Recently, I received a few questions about my real estate holdings – how they have been performing and what our goals are for the investments.
We own our primary residence plus 8 rental properties. Today I’m going to analyze 3 of the properties, which I will cleverly call Property 1, Property 2, and Property 3.
For each property I’ll run through how much we paid for it, what our actual cash investment has been, what the cash flow was for 2017 (since I don’t have data for all of 2018 yet), and what our total return has been for each property.
Goals for our rental properties
The reason we bought these properties was not because we thought we’d get better returns than we’d get in the stock market (although that’s been the case), but because we were looking for diversification, income, and an inflation hedge.
Diversification – real estate is a great way to diversify your stock holdings, as the returns from real estate tend to be completely uncorrelated from equity returns. Adding uncorrelated assets to an existing portfolio lowers risk and reduces volatility.
Income – I’ve never had any CD or bond investments, as I find their returns to be uninteresting. However, I knew I wanted to start transitioning some of our portfolio to more of an income-focused tilt. Real estate was a way to provide income but with more upside than CDs and/or bonds.
Inflation – during the Great Recession the Fed was providing an unprecedented amount of stimulus to the economy in hopes of avoiding a full on depression. My concern was (and still is) that it’s much easier to start stimulus than it is to end it. History has shown the the Fed usually errs on the side of too much stimulus for too long, which tends to lead to inflation and/or the next bubble.
Real estate tends to be a very good hedge against inflation (better than equities, in fact). The hope was that buying these properties would provide some defense in case inflation started getting out of hand.
Property 1
We purchased Property 1 in December of 2014. The purchase price was $149,900, and our total initial investment (down payment + closing costs) was $43,045.60.
When we purchased the property the projected rent was $1,295 – $1,395/month, and we put a tenant into the property at $1,295/month.
In 2017 this property provided $2,920.06 in cash flow. This is a 6.78% cash on cash yearly return on our initial investment.
The total return (cash flow + payment on the mortgage + appreciation) has been $76,587.70. That is about a 30% annual return.
Obviously this property has been a great investment – I’ll take 30%+ annual returns anytime. In addition, it’s provided a very solid yearly cash flow of 6.78% per year.
Property 2
We purchased Property 2 in April, 2014. The purchase price was $118,900 and our total initial investment was $30,821.45.
The projected rent was $995-$1,095/month and we found a tenant at $1,095/month.
In 2017 this property provided $3,349.81 in cash flow. That’s a 10.86% cash on cash yearly return on the initial investment.
The total return has been $63,257.80. That is a 30% annual return.
This has been another great investment for us.
Property 3
We purchased Property 3 in May, 2014. The purchase price was $122,900 and our total initial investment was $42,772.14.
The projected rent was $1,150-$1,250 and we found a tenant at $1,195/month.
In 2017 this property provided $1,040.72 in cash flow. That’s only a 2.43% cash on cash yearly return on the initial investment.
However, despite the low cash flow in 2017 (due to some repairs), the total return since purchase has been $72,714.12. That’s a 25% annual return.
This investment hasn’t been quite as good as the others, but it’s still been a great investment.
Additional details
If you want the gory details on the income and expenses for a property, here they are for Property 1:
Income
- Appreciation: $62,195.00
- Rent: $60,292.52
- Total income: $122,487.52
Expenses
- Property taxes & insurance: $17,008.32
- Mortgage interest: $19,257.09
- Property management: $7,345.59
- Repairs: $2,087.17
- Total expenses: $45,698.17
Profits = $122,487.52 – $45,698.17 = $76,789.35
Observations
First, for this property the appreciation was a bit higher than the rental income. For the other two properties the appreciation was a just a bit less than total rental income. I think this surprises a lot of people – people tend to think that profits from a rental property come solely from rental income.
Second, the reason the profits look so good is because of leverage. For Property 1 we spent a total of $43,045.60 to buy a house worth $149,900. That means we put down just 28.7% of the cost of the house, which puts our leverage at 3.48x. This means that if the rental property increased in value by 5% a year, we were getting 5% * 3.48 = 17.4% annual returns just from appreciation. Add on another ~10% annual return on cash flow and you’re looking at a pretty sweet investment (and that’s 10% on our initial investment, not the value of the house).
Third, the reason we were able to get such great appreciation is because we bought when home prices were undervalued. We haven’t purchased any real estate since 2014 because I don’t think there are screaming deals on real estate any more.
Conclusions
The annual returns on these 3 investments ranged from 25% – 30%. Since April, 2014 (when the first property was purchased), the S&P has returned 12.4% annually.
I do not think that these types are returns are easy to find in today’s market. We aggressively purchased rental properties when prices were low. In retrospect, I wish we’d bought even more properties than we did.
Similarly, at some point in the not-too-distant future we’ll be able to find screaming deals on the stock of high quality companies. And when those deals are available, you’ll wish you had more cash available to buy stocks on sale.
am curious as to why you chose to purchase single family homes as opposed to multi-family buildings? if your single family home is vacant for a month you’re on the hook for the entire mortgage payment, as opposed to a multi-family home which provides some risk mitigation by having multiple tenants paying in case one unit goes vacant.
Well, when a single family home (SFH) is sold, it will be purchased by either a real estate investor or a person who plans to live in the home. If you have a multi-family building you are only going to sell it to another real estate investor. That makes it easier to sell a SFH.
The advantage of having 4 SFHs instead of a single 4-plex is that you can sell just one of the units and keep the other 3. With a multi-family building you have to buy and sell the whole thing.
Finally, I have found that you can get a higher quality tenant in a SFH than you can get in a multi-family building. Higher quality tenant means less hassles.
It’s true that if a SFH is vacant you get no income, whereas it’s unlikely that you’ll have all the units in a multi-family building vacant. However, I don’t know of anyplace where you can buy a multi-family building for the same cost as a comparable SFH. If you’re looking at buying a 4-plex you can usually buy 2-3 SFH for the same price. So, you have some diversification. This is the reason we have 8 SFHs – our income stream is diversified across 8 properties located in 4 cities in 4 states.
If you have a lot of single family homes, the result is the same as owning multi tenant properties. Vacancy risk is spread out among multiple properties. In my markets, tenant quality and stability is much higher for single family homes than for multi family properties. Too much money is chasing multi family properties and the cap rates are too low to be attractive as well.
Thanks for the info. Very informative. Quick question on your last paragraph: What’s your trigger to know when the stock market is a “screaming deal”?
Well, I would start seriously looking at making large purchases when the average PE of the S&P is below the long-term average.
To put that in perspective, the current S&P 500 PE is 22.06, and the long-term average is 15.73. So the market is roughly 40% overvalued by that simple metric.
What are some high quality companies to potentially be on the look out for?
Would you say companies in the S&P 500?
I am only invested in index funds with Vanguard (VTSAX, VTIAX, VBLTX) in my Roth IRA and brokerage account and want to follow a similar investment strategy as you by adding stocks to my brokerage account.
I don’t think you can go wrong by starting with the “Dividend Aristocrats” list. That’s a who’s who list of large, stable, profitable companies.
Four cities in four states?? How did you decide where to invest? How did you find competent real estate agents, property managers, tradespeople, etc.?
What’s your price point? What kind of neighborhoods? What is your typical tenant profile?
For reference, I’m in the southern SF Bay area. I have been involved in real estate professionally for over 35 years, but not in sales. I own a number of single family houses in a nearby state. Good neighborhoods close to employment and decent schools. They were accumulated over 22 years and I made plenty of mistakes along the way as part of the learning process.
Although I use property management, I have some tradespeople that I have used for years. Property managers become complacent and tolerate poor service and workmanship from long-time vendors. It’s the nature of the business. Frictional losses are part of using property management. No property management company does an outstanding job in my experience. I wonder how property management is affecting your results.
I know the resale market where these properties are located better than most sales agents and I can tell you the market rent on any house in my investment cities. Having that knowledge makes me a much better investor than average. I would be extremely nervous about committing large sums of money to an illiquid asset without that knowledge.
I think you mentioned at one point that you are partners with your mother on some of these properties. That would make sense if she were a real estate professional and she found good properties at great prices in her markets. If you picked your properties up at fire sale prices in 2009-2012, smart move.
Otherwise, I don’t understand your strategy. I understand your desire to diversify, but passive investment in assets that need active management is risky to me. Your current income numbers appear weak. Leverage improves your rates of return but leverage can turn on you. You eat your income, not your rate of return.
Are you relying on long term appreciation and rent growth to make this investment worthwhile? Once your mortgages are paid off, what percentage of income and net worth will these properties represent? Do you anticipate your total returns on the rentals will exceed the rates of return from the stock market? Do you have an exit plan?
Just some thoughts…
Well, I chose the areas to invest in based on demographics, projected growth in the area, and what the real estate market looked like (CAP rates, etc.).
I chose to use property managers because I wanted a low to no involvement real estate investment. So far, the properties have largely delivered on that. The returns would obviously have been higher if we’d been able to manage the properties ourselves, but then again, we wouldn’t have been able to purchase those properties, given their location.
For the 4 properties we co-own with my mother – yes, they are all located within a few miles of her house, in an area she has lived most of her life. We bought in that area because properties were ridiculous cheap during the Great Recession. That is a large part of why they have performed so well.
The properties are cash flowing well, as the number above indicate. Again, the cash flow would obviously be better if we were managing the properties ourselves.
Our real estate investments current represent 10% of our net worth. Stocks are 68% and our primary residence is the other 21%. (the numbers don’t add up to 100% due to rounding).
We are relying on a combination of appreciation, cash flow, and debt reduction to provide our returns.
I’m pretty sure your return calculation is incorrect. Your equity build up through mortgage principal payments is not a return on your initial investment. You are adding the principal portion of the mortgage to your equity – trading cash for equity. The principal portion of your mortgage payments, the equity build up, is added to the denominator, not the numerator.
Appreciation is separate from equity build up. Your rate of return likely decreases over time as your leverage advantage decreases, unless the net income and/or the amount of appreciation increases to off set the decreasing leverage .
Go back and calculate your year-end ROI for each year by subtracting equity build up for that year from the numerator and adding it to the denominator. I believe that will get you the correct gross return with that calculation.
I’m not sure I follow your logic. If someone else is amortizing the loan for you, it doesn’t matter whether it’s building up in the form of equity or you’re realizing it as cash flow.
Let’s say you put $20,000 down on a rental (total cost = $100,000 on a 15 yr term) and there is no appreciation and cash flow is zero (rents = expenses). Using fictitious numbers let’s assume you sell the home in 15 years once the mortgage is fully paid off.
I’m going to stretch this example to the extreme and say that you had a tenant paying your rent every month for 15 years with no vacancies.
You sell the home for $100,000 – exactly what you paid for it 15 years ago with a 5X leverage loan based on your $20,000 down payment. You never put another dime into it.
The way I see it is you just made $80,000 on your $20,000 investment. Over 15 years leveraged other peoples money (the banks and the tenants) to generate a 11.3% compound return.
Your total return for the 15 year period is 400% ($80,000 divided by $20,000).
What am I missing?
Dom
Yeah, I’ve been thinking a lot about this question and I just can’t understand why a reduction in debt paid for/funded by income from a property wouldn’t factor into the return on an investment.
Dom’s numbers above look right to me.
I’ve been thinking about this. Let’s look at your example this way.
When you say that you didn’t put another dime in the example, I think you did with the principal portion the the mortgage payments. So, your initial investment of 20,000 increases monthly by the principal portion of the mortgage payment. At the end of 15 years, you now have 100,000 invested in the house.
Suppose you purchase a new car that costs 20,000. You put 1,000 down and make payments over 5 years. At the end of 5 years, you sell the car for 5,000. You didn’t make a 500% increase (5,000-1,000/5,000) on your investment.
Craig,
The BIG difference is that with the car payment I’m making the payment (interest + principal). In the rental example, the tenant is making the payment (interest + principal + mark up).
Dom
Hi Dom,
Do you agree that at the end of 15 years, you now have 100,000 invested in your example?
Sure, your total investment is worth $100k. But of the $100k, how much money actually came out of your pocket?
Scenario 1:
Let’s say that your rental agreement with the tenant was that they would make your mortgage payment directly to the bank each month and pay all maintenance, repairs, taxes, and insurance.
The tenant pays you nothing. The property has zero cash flow.
At the end of 15 years the mortgage is paid off.
When you bought the house it was worth $100k and you had a $80k mortgage. Total value = $100k – $80k = $20k.
At the end of 15 years the house is worth $100k and there’s no mortgage. Total value = $100k.
I think in this case we can agree that I haven’t put any additional money into the house since I bought it.
Scenario 2:
This is the same as scenario 1, except that each month the tenant pays you exactly enough money to cover the mortgage, repairs, maintenance, taxes, and insurance. That is, rather than paying the expenses on your behalf, as in Scenario 1, they send you the money and you then write the various checks to pay the expenses. At the end of each money you have a net cash flow of $0.
At the end of 15 years the mortgage is paid off, and the total value of the house is $100k.
There’s nothing fundamentally different about Scenario 1 and Scenario 2, other than the money going into my account before being paid out to the mortgage company, the insurance company, etc. In both cases I haven’t put any more of MY money into the property.
To answer your question about the rental car – yes, in your scenario, $100k has been invested in the car. However, the fundamental difference is that the car wasn’t generating any cash flow. A better analogy would be if you bought the car, then rented it out for 5 years, and the amount you rented it for was greater than your monthly car loan payment.
Here’s a final example. You and a friend are roommates. The utilities are in your name, but you and your friend have agreed to split the utilities each money. This month the electrical bill is $50. Your friend gives you $25 and you write a $50 check to the electric company. How much did YOU pay for electricity for the month? Would you say that you paid $50 for electricity, since that’s the size of the actual check? Or would you say that you paid $25, since you wrote a $50 check but your friend gave you $25?
Now let’s say that your agreement with your friend was that he would give you $50 each month for electricity, regardless of the size of the bill. This month the bill was $50, so you write a $50 check to the electrical company. Would you say that you paid $50 for electricity, or would you say that YOU paid $0, since you wrote a check for $50 and your friend gave you $50?
Thanks for the explanation. I was trying to point out that the denominator in the roi calculation will increase as the principal payment of the loan is paid in and should be considered an increase in additional investment dollars no matter where the money comes from.
I think you need to distinguish between the ROI calculation and ROE (return on equity).
If you mean ROE, then I agree with your statement.
So, if I made an additional 10,000 payment on the mortgage a month after I purchased the property, would the 10k be included in the roi calculation?
Money Commando,
I think these properties are doing fantastic. I’m curious what cities and states you are investing in and why you chose those locations?
Dom
We are invested in the following places:
4 – Tucson (my mom lives there)
2 – Dallas (fast growing, great demographics)
1 – Indianapolis (cheap, great rent-to-value. This is our “value play”
1 – Memphis – (fast growing, great demographics)
Also, all of these places have landlord-friendly laws. Texas has no state income tax, but they do have high property taxes.
In general, I was looking to diversify away from the higher cost coastal areas, as that’s where we live and own our primary residence.
I’ve got 9 units of property I manage myself. Would like to turn over to a manager and focus on finding more deals but I haven’t seen much since 2014 either. What kind of repair costs have u had to pay with your single family units?
Looking across all of my investments I’ve ended up paying around 10% of rent for repairs. A few of the properties have had close to $0, but a few have needed fairly major repairs.