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.
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.
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.
Full Disclosure: The author of this post is not actually against investing in rental properties. He owns one himself. He is, however, against making investments without fulling understanding and accepting the risks involved. If something seems too good to be true, it probably is.
Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.