So in a demonstration of how rarely I write this blog these days, we bought a second investment property a few months ago and I’ve barely mentioned it!
Rental properties are not central to our plan to retire early and be financially independent, but they provide a nice alternative investment to the more common defined contribution plan and the pension scheme we have. Unlike the stock and bond markets, the housing market behaves on its own set of rules, so in addition to being a source of cash flow, it’s another type of asset diversification. For example, while stock prices might tank, your house still holds its value (hopefully), or if the housing market tanks, your portfolio stays steady (hopefully).
But we’re lucky. Our area has never been susceptible to the waves of speculation in the housing market that have made many places unaffordable. So I am not too worried about big gains or losses. Housing is pretty boring and predictable, seeing as how widely accepted it is as a storage of wealth. I like all of my investments to be this boring (I’m looking at you, cryptos).
Some people (with more knowhow and time than we have) are able to buy houses cheap, rehab them, and sell them for a nice profit. For me, a worthwhile investment property is simply one that is basically ready to rent out that I can buy at a price that gets me my preferred return on investment. If I can mostly ignore it, and it brings in a certain amount of money, I’m happy.
What is a certain amount of money? I created a spreadsheet that lets you plug in the asking price, potential rental income, property taxes, and expected insurance, utilities and maintenance costs, and it will spit out a cap rate. My desired cap rate is between 9 and 10%. So you enter potential properties, and you’ll know exactly what purchase price you need to get for each to get your desired cap rate. On the reverse, it also tells you how much higher your rents would have to be to get your desired cap rate based on a static purchase price. This spreadsheet has been integral in comparing properties.
Our Second Rental Property
The fun thing about purchasing a rental property as opposed to a home for yourself is that you’re evaluating it on different criteria. You don’t have to like it. You just have to know that other people will like it. For instance, the rental property that we just bought had some renovations done probably ten years ago. The kitchens aren’t high end, but they still look good enough to impress visitors. The bathrooms are nothing special, but they’re sizable. If I was just out of college, I’d definitely be interested.
I like this rental property firstly because it meets my financial ratios. But I also like it because it’s much more basic than our first rental property. The apartments are smaller, the walls are all white (except for the grey in the kitchen), the floors are all the same laminate, and there’s a shared washer and dryer in the basement. Our first rental property is bigger, has washers and dryers in each unit, and lots of little details and weird layout things, which means some people will love it, but some will people hate it.
This second property is much more straight forward. It’s simple, easy to care for, and there’s not much to dislike. That makes it easier to find renters! We did a dozen showings over a week, got four applications, and accepted two. We closed on February 28th and had both units occupied two months later.
The inspector we used when buying this property has owned a ton of rental properties through his life. And he said owning rental property is a great way to “get rich slowly,” a phrase anyone in the personal finance community is familiar with. And that phrase made me think about how the biggest value of owning a rental property is in the asset itself. You go from a down payment of a certain amount to owning the full value of the property once the mortgage is paid off. Which got me thinking of a new way to evaluate return on investment: What does that down payment turn into after 15 years?
(Previously, I’ve calculated a straight annual profit amount, and a questionable, but fun, per-hour wage)
Assume your cash flow comes out to zero for the 15 years of the mortgage. I mean, hopefully you’re cash flow positive. But for the sake of the calculation, assume your expenses exactly equaled your income. This rental property cost $114,000, and our down payment was $28,500. Invest $28,500 of cash for 15 years requires a 9.7% annual return to get to $114,000 in the end. So even if the house doesn’t change in value one bit, that is nice gain you can’t get elsewhere. I’m ignoring the fact that you have to work for this return, and that your income and expenses won’t be equal, and that your house’s value will change. Hopefully these all turn out positive!