We have seen many times that Real Estate owning and renting has been a boon for investors looking for a passive income and generating long term wealth. You will hear troves of people talk about the tax benefits, the perpetual income and ability to be a hands off property manager as a few of the pros.
We rarely, however, talk about the severe headaches possible from owning a property as a passive income. Today, we want to talk about how passive this potential investment is, as opposed to other conventional investment vehicles.
Real estate investing takes an enormous amount of research and careful planning in order to select a profitable property. This research, when done correctly, can take years to find a property suitable for investment. You must depend on your agent, the seller, the sellers agent, and additional factors such as interest rates into account when finding the right property.
If you are a current homeowner, you can be expected to put down the full 20% as a down payment for a rental property, due to this loan being a second mortgage. This, along with closing costs, nears 25% of the total real estate value. If we take a typical property value of $250,000, this means at least $62,500. The typical appreciation for real estate in the United States is 4% per year. On $250k, this is $10,000 per year. 10k appreciation on an initial outlay of $62,500 investment looks pretty great… But wait, there’s more.
Mortgage rates of 4% on a total mortgage of $200,000 (250-50 down payment) comes to roughly $1,000 per month (30 yr mortgage). Now we are in the red in terms of gains. $10,000 appreciation minus $12,000 mortgage payments. In addition to mortgage payments, there are property taxes and insurance that need to be paid as well. Let’s be conservative and call this $400 a month. An additional $4,800 off your bottom line. Right now we are at a total monthly payment of roughly $1,400. So now we get to rental income. This can be variable, but lets be generous and shoot for double our total monthly payment: $2,800. This is assuming zero vacancies in your property. $2,800 x 12 months = $33,600 total rental revenue for the year.
We will take this $33,600 and subtract out all our costs and add back in the appreciation. $33,600 – $16,800 = $16,800 + $10,000 appreciation = $26,800. This $26,800 is the highest profitability scenario for your property. This equates to a return on investment of 53.6%. Now for the fun part. If we are looking to have a property management company manage our property, we are looking at 10% fee that comes straight from your rental income- now down to $15,120. Maintaining your property comes next. According to Freddie Mac, you should factor in 4% per year to maintain your property. This is a cost to you- you cannot forward this cost onto your tenants (it will be a part of your lease agreement). So we will subtract this from your rental income, which is now down to $5,120/year.
Now we have two ways of looking at this- the goal of this rental property is to be a source of passive income. So your monthly income from this property on an initial outlay of $62,500 is $426.67. Total return in cash for the whole year will be 8.2%. Do you feel this is a good investment? I would love to know your opinion. In my own opinion, I believe that there are far better investments to be had in the stock market. A diversified portfolio with downside protection– heck, even a portfolio consisting of simply the S&P index has 1/100th of the headache with as much if not more upside potential. What do you think?