Well, follow along with me over the next few weeks and months and watch me make all the rookie mistakes for you.
I’m officially a rental property owner. Here are the stats on my rental unit:
- 2182 square foot townhouse
- 3 bedrooms and 2.5 bathrooms
- Built in 2007
- Excellent school district
This property has a lot of things going for it: good schools, low crime, plenty of jobs, quick access to shopping, education, and the city. It’s also a townhouse so the maintenance would only be on the inside.
Nothing too exciting about the purchase of our rental. It’s actually our old home. We just purchased a new place and have decided to keep this property as rental. We purchased this rental property in 2007 for 205,000, putting 20% down. We refinanced in August 2011 back to 30 years at the new rate of 4.875%. The current payoff amount is 156,004.31. Zillow.com values the property at $197,800. Therefore, you could say I currently have $41,796 invested in this property.
Failing the 1% Rule
A good rule of thumb when evaluating your first rental property is to see if it meets the 1% rule. Meaning, does the price you can rent the property for each month equal at least 1% of the purchase price of the property. For many real estate professionals this is a way to quickly know if the property will be able to produce a positive cash flow annually.
Using this rule, my unit was purchased for $205,000 and should be able to rent for $2050 a month to pass. Unfortunately, I’m not able to rent it for that much. I should be able to get $1750 a month, or 0.85%. This isn’t bad, but it lets me know it may be cutting it close as to whether I can cash flow this property. Some have suggested that 0.7% is the absolute cut-off point when initially evaluating properties.
What About Return?
As for expected return, the property is going to be cutting it close. The property should rent for $1750 based on what I’m seeing with similar units in the neighborhood.
Gross Rental Income
Rent – $1,750
- x 10.5 months (10% vacancy) = $18,375
- x 11 months (7.5% vacancy) = $19,250
- x 12 months (0% vacancy) = $21,000
- Mortgage – $842
- Property Taxes – $353
- HOA – $175
- Insurance $25
- Repair and Maintenance $100*
- Total = $1495
- x 12 months = $17,940
*HOA fees include lawn care and external structural repairs.
Net Rental Income
Now let’s subtract our expenses from out gross income and determine our net income and potential return on investment.
Per Year Net Rental Income = $18,375 - $17,940 = $435
- Return on Investment = $435 / $41,796 (cash invested in the rental) = 1.04%
- Return with 7.5% vacancy = $1310 / $41,796 = 3.13%
- Return with 0% vacancy = $2060 / $41,796 = 4.93%
Based on those numbers it looks like I could make anywhere from $400 to $2000 in the first year. The returns could be worse, but are pretty bad considering the money I have tied up in it, the debt I’m carrying, and the amount of time I’m using to manage it. The returns don’t come near the 10% suggested by Jim Randel in his book on investment properties.
Alternatively, I could take the $41,796 and earn 1.25% in an FDIC insured online savings account right now. I could also take it and invest it in the market and get a much higher return for no effort.
The bottom line is that even if this property performs at its highest potential (i.e. no major repair and no long vacancies) it’s still not that great of a return on my money. I do have potential appreciation to look forward to one day, but that may be a pipe dream.
I suppose I could up the rental price to $1800, but that would only net an additional $500 and would likely increase my vacancy time.
What are your thoughts, guys and gals? Should I keep the property for this type of return? Is there something I’m missing? Can I somehow increase the return on the property (either by adding value or increasing leverage)?
Update: Some have suggested I remove the principal from this expense since that is coming back to me in the form of equity. Principal is on average $207 per month in 2012, making my total annual expenses $17,940 – $2484 = $15,456. This would produce a return of 10% with 0% vacancy rate. Is this an appropriate way to calculate return?