You are surrounded by zombies. Your neighbors, your coworkers, even your friends and family. All zombies. I just hope it’s not too late for you. If you aren’t careful, you will be an investing zombie too.
Zombies all do exactly the same thing without even thinking – retirement accounts with mutual funds. If everyone is doing it, that must be the way to go. Why even bother thinking for yourself?
What if with a little up front effort you could get drastically different results? I’m talking a million dollars different over the next 15 years – would that break you out of your zombie trance?
Break Out of the Trance
To understand why anyone should care about out of state rental properties, you need to have an understanding of the benefits. This article is going to explain it with words, then later we will look at the math which is even more convincing. But you have to go into it with an open mind.
Evaluating an investment can’t be done in a vacuum, it is always done relative to an alternative. Sometimes the alternative is money under your mattress earning no interest. Often it is money sitting in your bank earning 0.1% interest. But I am going to assume you are more sophisticated than that – you have money in the stock market through mutual or index funds, generally considered to average an 8% return.
How can remote rental properties beat that? The basics of the conservative approach I recommend are to put 20% down and hold the property for years. The tenant will pay your mortgage for you and after all expenses you get to pocket a couple hundred dollars each month. If you hold it for many years, you will be handsomely rewarded far beyond those couple hundred dollars a month. Expect above a 25% annual return!
Low Risk Leverage – Multiply Your Return By Five
Leverage and loans sound risky. They can be, but there is a conservative approach to real estate investing: cash flow rental properties. The houses will be rented out to a tenant for significantly more than your expenses each month. This includes real expenses like a property manager and insurance, as well as future expected expenses like repairs and vacancy.
As long as you go about it in the right way, there is very little risk involved. This includes:
- Rents well above expenses for a large margin of safety
- Fixed rate loans so you always know what the expenses will be
- Purchasing properties in markets that don’t experience huge run-ups and crashes
- Cash reserves to handle the worst case scenario
The benefit of financing your property is that you only need 20% of the price of the home for a down payment. Considering you have the same upside, this gives you five times the return on your investment.
Earn Money in Multiple Ways – The Five Components of Rental Property Returns
Usually there is only one component to consider for return on investment. For a bank account it is interest – the bank actually pays you a tiny amount money for keeping your funds there. Most stocks don’t pay you any money, so you are hoping that after you buy it, the stock’s price goes up. Some stocks actually pay a dividend, which is a second component to consider. You add that to the amount the stock went up to get your overall return.
Rental properties have five components that add up to an overall return. This type of investing is often underestimated because people usually only focus on one or two of the components. Here are all five:
- Rental income – after taking account for all the expenses (insurance, property management, repairs) and expected vacancies, we will get an 8% yearly return on the money invested. This component alone compares well to the stock market.
- Appreciation – we aren’t trying to time a volatile market for double digit appreciation, instead let’s estimate conservatively in the 2-3% range, which is roughly the rate of inflation. Considering you get all the upside and only had to put 20% of the money into the investment, you get a 5x multiplier on that. So your return is 10-15% per year.
- Tax benefits – there are some huge tax benefits on real estate, the most important being depreciation. I will go into this more later, but expect tax savings that are equal to at least another 4% return.
- Mortgage pay down – the longer you own the house, the more you pay down the mortgage. Or more accurately: the more the tenant pays down the mortgage for you. After year 1 you will only have paid down 1.5% of your mortgage balance, but with the leverage this is at least another 6% return per year.
- Inflation mortgage destruction – this one is more complicated so I will leave it out of this estimate. But there are huge returns here as well. The basics: you have the same $500 mortgage payment per month at the beginning of the loan and at the end. Over a long time period inflation makes it so that same $500 payment gets easier and easier… in 30 years a ticket to Disneyland will be $500 (and everything else will be nearly four times as expensive).
Add them all up: above a 25% annual return. It’s so good I am using very conservative projections so you don’t think it is too good to be true.
Start Now – The Power of Compound Interest
We have all heard the advice to save early for retirement. This isn’t just so you will have an extra 5 years of savings. That’s nice, but insignificant. Rather, it is because your investment gains will compound with time – you earn interest on the interest you previously earned, not just the amount of money you originally put in. The same holds for real estate.
Each month a property will net the investor $150-250 which can be invested back into more properties. After 5-7 years you will likely have built up enough equity to refinance, using the proceeds as a down payment on another property. This snowball effect starts slowly, you will hardly notice it at the beginning – but if you start now, you can build some serious monthly cash flow and long term wealth.
A Deeper Understanding – Crunch the Numbers
Does this sound appealing? I thought so. Use this as your motivation to dig deeper and really understand how it works. How did I come up with these numbers and are they realistic? How do each of the individual components work?
Take the time now to understand it fully. Don’t be a skeptic and disregard it as too good to be true. But don’t blindly follow what someone says on the internet either. Do the research required, embrace the math. Math is fun when you are adding up your money!
Photo: Daniel Hollister