TL;DR: Single family rentals are a great way to get into real estate investment. Deal sizes are smaller, and offer compelling returns if you’re looking in the right markets. One property I own in Kansas City was purchased for $107K ($28K equity check) and generates a 10.5% pre-tax cash-on-cash return, with all-in returns expected in the 15-20% range over time. These returns are not unique and I am not special. You can do this as well if you’re interested and motivated. Read on to review the detailed financials of a SFR, and then skip over to my ultimate guide to buying your first SFR if you want to try this yourself.
I often boast about the potential returns available through direct real estate investment. It can be one of the best ways available for the average American to generate cash flow, reach Ramen Retirement, and build wealth over time. One of the most accessible ways to unlock these returns is through the direct purchase of single family rentals (SFRs). With cash yields in the 8-12% range, and total returns between 15-20%, it’s the type of investment that should outperform the stock market and other conventional investments over time, while providing a healthy hedge against inflation.
That said, before I took the plunge and made my first investment, it was hard to believe those returns were real. I’m conservative by nature, and borderline paranoid when it comes to my investments. If something looks too good to be true, I assume it is until proven otherwise. After investing for decades through the financial industrial complex I had been conditioned to expect 5-7% at most from my investments, and it seemed suspect that 20%+ returns were just sitting there with relatively low risk and low effort involved. Yet, it turns out my fears were unfounded. Those returns are real. I think those returns remain available for a number of reasons – liquidity and laziness being the main drivers. But if you have decent credit and are able to get off your ass, you really can achieve similar results to what I outline above. With the right guidance, I believe almost anyone can and should add direct real estate investments to their portfolio, and SFRs are a great place to start. To help with that, I’ll lay out the full financial details of one of my recent properties, so you understand how the math pencils out. Then, if you think you want to do this yourself, take a read of my ultimate guide to buying your first single family rental.
To help with property analysis, I use a simple comparison sheet that helps me quickly run these numbers across multiple properties at a time. I’ve shared this sheet here and loaded it up with this example, so you can open that up and follow along if you like!
The property we’ll review is located in Independence MO – a suburb of Kansas City. It’s a 1970’s single family home with 4 beds, 2.5 baths, and a finished basement. I bought this particular property through a turnkey operator who had purchased it at auction and remodeled throughout. In parts of Kansas City (and likely many other midwest towns) there is a healthy number of properties that come through auction either due to a residual hangover from the housing crisis, or due to existing owners letting them fall into disrepair (and tax delinquency) for a whole host of reasons.
Here are a few pictures of the property to give you a sense for the quality of finish in the kitchen and bathroom:
Judging by the economic indicators highlighted in the below zipcode map, it’s located in a decent part of town. Above average relative to the rest of the US:
The choice of market (Kansas City) and sub-market (Independence) is an important part of this deal. I was looking for a property that would generate cash flow today and offer modest appreciation and upside in the future. Kansas City is a slow and steady market, so I don’t expect major appreciation – just keeping up with inflation would be fine – but it’s also a relatively stable market that continues to grow. Population growth is positive. Job growth is positive. The employment base is well diversified. They are expanding their airport capacity. All good things to ensure steady growth of available renters.
The first step to understand the financial performance of a given property is to calculate the expected net operating income (NOI), which is the rent less all expenses and reserves.
Rent – $1,175/mo => $14,100/yr
The rent for a property like this is in the $1,150-1200 range, and I have it rented now for $1,175, which implies a 1.1% rent-to-price ratio, definitely above the “1% rule” that many investors throw around.
Expenses – $535/mo => $6,425/yr
There are two types of expense you need to account for, direct and reserved. Direct expenses are predictable and usually paid monthly or semi-annually. Reserved expenses are less predictable, infrequent expenses, but nonetheless need to be accounted for when running the numbers on a deal.
Direct expenses – Total: $3,323
- Taxes – for Kansas City MO, assume 1.39% of property value => $1,460 / year
- Insurance – assume ~0.7% of property value => $735 / year
- Monthly management fee – 8% of collected rent => $1,128 / year
Reserved expenses – Total $3,102
- Vacancy – assume 8% of rent (~1 month per year) => $1,128 / year
- Repairs & maintenance – assume 10% of rent => $1,410 / year
- Lease up – assume 4% of rent (~1 month rent, every 2 years) => $564 / year
With single family homes your tenant will cover any consumable expenses like gas, electric, and water, so the above categories are all you need to worry about.
Net Operating Income
With the above information, we can calculate the NOI, which is the amount of profit the property will generate on its own without any debt financing. In this case, NOI is $7,675 ($14,100 – $3,323 – $3,102).
So $7K is nice, but to understand how that compares to other investment alternatives we need to take it one step further and calculate the capitalization rate, which is basically the NOI divided by the fully loaded purchase price.
This property cost me $105K, plus ~$2.5K in closing costs: $107.5K all-in. That equates to a 7.1% capitalization rate (cap rate) when you divide the NOI by the purchase price ($7,675/$107,500). The cap rate is the best way to compare potential property returns across deals. It’s important when calculating these numbers that you include all the expense items listed above. Often times sellers will quote NOI or cap rates that underestimate or omit certain expenses – particularly the ‘reserved’ expenses. So don’t take their numbers at face value. Do your diligence and make sure the numbers quoted are reflective of reality.
Adding debt to boost returns
Disclaimer: Use a modest amount of debt. Debt can help boost returns on the way up, but will also accelerate your losses on the way down. Capital preservation and risk mitigation are key.
In this example, if I had chosen to purchase the property with 100% of my own money, the cash-on-cash return, and the yield would have been the same as the cap rate: 7.1%. But, in most real estate deals using debt is a good option to help boost returns. The reason for this is that in early 2018 you can borrow money at 30-year fixed rates around ~4.5%, and if that money is earning you ~7.1%, then you get to keep that ~2.6% spread for yourself. As you increase the amount of debt, you reduce the amount of equity required, and your returns on that equity get amplified.
With a SFR you can get a conventional 30-year fixed mortgage from almost any lender out there. They will charge slightly higher interest rates when compared with a property you would buy to live in. Also, they will likely require you to put more money down – typically the max they will lend is 80% loan-to-value (LTV). Personally, I prefer to put a little more down upfront, as I get a better rate on the loan and I dial down my risk. So in this situation I put down 25% ($26,250), and took out a mortgage for the remaining $78,750. With a 4.25% interest rate over 30 years, the monthly payment is $387, which is $4,649 per year. With the mortgage added into the picture, we can recalculate the cash-on-cash return, and the yield.
Cash on cash return – 10.5%
Cash-on-cash return is pretty self explanatory – given the amount of cash you put into the deal, how much do you get out per year? In this case, we had NOI of $7,675. But now we have a mortgage to pay which is $4,649 per year, leaving me with $3,026. I put in $26,250 plus the $2,500 closing costs for an all-in equity check of $28,750. The cash on cash return then is 10.5%. This is good, it’s an increase from the 7.1% I would get if I had paid all cash.
Total yield – 15%
But, when you take out a mortgage, part of your mortgage payment goes toward paying down principal on the loan. In this case, of the $4,649 paid against the mortgage, roughly $3,350 of it was interest, meaning $1,302 of it was principal. If I add that principal to the $3,026 cash return, then the total return with principal pay down is $4,329, which is a 15% yield on the equity invested.
What about appreciation?
So this deal stands to generate a 15% return in the first year from rental yields alone. This doesn’t account for any sort of appreciation in housing value. If you assume even a modest 2% increase in the value of the home over time, that equates to an additional ~$2K per year, which boosts returns to ~22%. Not bad.
Tax benefits of real estate
But it gets better. For anyone in a high tax bracket, profit from real estate can be costly, often requiring you to pay up to 40% or 50% to the IRS. Fortunately, there are some tremendous ways with real estate investment to shield that income from taxes. One of the best ways to do that is with the depreciation of property value. In this example, the $4,326 return mentioned above would be considered profit. But assuming that 80% of the purchase price ($105K) was building value, I can depreciate $84K of it over 27.5 years (the depreciation period for residential real estate). This means I can deduct $3,055 per year as a non-cash expense. This reduces my taxable income to $1,271, and assuming a 45% marginal tax rate, means I pay $571 in tax, leaving me with $2,455 in after tax cash in my pocket – an 8.5% after tax cash return, and 13% after tax yield.
Bringing it all together
So to summarize, with a ~$28K investment, I now own a property worth ~$107K. This property should yield ~$2,500 in after-tax income per year (an 8.5% after tax cash on cash return). In addition, I am paying down principal that boost returns to 13% after tax, and any modest rental growth or appreciation will get those returns closer to the 15-20% range. In running these numbers, I’ve included reserve expenses to account for future repairs and vacancies, meaning the above mentioned returns could be even better if we get a decent tenant who decides to stay for more than a few years. I have full service property management taking care of everything from leasing to making the property rent ready upon vacancy, and at this point my involvement is pretty limited. It took some upfront research and analysis, but now that I have this property purchased and leased up, it should be relatively low effort to track and manage.
At this point you might be wondering how you can do this for yourself. The short answer is that there are multiple ways you can get into this game, and it’s easier than you think. I don’t live in Kansas City, and I’m not a contractor or real estate developer. If you want the full details, check out this post where I provide the ultimate guide to buying your first single family rental. Take a read and if you still have questions, drop me a line at firstname.lastname@example.org.
Here’s to taking the first step toward your future!