I ran a semi-surprising Excel simulation today. I am curious to get the feedback from the B&I board.

My long term plan has been to convert my current primary residency into a rental property whenever I purchase a new primary. Using the numbers of today, I ran analysis on my projected rental income vs. investing the profit from selling into the stock market.

While it is a simplified model, I was a bit surprised at the results. Thoughts?

https://docs.google.com/spreadsheets/d/16XKzLHM9G5gZNaNdUr0nxxNraTAc61ANxExQ_9Ao_pY/edit?usp=sharing

Assumptions:
- No Rental Rate or Cost Increases
- No vacancy
- No property value appreciation
- No taxes on income/investment gains
- No inflation adjustment
- No selling costs

I don't know ****, but 1500 for repairs might be a little low. Depending on the condition of your house, replacing an AC unit would eat that up pretty quick and most renters wont take care of your house like you would. Other than that, sounds like a good plan.

I'd be interested to see the result if you built in average property value appreciation as well as average rental income and home repair inflation.

It might end up being low but it is based on my costs owning the home over the last 7 years. Plus I would require security/damage deposit from the tenant.

I do keep a minimalist home warranty for large expenses like replacing the AC. I figure the ~$250-300 per year even over 10 years will pay for an AC unit replacement. Plus gives me access to reliable repair companies.

This is a fair point.

If I assume an average occupancy rate of 10/12 months per year, I can project breaking even until the mortgage is paid off. Once the loan is paid off (2026), I am looking at a ~40% return with the same average occupancy.

I expect over time the property value and rental rate to increase but so will taxes so I will call it a wash for now.

Diversification is a key point. I have and will continue to invest heavily into the stock market so having the diversification of income is a nice idea.

Your post hits home. The end goal is Financial Independence ergo the reason for running the analysis. My number one reason for Financial Independence is peach of mind. Number two is the autonomy to do what I want.

I am a huge believer in stock market investing through low cost index funds, which offers the lowest effort to return ratio I can think of.

Outside of the numbers, I can talk myself in and out of the effort aspect of the equation. ~$1000 per month cash flow from a "hard" asset for 10-20 hours per month of effort in retirement seems like a more than fair activity. But it loses its appeal if the same or better results could be achieved for less effort.

I think it might be worth diversifying into rental properties if you have enough wealth... but personally, I see the stock market as a better avenue to build wealth (especially since he requires less work) - even on a day like today.

evan_aggie said:

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Why is it surprising. People who buy additional properties or want to rent them out probably have tons of cash in the market and are diversifying anyway.

You'll be lucky to break 5% via a rental, not to mention the pain in the ass it'll be the entire time. Hell, I have friends who had bought second homes hoping for 4.25% return with 11mo yearly occupancy....and now look at interest rates in banks 2.1% and will be 2.75% by end of 2019.

So really clawing with a net difference of 1.5%?

Makes no sense if you ask me.

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You are not factoring property appreciation into that return. If it is a long term investment then you are looking at a minimum additional 3-4% of annual appreciation on your investment cost unless you are just buying a bubble.

Don't forget the depreciation expense on your rental property and how that will offset other taxable income.

I hope my understanding there is correct.

If you're willing to look overseas for investment properties, you can find higher yields.. but it introduces new risks... namely geopolitical (country you purchase in may decide to not let foreigners own anymore) and currency.

Looking forward to it. I hadn't thought about potential tax benefits.

We will be paying more under the new plan. Wife and I both work from home full time so losing the home office deduction had us go from Itemized to Standard with the new tax bill so looking for any shelters possible.

The only way the stock market is going to give you better returns is if you are either incapable or unwilling to commit to property investing.

And like has been mentioned, you can't even begin to talk about potential returns without estimating property value and rent appreciation.

Holy smokes, I couldn't disagree with you more!!!!!! You have been listening to too many real estate radio broadcasts / podcasts.

If I read your comments correctly, visualize your goal and your reasons, forget the analysis?

I agree with you on having goals and using those goals to justify a little extra work. But you should have reasons / analysis that gets you to those goals.

Sorry if I misread your post. In disclosure I only own 1 rent house, it has been pretty profitable and it isn't much work. I wish I owned more, but at these prices, my time is spent better other places.

A few points. Once up and running, I find I average about 3 hours per month of actual work per property. I pay a leasing fee and manage the year by myself. Sometimes you get an outlier that will wear you out but in general they don't require as much time as you might think.

For the best Return On Investment, you might consider refinancing the house to 80% LTV before turning it in to a rental. You should destroy any stock market returns from an ROI standpoint. If that doesn't sound like your cup of tea, I'd try to pay it off ASAP. Keeping a large chunk of equity just floating in the house while also paying a note, is about the worst option.

I did not mean to imply the OP should not conduct a thorough quantitative analysis, only that he consider the qualitative aspect of his investment choices as well. I analyze any investment from both sides. What is the return? What does it cost me in time/effort?

Is an 8% passive investment of greater value to me than a 12% active investment? It just may well be. Call the 4% my "peace of mind" margin.

freecashflow said:

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Quote:

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Don't forget the depreciation expense on your rental property and how that will offset other taxable income.

I hope my understanding there is correct.

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Depreciation offsets your rental income for that property and if to the point of net loss is disallowed as a passive activity loss which can only be offset against passive income (in most cases) or is suspended until the activity is disposed. So no, depreciation does not offset "other taxable income."

Another fun fact about depreciation? Sell your home at a gain and the depreciation is recaptured as Unrecaptured Section 1250 gain at 25%.

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You conveniently left out the $150k threshold. Us peons can reduce other taxable income drastically via rent house depreciation.

Quote:

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can only be offset against passive income (in most cases)

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Not trying to turn this into a tax argument, I do that all day for a living, but yes I'm well aware of material participation rules for real estate professionals allowing $25,000 in deduction of passive losses up to AGI limits.

But you're helping me prove my larger point - taxpayers then bear the burden of proof to substantiate their material participation. More time and effort!

One thing to note is often times the house you would buy for yourself is not the best return for a rental. Unless you have an extremely low interest rate or don't have 25% down for a different property, it might make sense to just look at investment properties and find one where the numbers look even better and can include a property manager etc...

Good input. We have 20% Down available for the new primary residence. Current property has 8 years left at 2.5%. No escrow account so can get a little interest spread on taxes & insurance.

Having 1 property does not make you are real estate professional. If you have a good job, you will likely not be able to take a loss on any rental property.

The long term returns, when considering compound interest and favorable tax rates, make the market beat the rental at 30 years - If you are cash-flowing the property by then, you are in good shape.... BUT, you are not compounding your investment.

And favorable tax rates - I would much rather face the tax rates of investments than I would rentals. You have to keep in mind, too, that you have to spend money to get deductions on rentals.

Bottom line, you are not comparing apples to apples in the original OP. I, personally, while I am young, would rather not have to spend time dealing with tenants in hopes that I may beat the market in 30 years. I'd rather put it in the market and let it work for me.

freecashflow said:

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I did not mean to imply the OP should not conduct a thorough quantitative analysis, only that he consider the qualitative aspect of his investment choices as well. I analyze any investment from both sides. What is the return? What does it cost me in time/effort?

Is an 8% passive investment of greater value to me than a 12% active investment? It just may well be. Call the 4% my "peace of mind" margin.

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I totally agree. I just approach it from a different perspective. I own a small business and spend a good bit of time thinking of ways to get it more passive. My margins are good, but scaling is tough. I would pay pretty good money to get my time back. If I can get the business more passive, I could scale easier. As they say, "nail it, then scale it". "Nail it" in this case means setup enough processes that enable the business to be more passive.

Some of this has been mentioned, but your analysis is pretty incomplete. To maximize return, you need to:

1. Withdraw equity from your home up to 80% LTV (home re-financing or HELOC) - This is the big mistake people make when turning a primary into a rental. You need to calculate your return based on the total amount of equity in the property, not just the cash flow you can make over your mortgage payment.
2. Consider the debt paydown by the tenant as a return on your equity (I don't see this in your calculation)
3. I would model 2% appreciation and 2% rent increase to match inflation (people often use 3% also). This is a pretty standard assumption.
4. As previously mentioned, there are tax benefits with depreciation that allows you to put more money in your pocket now, and re-invest.

My overall strategy advice is that you need to look at your property and really evaluate whether it's a quality rental. Personally, I've always purchased primary homes that I thought would be good rentals (i.e. it's in a popular rental area, it has a good purchase price vs. rent rate ratio, etc...). I don't know where your property is, but even if you could get a decent rental rate, is it in a location where being able to rent it consistently is possible. Vacancy absolutely kills your return. Additionally, I would consider if you think your property is in a good location for potential long-term appreciation (i.e. is the area growing?). If so, this could make it an attractive asset to hold longer term, but you need to make sure you consider what capital expenses could come up during your hold period (new roof, appliances, HVAC, etc...). Further, you are giving up the primary home tax exclusion unless you sell it within 3 years after turning into a rental (IMO this is a great strategy for maximizing tax benefit - you get to exclude taxes from from the appreciation that has occurred since you purchased the property to the transition date and you get 3 years of deferred tax benefit before you sell and recapture that depreciation).

Anyways, those are just some thoughts. Good luck!

I own no rental properties but am thinking about it. While the stock market might offer a better and easier return, to me the appeal is developing a source of actual cash flow each month that will not be subject to so many factors way beyond my control.