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
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:
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.
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. 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.
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!
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?