Numbers

Investing in rental properties is a long and well traveled road. I know within a decade or two I’ll reach the destination of financial freedom and flexibility – whether that means retiring early, paying for kids’ college, or exciting vacations.

Four and a half years since starting, I am ready to examine the results so far.

Last week we saw the numbers for each individual property: Behind the Numbers – How I Calculated the Return on My Rental Properties. The complete calculations can be found in this spreadsheet:

Click Here For Access

Treating All My Rentals as a Portfolio

It was cool to see that I have made 155% on my investment in the Atlanta property in less than 5 years. I’m pretty pumped about that, but I have two properties to consider. And a year from now I’ll have 3 or 4.

As I add more, that 155% return on Property 1 contributes less and less by itself. It is just one part of the whole portfolio, so we have to zoom out and look at it all together.

How to Calculate the Overall Portfolio Return

I initially struggled with how to answer the question – what is the overall return for my rental portfolio? It is easy to calculate for each individual property, but the hard part is that each property is purchased at a different time.

Imagine putting $20k down for Property A five years ago. Then $40k down for Property B two years ago. Do you consider $60k as the initial investment and calculate your return from there? That will really warp things because most of the money was not invested those first three years.

Instead we have to treat it as individual cash flows to account for when the investments were made. Here is an example for the hypothetical Property A:

How Do We Figure Out the Individual Cash Flows?

Just put all the income and expenses in a spreadsheet, then subtract!

Cash flows are usually done monthly or yearly, but I opted for every 6 months. I think this strikes a nice balance to give an accurate picture without too much extra work.

Each cell in the spreadsheet will have the net (income minus expenses) for a given six months. An example is H2 2013, meaning July through December in 2013.

Looking at my Atlanta property, in H2 2011 the net was negative $21,013. This was paying the down payment, closing costs, taxes, insurance, etc. Then in H1 2012 the net was positive $1677 after all expenses. Keep doing this for every half year until the present.

Adjusting for Time

When doing cash flow analysis, you should build in the adjustment for the time value of money. This sounds complicated, but the concept is simple. Would you rather have a dollar today or a year from now? Obviously now. So let’s adjust our calculations to take this preference into account.

The tricky part is quantifying exactly how strong this preference is. It’s not just inflation (a dollar a year from now is worth less) or opportunity cost (you can invest the dollar today for returns in the future). The good news is that there isn’t just one right answer – so let’s go with a generally accepted number and not worry about it too much.

I decided to use a 2% per half year discount rate. This means I value $1 today as equal to $1.02 six months from now. Which is equal to $1.49 ten years from now (notice the compounding effect, it isn’t just 20x.02). Making these adjustments is called a discounted cash flow.

Add them all up for the net present value of the portfolio – a profit of $33,000 in today’s dollars.

What is the Equivalent Yearly Rate of Return?

The easiest way to evaluate an investment is a simple percentage: the yearly rate of return.

Luckily there is a nice Google Spreadsheet function to calculate the internal rate of return for the given cash flows.

After adjusting it from the six month to yearly number, it gives a nice easy to understand percentage. A 29% yearly return. Boom!

This Is More Complicated Than It Needs to Be

Trying out all these Econ 1 calculations was fun, but not necessary. The return of my rental property investments is very good, I already knew that.

Does it matter if it is a 20% return or a 30% return? Well sure, that will change the result drastically over the course of a decade.

Do I need to accurately know the result of my portfolio? Not really. Either way it is significantly better than I would get in the stock market.

Don’t let complex calculations hold you back from something that is very easy to understand. People need a place to live and many want to rent. You can help and make a huge profit without too much effort.
 
 
 
Note: I believe using MIRR might be better than IRR because there are multiple negative cash flows. But it also brings in more assumptions that result in huge swings in outcome, so seems less accurate for this. Someone correct me if I’m wrong.

There are three kinds of lies: lies, damned lies, and statistics.

I am a natural skeptic – make any kind of blanket statement and I’ll tear it to threads. “Everyone should be treated equally.” Ugh. Don’t get me started. What does that even mean?

Make a statement with a statistic and it sounds much more believable. “Women make 77 cents for every dollar a man earns for doing the same work.” Dang, it’s a fact. They did math, no way around it.

NOT! How did they come up with that? How many people did they compare? What are the assumptions they made? The statistic itself isn’t enough – we need to know the full story of how they came up with it before we can determine if we should draw any conclusions from it.

Digging into my Rental Property Statistics

There are two ways you can invest in property. Speak to a team of property valuers if you have bought a property and plan to renovate it before selling it on for a profit. That is the first way and it is very popular. However, buying a property and renting it out for a regular stream of income is another successful way to invest in property and that is what I’ve done. It is, however, a little more complicated with the numbers involved. Last week I published My Actual Results – An Examination of My Rental Portfolio After Four and a Half Years. It contains a bunch of numbers that make rental property investing sound pretty awesome. The complete calculations can be found in this spreadsheet:

Click Here For Access

But numbers can lie. I want to be fully transparent about how I arrived at those numbers so that you can decide if you should draw any conclusions from them. So let’s break it down.

Disclaimer: 10 Weeks of Econ 10 Years Ago

I have an engineering background and I’m good with numbers. But these types calculations aren’t exactly in my wheelhouse. I am not an investment banker and I didn’t go to business school. But I did take one Econ course in college and have stayed in a Holiday Inn Express, so let’s give it a shot. If you notice any errors or know a new approach that will help, please let me know in the comments below.

Since there is a lot to cover, I am going to break this up into two separate posts. Here we are going to look at the calculations for each individual property. Then next week we will dig into calculating the overall portfolio return. Without a doubt, running a property business presents many challenges although some of these can be overcome with the assistance of McGraw Property Management. I hope this update sheds light on how you can follow in my footsteps in the near future.

Calculating the Cash Return

The cash return is how much actual money was put into my pocket for a given year because of each rental property. There are two numbers that I include as cash return: 1) the money paid by the tenant minus all expenses and 2) the tax benefits for that year.

The first is easier to understand. Take all the money coming in and subtract all the money going out. The money coming in is what the tenant pays in rent each month. The money going out is any real expense. This includes property management, repairs, insurance, taxes, mortgage interest, and legal fees. The cash return number is actually what I have on my tax return – I didn’t include anything bogus like “oh in a normal year I should collect more rent, so let’s increase this number a bit.”

The tax benefit is a little less tangible, but important to understand, even if you decide to use an accountant like Dave Burton to manage your books. It boils down to how much money I saved on my taxes for a given year because of the rental property. The IRS allows you to put some “phantom expenses” down on your tax return as if you had an actual expense, when in fact, you paid nothing out of your own pocket. The biggest of these is depreciation.

The IRS says you can deduct 1/27.5 of the building value for depreciation (and it’s easy to do). So if the building is worth $70k, you can deduct $2545 as an expense for the building getting older. Did you actually have to pay $2545 to keep the property from falling apart? No. Is it worth $2545 less because everything is a year older? No. In fact, it’s likely worth more! Yet you get a tax benefit for it right now.

If you can deduct an expense that you didn’t really have, what is the dollar benefit to you? For this, it depends upon your marginal tax rate. This means, if you were to make another $1 in income, what would you owe in taxes? For me, it is 37.3% – 28% federal and 9.3% California.

In the example above, my $2545 deduction would mean I get to treat $2545 as tax free. The tax on that would have been $2545 x 0.373 = $949. That’s a pretty nice gift each year for just one rental property!

Note: this is the only phantom expense I included in the tax benefit, but you might have others. You could include things you would have paid for anyway, that now you can deduct from your taxes because you have a rental property business (you don’t need an LLC or anything, the IRS considers rental properties a business without it). Is part of your home an office you use for your business? It’s a right it off! What about your internet, what portion is used for your business? It’s a right it off! Cell phone? It’s a right it off! I already deduct these things because I am self employed, so I did not include them as a tax benefit of owning rental properties. If you don’t own a business already, talk to your tax adviser about this – you could have another $1-2k in yearly tax benefits through these other phantom expenses.

Calculating the Equity Return

There are two ways to build up equity in the property: by paying down the mortgage and appreciation in the property’s value. The tenant is paying down the mortgage for me, right now to the tune of just over $1k per property each year (this increases over time). However, the increase in the property value for the year is more of an estimate.

Each year I look up the properties on Zillow to get an estimate of their current value. Then I decided if the estimate makes sense or if it needs an adjustment. I believe the Atlanta estimate is too high because I had an agent look up comparable property sales. So I dropped it down by 10% for a more accurate estimate.

For the total equity gain, there is a more accurate way than adding up each year’s estimated gains. What matters is simply: what is the property worth and what do I owe on the mortgage. Finally subtract what I paid to acquire the property to get the profit. This includes the mortgage pay down, appreciation, and also the closing costs on the loan.

The Results

I’ve made a 155% return on my initial investment for my Atlanta property in 4.5 years. For the Memphis property is still a little early to get a clear picture, but it is up 24% on my initial investment. Sounds pretty good to me!
Well, the statistics can be similar for you too. You just need to put the right practice or right people in place. By contacting the right hosting team, you can get the most out of your property. You might want to look at what Jacksonheim Property Group offers for the landlords seeking Property Management Manchester and consider hiring a similar team for your real estate. More the number of properties, better the return!

The returns of each individual property are nice to know, but the overall portfolio return is what is important. If we take the proceeds from property 1 and use them to buy property 2, we get the snowball effect of of compound interest. We will dig into this next week.

Would you be interested in seeing a breakdown of a typical year’s expenses? Anything else you’d like to see?

When you were a kid, did you ever try to burn something with a magnifying glass? I used to try it with a piece of paper. There were also those messed up kids who would burn ants to death – if that’s you, stop reading right now and go find a therapist.

It takes time to see results. You sit there and focus the beam of light on a specific point. At first nothing happens and you think about going to ride your bike off the 5 inch ramp you built instead. But after a while you see the first tuft of smoke. That small sign of progress hooks you and is all the motivation you need to see your efforts all the way to the end.

The Long Game of Rental Property Investing

Rental properties are the absolute best investment you can make over a decade or two. You might not notice much progress at first, but just like the piece of paper under the magnifying glass, the results are on their way.

Back in 2011 I purchased my first rental property. It took a solid four years for me to see the first tuft of smoke that the plan is working. Now I am past the tough beginning period and hooked – not just to keep going myself, but to also help others get started.

Finally Running the Numbers

It took four years for me to sit down and calculate my return on investment for those properties. That might sound crazy to a typical investor, but I knew I was in it for the long haul. Worrying about the numbers every month, or even every year, would not help. For some people, calculating their ROI can be difficult, so they may use additional resources such as UiPath Automation Hub, and similar others, for ROI help if they are in need.

What difference does it make if I had a 20% return per year or a 30% return? Yes, that will give drastically different results over time, but either way, it beats the alternative investment options. I knew that my out of state rental properties were a better investment than the stock market, and that’s all I needed to remember to keep with the plan for the first few years.

My Actual Results – $33,000 of Passive Profit

The Atlanta property I purchased in July 2011 with $19,936 for down payment and closing costs. The cash return is $7,627 including the yearly tax benefits. Even more impressive is the equity return of $23,245 from paying down the mortgage and appreciation. Overall this is a 155% return on investment in just four and a half years!

Note: the equity return is a paper return right now. There are ways to access that money by refinancing or selling the property. Refinancing gives a chunk of cash tax-free that can be invested in another property – I will be going through this for the first time later this year.

The Memphis property is slightly different – it should produce a higher cash flow and less appreciation. The initial investment was $24,030 and it has a $4,063 cash return including the tax benefits. The equity return is $1,735 from paying down the mortgage and appreciation. Overall this is a 24% return on investment in just a year and a half.

More In Depth Analysis

I created a spreadsheet to calculate the return on investment. It has the numbers for each property broken down by cash value, tax savings, mortgage pay down, and appreciation. It also has more advanced discounted cash flow, compounded annual growth rate, and internal rate of return calculations for the overall portfolio. Plus exterior photos of the properties.

Click Here For Access

Note: These are useful calculations because a dollar today is worth more than a dollar a year from now. The total profit of $33,000 takes this into account rather than just simply adding up the numbers in the section above.

The overall compounded rate of return is 29% – try getting that in the stock market!

What do you think, how am I doing so far?