To Buy or Not to Buy: Your First Rental Property

You've worked hard. You've been smart with your money. You've got some cash in your figurative pocket, burning a figurative hole. You want something tangible, something you can stand on, something that will grow with you. You want real estate. You want to buy a rental house.

Before you dive in though, you do your homework. It's the Foolish thing to do. And the numbers are compelling.

Photo: Images Money.

The dream scenario
You learn that your mortgage payment, plus taxes and insurance, will be about equal to the amount of rent you expect to collect. That's lucky. You calculate the tax break you'll get with all the depreciation and business expenses you'll be able to claim. And that's return on investment! It compounds so beautifully as the mortgage gets paid off and the property appreciates!

With $20,000 available for a down payment, you find a nice two-bedroom condo with a great rental history, priced right on the money at $100,000. You estimate the mortgage payment to be $600 a month based on a 6.5% interest rate and a 20-year payback. Adding in $200 a month for HOA fees, insurance, taxes, for a total monthly commitment of $800.

That's perfect, because you know the property is currently rented for $850 a month. You'll certainly be able to maintain that rate going forward.

Your cash flow is better than break-even, but you know this investment is a long-term play, and the windfall will be in the equity. 

The numbers always look great on the spreadsheet
After year one, you'll have paid the bank a touch over $2,000 in principal payments. That's a 10% return on your investment right out of the gate. That already beats popular REITs like Realty Income Corp's (NYSE: O  ) 5.6% dividend or Apartment Investment and Management Co's (NYSE: AIV  ) 3.8% yield.

After year five, you will have paid the bank north of $11,500 in principal. That's a 57.5% return on your initial investment. Not bad at all. 

And don't forget capital appreciation. Assuming the market performs reasonably well, say 4% per year, your $100,000 property today will be worth about $117,000 after year five! Total return from principal pay-down and capital appreciation is up to $28,500! That's 143%! And it's only year five!

Why not buy this property? You're a real estate genius! Maybe its time to go to Omaha and pitch Buffett himself!

That "ssshhh" sound you hear is reality slowly bursting your bubble
Hindsight is always 20/20, as they say, and it turns out you were not the best property manager in your first year as a real estate mogul.

Photo: Woodleywonderworks.

After six months of failed Craigslist ads, you resign yourself to hiring a professional property manager. It's just 10% of gross rentals, and they'll handle everything. No more late-night phone calls to unclog a toilet.

Lesson one from your new manager, however, its a hard one. Your rental isn't renting because you're asking too much. Suddenly, your cash flow isn't break-even. It's negative $1,500 per year. But at least the property is now occupied.

And how could you have predicted the air conditioner would break on the hottest day of July in year two? And how could you have known it would cost $4,000 to replace it?

Ahh year three. The year of the tenant from hell. It's almost funny now -- the holes in the wall, the ruined carpet, that broken window, that unidentified smell that just wouldn't go away. All told, the repairs and unoccupied time cost you $3,000.

No one blamed you in year four when you decided it may be time to sell. The property had become a headache, but it was currently occupied and the timing felt right. Well, it felt right until you spoke with a few real estate agents.

While the real estate market in aggregate had appreciated at 4% per year, your property was in a neighborhood that had not seen much improvement. The devil is in the details, you supposed.

The agents recommended a listing price of $107,000, which net of the 5% sales commission, meant a cool $101,650 coming to you (assuming you could find a buyer willing to pay asking price). 

A moment of reflection in year five
So, here we are in year five. Your property has effectively appreciated zero. The unanticipated repairs, unoccupied months, property manager, and lower rent has fully offset any pay down you've made to the bank. You are break-even at best. And it's more likely you've lost money.

And you can't just sell the property and start fresh. Bank standards are tighter than ever. Mortgage rates are starting to rise. Finding a buyer could take months. Your money is stuck. 

Those REIT dividends have never looked so sweet.

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Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 08, 2013, at 1:55 PM, goofycat wrote:

    As a real estate investor since 19994, I can attest to the reality in the above article.

    Potential rental owners must be aware that there are neighborhoods that can go downhill, resulting in the loss of properlty values (ie., yours), competing property owners can limit the upper end of rents being sought, and the real estate market as a whole depends on the health of the U.S. economy.

    It must also be realized that if nearby businesses fail, potential renters will tend to evaporate.

    And...what about competition from new housing projects that promise monthly mortgage payments that will compete with your monthly rental payments? Many pitfalls, dangers and the distinct possibility of losing your real estate "investment" entirely.

    If you decide to plunge into rental property, make sure that you have a "cushion" of several thousand dollars to take care of surprises such as appliances and air conditioners that fail, paint and/or landscaping that needs attention, home owners' associations that increase their fees, etc., etc.

  • Report this Comment On December 08, 2013, at 4:51 PM, cashchecks wrote:

    Learn to do it right at www.aaronthehousebuyer.com

  • Report this Comment On December 09, 2013, at 9:50 AM, innkeepernj wrote:

    FIRST- do your homework. Ignore, avoid, and be skeptical about real-estate investment TV and radio shows. They are like those bass fishing shows where the star lands a whopper on every cast. There are pitfalls at every turn of property ownership… and rewards aplenty if you prepare.

    After 37 years in real estate, I own over 100 rental units. I am a hands-on landlord. I didn’t come from a family of contractors or finance professionals; I learned all the aspects of this business as each “crisis” made it necessary to learn a new skill. But gong in – at a minimum – you have to be ready to do some financial analysis, market analysis, and facility assessment.

    Start off with a best-of-circumstances versus worst-of-circumstances estimate of rental income and operating expenses. If your worst-case scenario is even near the edge of negative income, look for another property. Look at competitive rental properties to see the strength of the market. Be especially aware of declining neighborhoods. And finally, find a contractor recommended by a very reliable source who can both evaluate the condition of your future investment and give you reasonable estimates for any improvements you initially plan to make.

    My advice to anybody starting out is simple. Buy a two family house and live in it. Be a landlord on a small scale, and let your tenant help subsidize your cost of living while increasing your equity. At the same time, you will learn to deal with tenancy, repairs, hopefully infrequent evictions, and all the other bumps in the road. If it works for you, then a few years down the line you can leverage your equity into property number two and go on from there.

    There will be plenty of time, later, to jump into the deep end of the pool.

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