: Tue Aug 21, 2012 7:23 am 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5285
Bichon Frise wrote:
I disagree that the depreciation can be "recaptured" tax free. You can exchange and exchange, but eventually, someone will have to pay the capital gains and decpreciation recapture.

I will look into the "paper loss". Is there a specific pub I should look at it? Is this referring to providing "other" services to tenets?

I also left off property taxes...


See Pub. 527, specifically p. 13. If you make management decisions you usually qualify. You do not need to provide other services.

Depreciation can be captured tax free by donating after death...after stripping equity that you use while alive, by converting the property to your primary residence for a period, and in other ways. There are major pitfalls of course so you must be familiar with the laws and regulations. Property is complex enough that not all the IRS publications are entirely correct so studying up on some tax court decisions can also be profitable.

One trick to keeping your ROI high is minimizing the equity, i.e. maximizing the debt. This also maximizes risk of course. That pushes you up the risk-reward curve...


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 Post subject: Re: Economics of Rental Property
PostPosted: Tue Aug 21, 2012 7:53 am 

Joined: Fri May 04, 2012 2:23 pm
Posts: 810
DoingHomework wrote:
Bichon Frise wrote:
I disagree that the depreciation can be "recaptured" tax free. You can exchange and exchange, but eventually, someone will have to pay the capital gains and decpreciation recapture.

I will look into the "paper loss". Is there a specific pub I should look at it? Is this referring to providing "other" services to tenets?

I also left off property taxes...


See Pub. 527, specifically p. 13. If you make management decisions you usually qualify. You do not need to provide other services.

Depreciation can be captured tax free by donating after death...after stripping equity that you use while alive, by converting the property to your primary residence for a period, and in other ways. There are major pitfalls of course so you must be familiar with the laws and regulations. Property is complex enough that not all the IRS publications are entirely correct so studying up on some tax court decisions can also be profitable.

One trick to keeping your ROI high is minimizing the equity, i.e. maximizing the debt. This also maximizes risk of course. That pushes you up the risk-reward curve...


I agree you can exchange and exchange (or donate). But eventually, if the structure is sold for more than it was originally paid for, the depreciation will be recaptured. Kind of kicking the can down the road.

I'll check into that pub. Thanks!

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 Post subject: Re: Economics of Rental Property
PostPosted: Tue Aug 21, 2012 10:11 am 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5285
Bichon Frise wrote:
I agree you can exchange and exchange (or donate). But eventually, if the structure is sold for more than it was originally paid for, the depreciation will be recaptured. Kind of kicking the can down the road.


The cows do eventually come home. But you don't have to stick around to see it happen.


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 Post subject: Re: Economics of Rental Property
PostPosted: Wed Aug 22, 2012 6:23 pm 

Joined: Thu Dec 30, 2010 4:59 pm
Posts: 62
Location: San Diego, CA
I am hoping you decide to share you analysis.


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 Post subject: Re: Economics of Rental Property
PostPosted: Thu Feb 07, 2013 4:59 am 
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Joined: Wed Feb 06, 2013 4:40 am
Posts: 2
Location: US
Hi
When I sold my rental property, then as per my expectations, the profits were taxed as capital gains as opposed to ordinary income. The difference was important, because the maximum capital gains rate was 15 percent, whereas the maximum tax rate on ordinary income, as of 2010, was 35 percent.

Moreover, I support you 100% for the statement that it changes from market to market and it is also a natural thing in any realm of life.

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 Post subject: Re: Economics of Rental Property
PostPosted: Thu Feb 07, 2013 1:16 pm 

Joined: Fri Jan 18, 2013 7:21 am
Posts: 95
Location: New York
First, let me post this way to look at annual flows after you've purchased, which I use when deciding to sell or not...more to follow about your numbers from start to finish.

Rent, net of fees, maintenance, repairs
(Int exp)
(Prop tax exp)
(Ins exp)
(Dep exp)
Taxable income
x (1-tax rate)
Net income
Add back Dep
Cash flow
Cap appreciation
Net change in wealth

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 Post subject: Re: Economics of Rental Property
PostPosted: Thu Feb 07, 2013 1:56 pm 

Joined: Fri Jul 27, 2012 8:28 am
Posts: 88
The only people I know that have found that renting is worthwhile are those that buy a duplex - quad unit, live there and then rent the rest out.


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 Post subject: Re: Economics of Rental Property
PostPosted: Thu Feb 07, 2013 2:34 pm 

Joined: Fri Jan 18, 2013 7:21 am
Posts: 95
Location: New York
Bichon Frise wrote:
I figure most people, if they put $50k down on place would calculate ROI based on that, and not the entire $250k invested. And perhaps the analysis should reflect that since an avg joe/jane couldn't borrow another 80% to invest in the stock market, but let's discuss that and I plan to eventually put that analysis together as well.


This actually makes a ton of sense and makes the calculation more like investing on margin... and the calculation more simple. Maybe something like this:

Define:
x = initial investment = 1/5 g, the gross purchase price
r = rent collected - expenses
m = escrow payment composed of principal and interest payment (a factor of g, interest rate, term), insurance (a factor of g), property tax (a factor of g)
c = capital appreciation

Cash flows by period are:

purchase
-x, 0

Each period t
r-m, t

sale
g * (1+c)^30, 30

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 Post subject: Re: Economics of Rental Property
PostPosted: Wed May 15, 2013 9:13 am 

Joined: Fri Jul 27, 2012 8:28 am
Posts: 88
my understanding from helping my old boss run his property investing was that numbers you run it on are as follows:

1. you calculate the roi based on putting 0 down (Even if that is not your plan)
2. you assume that maintenance and management cost 2% of the purchase price plus initial repairs/remodeling (per year)
3. If you can't make at least 10% of the total purchase price (price + inital repairs/remodeling) per year as FREE CASH FLOW (above and beyond your costs including interest on any loan) it is a bad proposition.

Here's how this would look on a $250,000 house.

1. purchase price 250,0000
2. closing costs etc 15,000
3. repairs/remodel 10,000

total cost = 275000
2% (maintenance + management) = 5500
real estate taxes = 3000 (based on my local rates)

for a fully cash deal, this means the property would have to rent at 2750 to be a good deal.

This pretty much means that the vast majority of properties are not suitable investments for renting, except in irrationally depressed markets like south florida or nevada, or in very specific cases.

Using this as a guide, he was able to make quite a bit of money on the side in real estate, even while hiring a property management company and paying for repairs.


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