I’ve mentioned our rental property in fits and starts here. Long story short: We bought an old two-family house. It was built in 1890 and since then has only had a few owners. It’s in very good condition after being (almost) completely renovated by the former owners. We closed at the end of July and then got to work spiffing it up and getting it ready to rent. We bought it with the intention of renting out both floors.
Today I’m going to give you what our ideal return is on this rental property would be. By ideal I mean rented out for 12 months a year, with minimal maintenance expense. And then as time goes on, we can check back in and see what the reality is and how it compares! This whole rental property business is new to us.
A few weeks ago, we listed the first floor apartment at $1,150 a month and have gotten very few bites. The few bites we did get, through Craigslist, punked out and stopped responding to me. I’ll admit, $1,150 is on the high end for this neighborhood, but I figured all it would take would be to get someone in to view it for them to snatch it up. It’s just that good.
Well, after we listed the second floor apartment, I was almost proved right. The second floor is not as nice (I think) as the first, since it has smaller rooms, an older kitchen, and an odd layout. Still, it has all of the same new windows and floors as the first floor. I listed the second floor on a Saturday night for $950, we probably received five times as many replies, and by Monday night we had accepted tenants!
Basically, I think people search by price and bedroom count. So we’ve dropped the price on the first floor to $1,100. We’ll see…
So where are those numbers?
Let’s see. The house cost $134,000. I’ve shied away from leveraging debt before, but we ended up going whole hog this time. So while we took out a mortgage on about $102,000, we covered another $25,000 with a Home Equity Line of Credit. So much for being debt averse!
I did the HELOC for two reasons:
- We could still easily afford the mortgage and HELOC even if we had no tenants. Since we save about 50% of our income every month, we would just tap that down a bit.
- The obvious reason: Less cash outlay!
I see we actually paid out about $35,400 on closing day. Even though that includes expenses that aren’t even part of our down payment, I am just going to call that our down payment, subtract the HELOC amount ($25,000) and say we actually put down about $10,000 in cash out of pocket. That $10,000 down payment means our return, in ideal circumstances, should be pretty eye-popping.
Expenses
Our monthly mortgage payment is $758. Our monthly payment on the HELOC is $112. So our yearly expenses would look like:
| Mortgage | $9,096 |
| Home Equity Loan | $1,344 |
| Insurance | $1,435 |
| Property Taxes | $4,500 |
| Gas Bill (Estimated) | $1,200 |
| Water & Sewer (Estimated) | $500 |
| Maintenance (Estimated) | $1,000 |
| Total Expenses | $19,075 |
We have to pay for the gas heating because there is one meter and it is not zoned, so we include that in our tenants’ rent. Only time will tell what maintenance expenses will be needed, but let’s just go with the low end $1,000. After all, this is supposed to be ideal, isn’t it?
Income
| First Floor | $1,100 |
| Second Floor | $950 |
| Monthly Total | $2,050 |
| Annual Total | $24,600 |
Subtract the $19,075 in expenses, and that is $5,525 in net income.
Return
Our Return on Investment = Income/Down Payment = $5,525/$10,000 or 55 percent!
But that’s not all! Mortgage payments aren’t just an expense, they build up equity in a house. Since the mortgage is at 4%, I’ll estimate that, out of $9,096 spent on mortgage payments, the interest is $4,080 on the $102k mortgage. That means $5,016 of the mortgage payments is principal. Add that back into the net income, and we magically now have $10,541 in income.
$10,541 net income /$10,000 down payment = 105 percent return!
Wow! Too bad numbers can be misleading! If we had used even more HELOC and put down less cash out of pocket, say $2,000, our return would technically be 527 percent! Hell, if we did used a home equity loan for our entire down payment, you could say our return is infinite!
In reality, that 105% return is completely unsustainable, since the second year, the income would stay $10,541, but the basis would be $20,541, making the return 51%. What serious real estate investors look at, I think, is the “cap rate,” which calculation depends on who you ask, but basically it’s…
Net Income/Home Value = $10,541 /$134,000 = 8 percent.
That calculation is a good way of comparing different rental properties, but I didn’t shell 134 thousand clams out of pocket for this house, so it’s kind of irrelevant at this point.