My First Rental Property: Not Really a Great Investment

Update: As it turns out, this rental property IS a really great investment. Vacancies have been zilch, rent was raised by $100, and there have been minimal expenses related to repairs and maintenance. See my current cash flow analysis here showing returns around 10% (even with principal payments included).

Looking for your first rental property? Check out our How to Find Rental Properties guide or start your property search at Roofstock.

Previous 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?

My First Rental Property

It’s got a great kitchen!

Are you interested in owning a rental property to create extra cash flow?

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.

The Purchase

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, first real estate investment 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

Alternate Vacancy Rates

  • x 11 months (7.5% vacancy) = $19,250
  • x 12 months (0% vacancy) = $21,000

Expenses

  • 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%

Alternate Vacancy Rates

  • 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)?

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Avatar About Philip Taylor, CPA

Philip Taylor, aka "PT", is a CPA, blogger, podcaster, husband, and father of three. PT is also the founder and CEO of the personal finance industry conference and trade show, FinCon.

He created Part-Time Money® back in 2007 to share his advice on money, hold himself accountable (while paying off over $75k in debt), and to meet others passionate about moving toward financial independence.

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  1. Definitely I agree that a rental property is one dependable income that can be used for a long term. I have my first rental property in 2001 and I purchased this for my daughter. I am a single parent so I really need to have some extra bucks for her future.

  2. Avatar Squeezer @Personal Finance Success says

    It sounds to me like there’s too much risk with not enough return.  I would not count the principle in your figures because you will not get that back until you sell the house (or pay it off and can start pocketing the portion that went to principle).  You’re just slightly over breaking even, and there are costs associated with the ownership that come up every so often, such as a new a/c unit, new roof, etc.  Having one major expense like that in a year will kill your budget.

  3. Avatar AustenNut says

    Until very recently, I was a landlady.  I had originally bought a duplex, living in one side and renting out the other.  When I got a new place, I decided to hold on to the old one and rent out both sides.  The rent from both sides just covered standard expenses (mortgage, with escrows, the water bill, and minor repairs).  And some years (when there was a big hike in home insurance), it was a negative outflow property.  But we had the thought of holding on for the long haul, and eventually having cash flow for retirement, so that any cash outflow was really just an “investment” in our future, which wasn’t a terrible idea considering the instability of the markets. 
     
    But we just sold the property about 2 months ago.  Why?   Even though we’d had remarkably good tenants, I still freaked out whenever there was a vacancy (and it was always rented at 23/24…the one side was always rented, and the other was never vacant more than 1 month a year).  Maintenance costs were getting bigger.  Fixed expenses were getting bigger.  And if we took the equity out and invested it in index funds, chances were that we’d come out in the same place financially.  For us (more like me), the stress just wasn’t worth it. 
     
    That being said, Romeo’s post about the tax advantages certainly holds true.  But when you do sell, though, your profit will be considered anything over expenses plus the DEPRECIATED value of the house, not the original value.  Also, if you rent the house for more than 3 years, then any gain will be taxed differently then if it was considered a personal property (at a higher rate).  If you rent for less than 3 years, and can show that you didn’t sell earlier because of the real estate market, then you can consider more of the profit as personal gain (and it’s taxed less).  With the same caveat as Romeo, I am not a tax professional. 

  4. My wife and I have kicked around this idea as well when we sell our $100,000 starter home.  However, in our area, we’re looking at less than 1%, about $800/month.  We’d be much better off buying two $50,000 properties or even three $33,000 properties than we would be with one, $100,000 rental.  If I were you, I would sell the condo and a)buy a smaller property with equity or b) apply the equity to your new house.  In your current situation, carpet replacement from one bad renter could wipe out 2 years of profit.  TOO RISKY!

  5. Wow, your insurance is really low! Did you get landlord insurance? We have a rental property (about the same year as yours), and the landlord insurance is about $50 a month. Must be difference in areas, or the fact that yours is a townhouse. Unfortunately, ours seems to go up every year (grumble grumble, inflation, grumble). 

    • Avatar Philip Taylor says

      It’s condo insurance, which is a little like renter’s insurance. The HOA dues cover the insurance for the outside and roof. Good catch.