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So, you’re thinking about joining the real estate game. You’ve heard about folks getting rich in real estate, taking advantage of the boom in housing prices, and you want a part of it. Likely, your first questions are: “How much money will I make by owning a rental property?” , “Realistically, what will be my return on investment (ROI) if I held a rental long-term?” and “Is the hassle of actively owning a long-term rental (LTR) property (e.g. endless education, hunting for deals, negotiating price, managing property, legal fees, accounting headaches, liability risks, financial risk, etc.) worth it?” In summary, you might be wondering: “Is the juice worth the squeeze? Or should I just increase my retirement contribution and throw it all into S&P500 and not take on this rental headache?”
The answer to all these questions is: “Well, it depends” It depends on the leverage you use, your risk appetite, and your financial goals. Investors consider LTRs for varying purposes – e.g. growth, speculation, cash-flow, hedge against inflation, retirement planning, tax benefits, estate planning, creating generational wealth or portfolio diversification. Therefore, your overall ROI will come down to your own financial goals and the leverage you deploy. Simply stated, more leverage means higher ROI. However, remember that leverage is a double-edged sword. Higher returns also mean higher risk. It is prudent to keep risk at top-of-mind, especially in a leveraged investment.
Acknowledging and mitigating the risk is essential when investing in real estate as an active investor. Future blogs will go into different types of risks (financial as well as liability risks) of owning LTRs and the strategies to mitigate risk. Still, it does help to have a ballpark idea of what ROI an investor can realistically expect when using a prudent leverage. Below, let’s consider the performance of an average turn-key LTR.
Assumptions:
Before we get into the numbers, a quick disclaimer: These sample calculations involve numerous variables and assumptions. Even a slight modification to any variable significantly impacts the overall outcome. These numbers are not generalizable and will vary based on geography and individual rentals.
I chose these specific assumptions based on personal experience. I use an interest rate of 5.5% for my long-term projections. Although the current interest rates are higher, these high rates are not the norm. If you believe that inflation is going back down to 2%, using a 5.5% interest rate for making multi-decade forward projections is reasonable. I do also analyze a rental based on current interest rates, but primarily for immediate cash-flow analysis. I don’t focus too much on the current rates for long-term projections, realizing that mortgage can be refinanced in the future. As the saying goes, “Marry the house, date the mortgage.”
The Internal Rate of Return (IRR):
The rate of return for a LTR includes the cash-flow, property appreciation, and the mortgage payoff. For real estate investments, the Internal Rate of Return (IRR) is considered the most appropriate and accurate way of calculating overall return. IRR is similar conceptually to the widely-understood Compound Annual Growth Rate (CAGR), but with one key difference: the IRR considers the time value of money because real estate investment generates monthly cash-flows. CAGR, on the other hand, assumes that the entire payout of an investment is at the end of the period. For more information about IRR, please check out: Investopedia - IRR vs CAGR.
The overall IRR is approximately 12.5%.
Additionally, this is what the returns would look like over time. Notice that in the first few years, the IRR will be negative if the property was sold. This occurs because the upfront closing costs (3%) and the cost to sell (7%) have not been recuperated yet. By year 3, the IRR turns positive.
So, there you have it. Conservatively, you can expect approximately 12.5 % return, if you hold a rental for roughly 20 years while using reasonable leverage. Not too shabby, right? Most seasoned real estate investors would argue that an IRR of 12.5% is a bit too conservative and they are used to seeing better returns. These numbers underestimate the real performance of a LTR for one primary reason: as time goes on, the equity in the property starts to build, thereby reducing the leverage (and risk) and, consequently, impacting the overall returns - notice how the IRR plateaus off at year 12 and then starts to drift down. Please check out my next blog on how to optimize the long-term returns by using cash-out refinance strategy.
Taxes:
Impact of taxes is not included in this calculation. There are numerous tax benefits of owning real estate, and it is not unusual to experience positive cash flow while showing a paper loss due to property depreciation. However, these tax benefits are offset when selling the property. The investor who sells must repay this amount in the form of depreciation recapture and long-term capital gains tax. Sure, there are tax strategies, such as coordinating a 1031 exchange to defer these taxes further, selling during retirement when an investor is in a lower tax bracket, purchasing LTRs through a Solo-401K, or leaving the property to heirs who benefit from the use of a step-up in cost basis. Then there is the coveted Real Estate Professional Status (REPS), which will allow qualifying investors to offset earned income with paper losses. Finally, there is a tool known as the cost-segregation study, which accelerates depreciation. For simplicity’s sake, tax impact is not considered in this proforma, for better and for worse.
Calculator:
Please note that these data were generated using the rental calculator available on https://www.calculator.net/rental-property-calculator
This is the best free rental property calculator I found. Feel free to play around with the calculator, while changing assumptions to see what happens. Here are some scenarios to consider:
What will be your IRR if you choose to manage the property yourself?
What if the property appreciates more than 3.5%? What if the property goes down in value?
You will see that future appreciation is the singular most important parameter that drives overall returns. Therefore, it is important to buy properties that are likely to appreciate over a long period of time.
What would happen if you used more leverage (i.e. used a lower downpayment), or purchased it with 100% cash? You will see the impact leverage plays on ROI.
What if you were able to negotiate a good deal and acquired the property at 5% below market value?
What if, instead of purchasing a turn-key rental, you decide to buy a value-add investment - i.e. doing minor renovations that improve the property value creating instant equity in the property? Investors use a common strategy called BRRRR (Buy-Renovate-Rent-Refinance-Repeat) for deep value-add investments.
What if you acquired a rental with a better cap rate - e.g. a $220K rental that takes in $2,200
monthly rent?
What if you never sold the property, did not have to pay an exit fee of 7%, and instead left it to your heirs who could inherit the property at a step-up basis and re-depreciate the property all over?
As you see, you can tweak the assumptions and make the IRR look terrible or amazing. However, in my personal experience, the 12.5% IRR is reasonably achievable.
Is the juice worth the squeeze?
Okay, so you could make 12.5% return in real estate with all the hassle, versus ~10% in S&P500 without the headaches. Is the juice worth the squeeze?
Return on investment in stock market can be unpredictable, and the overall return varies greatly based on the timing of entry and exit. It is not unusual to see a 20% drop in the stock market. LTR returns are generally more predictable with less volatility, the 2008 Great Financial Crisis notwithstanding.
Consider this: $60K invested for 30 years earning an annual compound interest of 10% (a 20-year historic S&P500 return) would yield approximately $1 Million, while the same money invested at 12.5% return would yield approximately $2 Million. The measly 2.5% difference between the two investment strategies is worth roughly 1 $Million in the long term. As a teaser - what if you optimized your leverage and were able to hit 15% IRR long-term? The graphs below also show how 60K compounded annually at 15% would perform over 30 years. Please check out my next blog on this topic.
Some food for thought!
Above graph and image was generated using: https://www.investor.gov
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DISCLAIMER:
This post is meant for educational purposes only. The information provided via LokhandwalaRealEstate.com is not intended as individualized legal, accounting, tax planning, or investment advice. Lokhandwala Enterprises USA, LLC and its affiliates disclaim any liability, loss, or risk incurred as a direct or indirect consequence of using any information contained in this blog. Please contact us for a private consultation and/or consult your own network of licensed professionals before taking specific actions.
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