Real Estate Basics: How Rental Properties Make Money

By: Mike Otranto at  OtrantoRealEstate.com

 

It is no secret that a well located, reasonably priced real estate investment can effectively generate more revenue than the cost of the money used to finance it.

Many who have held on to single family homes in good areas, for 10 years or more, have built up substantial amounts of equity, and a lot of savings.

Before deciding to write this article, I did some research online, but was unable to find a concise explanation for “how a single-family rental property makes money”.

To answer this question, I think it helps to simply think of a stool with 4 legs.

1. Cash Flow
2. Amortization
3. Appreciation
4. Tax Benefits

Let’s look at each of these legs in a little more detail.

#1 Cash Flow

The main way a rental property can make money is through cash flow. Simply put, this is the difference between the rent collected and all operating expenses.

For example, let’s say you buy a house for $200,000 and rent it for $1,500 per month. If you get a great interest rate and put down a healthy down payment, your “PITI” (Principle, Interest, Taxes, and Insurance) would be about $985 per month. This leaves you with a $515 difference between the rent you collect and the monthly “PITI” payment.

Is it really that simple? Of course not! To understand how much money we're ACTUALLY making here, we need to talk about something called Net Operating Income.

What is Net Operating Income?

Net Operating Income (NOI) is the rent you collect, minus all operating expenses. The most common operating expenses are:

• Vacancy (when your property sits empty)
• Repairs (when your property needs fixing)
• Management fees (for finding/evicting tenants and paying attention to the details)
• Delinquency (when tenants pay late, or stop paying altogether)

To calculate Net Operating Income, we can multiply the monthly rent by 12 ($1,500 x 12) = $18,000; this is often referred to as Gross Scheduled Rent.

Now let’s look at the expenses.

Vacancy Allowance

Vacancy is the time in-between tenants. When one tenant moves out, the property must be “turned over” into rent-ready condition. You'll have to recognize that no rent will be collected during this period, and as such, you need to realistically budget for lost rent. To be conservative, I like to assume that my property will sit vacant for one full month out of the year.

So let's deduct one month's rent of $1,500 from our Gross Scheduled Rent above.

$18,000 – $1,500 = $16,500

Repairs

These are the day to day maintenance items such as, faucets, appliances, doors, locks, light fixtures, HVAC repair, etc. This amount can vary depending on the size and age of the property, but as an average, a decent benchmark for a newer home in good condition is about $2,000 per year.

Let’s deduct another $2,000 from our Gross Scheduled Rent.

$18,000 – $1,500 – $2,000 = $14,500

Management fees

Unlike vacancy and repairs, this is a discretionary expense. You are not required to hire a property manager, however – somebody will have to manage every property you own (even if it's YOU), so it's wise to acknowledge this very real cost.

I like to manage my own properties, so I'm not paying this money out to a third party property Management Company – but I have a lot of experience, and I do pay the price in my time.

You must decide for yourself if you want to go it alone or hire a manager. Many property management companies will charge about 10% of the gross rent ($18,000 x 10%) = $1,800.

Let’s deduct another $1,800 from the GSR.

$18,000 – $1,500 – $2,000 – $1,800 = $12,700

Delinquency

This cost is a little harder to predict when compared with vacancy and repairs. Assuming you are buying a good house in a good area of town, and your tenants are being screened properly this should not be an issue. However, even the best screening process won't make a landlord immune to the occasional delinquent tenant. Things happen – so let’s budget for 2% of the gross rent ($18,000 x 2%) = $360

Let’s knock off another $360 from our gross rent for the year.

$18,000 – $1,500 – $2,000 – $1,800 – $360 = $12,340

As you can see above, your Net Operating Income is the Gross Scheduled Rent subtracted by all operating expenses (and keep in mind, the mortgage is not part of this calculation).

Mortgage (PITI)

The Principal, Interest, Taxes and Insurance payment (or “PITI” for short) will be your greatest expense and will include the total amount of Principle, Interest, Taxes, and Insurance for the year.

Now let’s look at the numbers…

After these expenses, you will have $520 profit for the year – which isn't a lot of money.

However, it's important to recognize, if you had a management company doing all the leg work, this would be passive income that required virtually no time or work from you.

Also, assuming rent prices rise as time goes on, your gross rents will increase while your principle and interest payments remain the same.

Ending the year with $2,320 isn't a bad deal (assuming you didn't put a huge amount of your time into managing the property), but what else do you get for your investment?

#2 Amortization (Principle Pay Down)

With every monthly payment made toward your loan, a portion of that payment goes to pay down the principle amount owed on the property.

The key point to remember here is that you will be paying down your mortgage with someone else’s money (the rent you get from your tenant).

If you've ever looked at how a 30-year fixed mortgage is calculated, you'll see that with every year that goes by, you pay down progressively more principle than the previous year. This means you are building equity (the difference between the value of the property and the principle balance of the loan) each year with someone else’s money.

The specifics of how mortgages pay down is another subject – for now, all you have to remember is that every time a rent payment comes in, a progressively larger portion of your Principle & Interest payment goes toward paying down your mortgage, which effectively build up your equity with your tenant's money.

As you can see in chart 1 below, you would be paying off $3,166.56 of principle in year 1, effectively increasing your net worth (all your assets minus your liabilities) by a little over $3,000.

Again, not a lot of money—I get it!

But remember, buying and holding real estate is a long-term strategy. Let’s look at things around the 5^th year.

As you can see above, at the end of the 5^th year you have added an additional $17K to your net worth, and you have done so with the rent from your tenant.

Appreciation

The average appreciation rate for homes is heavily dependent on local factors as well as some booms and busts of the U.S. economy. Zillow gives an estimate of 3% – 5% annually, depending on local factors and Appreciation is the increase in the value of an asset over time.

In Wake County, North Carolina, where I currently invest, we have experienced some of the most competitive appreciation rates in the area. The average appreciation rate in Raleigh between 2016 and 2017 is 5%.

To avoid getting mired down in complicated economic data, I like to be conservative in assuming a good house in a good area will appreciate on average of 1% per year.

Why does the value of a home appreciate?

Home appreciation isn't always a guaranteed thing – so it helps to start with an understanding of why appreciation happens in the first place.

Fixed Supply

There is a fixed supply of land to put houses on in the United States. The increase in population gradually increases the demand – and with a fixed supply of land, this will naturally drive up the price.

Population Growth

The United States has seen a steady increase in population over time. More people means more roofs are required to house them.

In July 2015, Wake County was listed as one of the fastest growing counties in the country. According to the Wake County Demographics Study, Raleigh is growing at a rate of 14% per year. This surge in population increases the demand for housing which increases the price. Do your research on local appreciation rates in your city and state. Many counties like Wake County NC, will publish demographics data that they share with the public. Zillow.com is another good resource for average appreciation rates in local areas.

Equity

Amortization and appreciation contribute to profit by virtue of another concept called equity. Equity is defined as the difference between the value of an asset and any debt on it.

When we combine appreciation with the gradual paying down of the principle balance of the loan (amortization), we are left with the equity.

Look at the chart below.

As you can see, the amount of equity in the property 5 years after purchase, assuming a 30-year amortization schedule and 1% per year appreciation, is $47,898. As an owner of rental property, your net worth would now be almost $48,000 higher due to your investment decision.

Tax Benefits

Real estate offers some of the most generous tax advantages of the asset classes. Rental properties can be depreciated each year to offset any cash flow, and all maintenance and expenses can be deducted against any profits received.

Remember the $5,700 in mortgage interest that you paid the first year? All of it is tax deductible. So, any cash flow you made at the end of the first year, whether it be $500+ (managed by a professional company), or $2,000+ (if managed yourself) would be offset by the mortgage interest that you paid. You also have the option to deduct that mortgage interest against any personal income you made that year.

There is another benefit called depreciation. Basically, you can depreciate the fixtures of the house to offset any income that you have. Even though you don't literally have to pay out of your cash reserves to pay for this expense, the IRS will allow you to count this as an expense all the same, because they recognize that all physical assets will eventually wear out.

1031 Exchange

Remember the $47,000 in equity at year five? If you decided to sell the property, you could use a 1031 Exchange to defer paying any taxes on that money so long as you use it for another investment property. There are other criteria that must be met that we will not be addressed here.
Books have been written on this subject and this article is meant to be a brief overview. Hopefully, you can see that owning rental property, when held for the long term, can be a very profitable and low risk investment strategy.
While it can be difficult to get a single-family home to show cash flow when bought for “retail” price (the example used in this article assumes that the property was bought at a substantial discount), it is possible when using an effective marketing approach.

Give Jinks Realty a call at (956) 429-3232 for All your Real Estate needs.

How To Get Your Home Ready To Sell

Written By: Luke Skar

Prepping Your House For Sale

Although blind luck can sometimes play a part in helping a home sell quickly, most of the time it is the result of hard work and a well-developed plan. Since most areas usually have multiple homes for sale across a range of prices, attracting a buyer will require your home to stand out from the crowd.

The following tips will explain how to get your home ready to sell and help you complete the process sooner rather than later.

 

Make The Home Neutral

When potential sellers visit the home they want to envision living in the home. However, this can be a tough task if they are surrounded by photos and personal items that all reflect you and your loved ones.

Put away the personal stuff along with your heirlooms that speak to your personality and tastes.

The idea is to create an environment that a buyer looks around and thinks “it would be SO EASY to live here!” This means having only a few pieces of furniture in each of the major areas of the living room, kitchen, and bedrooms. People can picture their own items better if there are few distractions.

It is also a good idea to have neutral colors. Off white, tan or similar colors for walls make the place feel as if it could be changed easily to fit the buyer’s tastes.

Take Some Time to Let Go

If you have been in your current home for any length of time, there are likely many warm memories wrapped up in the place. Moving away and leaving those moments behind can be emotionally painful. Here are some ways to help you make the transition.

• Spend time in each room to reflect on the memories of those specific spaces. Then say goodbye to the rooms.
• Keep repeating to yourself “the precious memories of this place will always live on in my heart and mind. The home is merely a place to be bought and sold.”
• Consider the fact that a new owner(s) is looking for a place to create their happy spot and joyful memories.
• Also, consider that you are enabling the new owner to develop a calm and peaceful place to call their own by selling your wonderful place to them
• Now is the time to embrace a bold, new future

By physically and mentally going through the process of saying goodbye to your old home, it will make the sale easier. Instead of only being sad at the thought of change, you will be in a mindset that you are making an opportunity for a new owner.

Physical Actions to Improve the Appeal of Your Home

There are 3 main things to focus on in order to physically improve the appeal of the home.

Rearrange – closets and cabinets need to be organized to maximize space and allow future buyers to see how their belongings will fit in the confines of the new home.

Neatly arranged closets and storage spots will indicate to the buyer that you have taken great care of the home.

Here are a few ways to make order out of chaos.

• Stack all of the pans and dishes as neatly as possible.
• Hang pants together. Likewise, hang shirts together and facing all to the same direction.
• Place the shoes in a neat line.
• Align all the spice jars in alphabetical order.
• Turn each of the coffee mugs so that all handles face a uniform direction.

Remove all clutter – The majority of people hang on to a number of things long after their usefulness has expired. Now is a time to get rid of the stuff that you no longer need.

• Pull down all of the books from the various bookcases.
• Items that are used every day should be kept in a box. The box can then be put away in a closet. Things like coffee maker, toothbrush, razor, comb, etc.
• Put things that are no longer used in one spot. Sell them online or donate them if they are truly of no use to you any longer.
• Gather all knickknacks, gifts, etc. and pack them up.
• Clear off all the counters in the kitchen. Makes the room look bigger and more user-friendly

Store things in a temporary unit – Homes are usually easier to sell when they are not packed with furniture, clothes, appliances and the like. For this reason, it may be a good idea to remove a few items from the home and place them in a storage facility.

The books and knickknacks mentioned earlier can be stored away. Also, if you have a dining table with removable leaves, take out the extra leaves and store them away. Each room needs a modest amount of furniture.

This allows potential buyers to picture their own items in the various rooms without too much distracting them.

Take Out Items to Avoid Haggling

There are people who are truly gifted at decorating a home. They are so good at it, that some buyers may see the home and wish to buy it as is, with everything in place. However, most sellers envision taking their belongings with them when they move.

If you are attached to any particular fixture, or you wish to keep the appliance(s), go ahead and move these things out now. If you cannot move them to the home of a friend or relative, consider putting them in short-term storage.

Buyers will never ask to buy something if they have never seen it.

Shine Up the Home

This is a great time to perform a deep cleaning of the whole place. It may take more than a day. It could also be a wise investment to hire a professional cleaning company to help out.

Do not rule out staging your bathroom either. It’s an important opportunity to add appeal that a lot of home sellers miss out on.

Here are some of the major items to clean:

• Wipe down any cobwebs from all rooms
• Remove old items from refrigerator
• Clean both the outside and inside of every window
• Apply fresh caulk to sinks, tubs, and showers
• Dust all the light fixtures as well as the blades on ceiling fans
• Put up clean, new towels in all bathrooms
• Clean the sidewalks and driveway with a pressure washer
• Wax any hardwood floor
• Use bleach to clean the grout in tile floors
• Apply polish to all mirrors and the faucet fixtures in bathrooms and kitchen

Getting everything sparkling clean will impress potential buyers with not only a nice look but also a fresh smell in the home when they make their first entrance.

Fix the Small Stuff

Walk through the home and make note of any small repair that you have put off. Getting everything in working order will boost the home’s appeal.

• Repair leaks to faucets
• Replace any cracked tile. This includes tiles on the floor and tiles along the walls in the bathroom
• Remove any non-working light bulb and replace with new bulb
• Apply oil to squeaky doors.
• Fix any drawer in the kitchen or bathroom that does not close/open easily
• Apply spackle to any holes in the walls. Then paint over the spackle

If a potential buyer sees multiple small repairs that need to take place, it could have a negative impact on their perception of the home. Instead of viewing the place as move-in ready, they may see your property as a fixer-upper and try to negotiate the price down severely.

Maximize the View from the Curb

Some people make a choice to see a home or turn it down based on the appearance from the curb. Take some time to improve the exterior of the home to get as many buyers as possible to make an appointment.

• Clean off the sidewalks of leaves, toys and any other item.
• If the paint on the trim around windows is faded, repaint it
• Trim the hedges
• Keep the lawn mowed
• Add some yellow flowers to the front entrance. Yellow has been shown to cause people to buy more frequently
• Check to see that the house number either on the mailbox or the home is easy to read

Improving the curb appeal should improve your chances of getting more appointments to view the home. Remember, only one happy buyer has to agree to purchase your home.

Summing Up How To Get Your Home Ready To Sell

As previously mentioned, properly preparing a home for sale can take a bit of work. The strategies outlined above will help you with every section of the home and should increase your odds of getting more viewers to your property.

By upping the number of people coming through your home, you should be able to sell the place much sooner than you originally anticipated.

Give Jinks Realty a Call (956) 429-3232.