Is this the new normal?
Iwas talking with a buddy of mine this week about how to evaluate the returns on rental property using the financial calculator. I’d like to share with you what we did.
Before we get started, if you haven’t had your morning cup of coffee, put me down and go get.
This column is going to be numbers-heavy and will require an acute mind. I’ll be here when you get back. Ready? Let’s go.
My buddy wanted to know how to calculate the return on rental properties. To do this, we must do a calculation for a variable called yearly return (YR).
YR lets you know what percentage of your initial investment you received annually while taking into consideration the time value of money, which is important for evaluating longer-term investments like real estate.
To help us find YR, we use a tool called a financial calculator which has five buttons at the top: N, I/YR, PV, PMT and FV. Each button stands for a piece of information you’ll need to do a calculation. If you know four pieces of the equation, you can find the fifth.
Here’s what each button stands for: N — number of payments (in months); I/YR — interest/ yearly return; PVpresent value of the loan or investment; PMT – payments; and FV- future value.
My buddy wanted to know what the yearly return would be for a rental property if you paid $200,000 cash for it, kept it for 30 years and rented it for $1,200 a month.
Punching those numbers in: N = 360 months; I/YR = ? (because that’s what we are looking for); PV = -200,000 (it’s negative because you spent that money buying the house); PMT = 1,200 (rent coming in is positive); and FV = 0.
When you punch that info in and solve for I/YR, you should get 6.01%.
With money market accounts only producing a 1.01% average return, that 6.01% looks great. The problem is that number is inflated.
Although it rented for $1,200, we didn’t take any expenses like taxes, insurance, vacancies or repairs out of that amount. Figuring that $1,200 will be reduced by 40% in expenses, then your real income for the month is more like $720. Let’s see what I/YR that produces.
N = 360; I/YR = ?; PV = -200,000; PMT = 720; and
FV=0.
Which means I/YR = 1.81. When my buddy saw that, he said buying rental property doesn’t sound all that great right now because of how high houses have gotten. I agreed with him that houses are expensive right now, but I think there is some things we haven’t taken into consideration.
For one, FV, or future value, is an unknown. We have no idea what it will sell for in 30 years. But let’s just say it doubled in value and would be worth $400,000.
We also didn’t account for any tax advantages like depreciation. In order to do that, you take your purchase price, subtract the land value and divide the resulting number by 27.5 years.
So, if the land was worth $20,000, that means you could depreciate $180,000 over 27.5 years to receive a tax savings of $545.45 a month. If you count that tax savings as income then PMT is $1,265.45.
So: N = 330 (27.5 years); I/ YR = ?; PV = -200,000; PMT = 1,265.45 (720 + 545.45); and FV = 400,000.
Which works out to I/YR = 8.51.
That’s getting better, but it’s still very speculative. We don’t know how much the house will sell for in the future. We don’t know if you’ll lose revenue due to vacancy or expensive repairs. We tried to account for it, but we won’t know until after one of those events happens.
My buddy said it sounds like you have to evaluate rental properties in the past and not speculate about the future. I agreed.
I’m seeing properties go under contract for investment purposes with greater purchase prices than I feel comfortable with. For instance, I saw three older 2 bedroom, 1 bath single wide mobile homes with average rents of $550 go under contract for $90,000 this week. With $15k rehabs a piece, that would make the projected YR 6.29% over 20 years.
N = 240 (20 years); I/YR = ?; PV = -45,000; PMT = 330 (550- 40%); and FV = 0. That results in I/YR = 6.29. We are used to 20% or better true returns on single-wides.
So, does that mean investors are grasping for higher returns with projected numbers? Or is higher entry cost the new normal? I guess time will tell.