Why the Resale Value of Your Rental Property Doesn't Matter

Don't focus on price appreciation, focus on cash flow.

Jul 27, 2014 at 2:07PM

I own two rental properties, I'm planning to buy a third, and I don't care if my investments appreciate a dime. 

There. I said it. I just don't care.

The real estate crisis taught homeowners and real estate investors everywhere a very painful lesson: home values can go down just as easily as they can go up. But that's irrelevant to me, because my investment thesis has absolutely nothing to do with asset appreciation.

Rent Graphic Flickr

Source: Mark Moz

Sure, I may be crazy. But I'm consistently earning 13-15% annual return on investment on these properties. The average return on equity, or ROE,  for U.S. banks was just 9% in the first quarter. A quick stock screen shows that just 1,938 of the near 30,000+ investment options in the screen achieved these results, so by that measure I think I'm doing alright.

Wait, what?
The best way to explain my theory is to just dive right in with a case study. This example is just an example, but it's based on a specific property in my portfolio. Bear with me, there is some math ahead, but I promise to keep it simple.

The property we are going to break down today is purchased for $100,000. After a $30,000 down payment, the remaining $70,000 is financed with a 20 year, 5% mortgage.

The property is rented for $900 per month gross. I always recommend hiring a property management firm to handle the leasing process. It costs a little money, but the benefits are well worth the cost. With a good manager, the property will be marketed effectively and all potential tenants will be screened for income and credit scores. The last thing we need is a late paying tenant or a trip to small claims court.

Here's how a typical monthly income statement breaks down. I'll explain the details below.

Gross Rent $900
Vacancy 8.33%
Net Rent $825
Property Taxes $(71)
Insurance $(100)
Reserves $(30)
Management Fee $(83)
Mortgage Payment (P&I) $(462)
Cash Flow $155

The line items for gross rent, taxes, insurance, mortgage payment, and management fees are straight forward. You may have some questions though about the others.

First up, is the vacancy estimation. The fact of the matter is that no rental property is occupied 100% of the time. Tenants move out, and it takes time to find a replacement. Why 8.33%? Because one month per year is a reasonable estimate for vacancy of a desirable property. One divided by twelve is 8.33%. It may take longer, it may be shorter. But 8-10% is a reasonable estimate.

The management fee should be calculated based on the net rent amount. Property managers only get paid when the home is rented; your interests are 100% aligned with theirs. It's a win-win relationship.

Next, is reserves. Homes need to be painted. Ceiling fans break. Carpet wears down. Accept that and budget for it. At $30 a month, we build up $360 per year which is generally enough to cover routine fixes and up-keep from tenant to tenant. Over the longer term, HVAC units, roofs, or other more expensive repairs may be required, but a $30-$50 monthly reserve built up over five to ten years should be sufficient to cover those as well for a small home like this one.

With our $155 per month in cash profit, we accumulate $1,854 annually. That's a 6.2% annual return on our $30,000 equity. Not bad, and that's only part of the story.

This is also a forced savings account
The next consideration is the mortgage. We are paying the loan down over 20 years at a fixed payment of principal and interest. That means that over time, the principal portion of each payment will increase as the outstanding loan balance decreases. 

In year one, your mortgage payment will pay down the loan by $2,091. By year five, that paydown has increased to $2,553. By years 15-20, the overwhelming majority of your payment will go to pay down instead of interest. Its a snow ball effect.

Assuming that our property maintains its value over a 5-10 year period -- remember, we don't care if it appreciates or not, we just want it to maintain its value -- we can now project out our equity gains from the mortgage pay down.

Year Mortgage Paydown
1 $2,091
2 $2,198
3 $2,311
4 $2,429
5 $2,553

Bringing it all together
The conclusion, of course, is to combine both our profits from cash flow and the mortgage pay down. The real beauty here is that over time, return on investment increases without any change on the income statement. 

Year Total Return Return on Initial Investment
1 $3,945 13.2%
2 $4,052 13.5%
3 $4,165 13.9%
4 $4,283 14.3%
5 $4,407 14.7%

And if you're an optimist and the value of your property does appreciate, the returns get even prettier. With just 0.5% annual appreciate, your year 1 retun on investment, or ROI,  jumps to 14.8%.  Year 5 jumps all the way to 16.4%. It doesn't take much imagination to see what happens if the property appreciates faster than that.

When tax time rolls around, you're accountant will unlock another major benefit of rental properties. Through the magic of depreciation, this property will show a paper loss for the year. 15% returns and no taxes -- that's tough to beat!

No investment is a sure thing. That's true for stocks, commodities, real estate, and anything else. The name of the game is uncertainty. With that being said, if you find a rental property with a strong location at a price that makes sense, these investments can be a very attractive addition to your long term investing plan.

The keys, like always, are to do your homework, ask for help from experts (like a property manager!), and manage your risks.

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