When my wife and I were in the process of selling our house in order to move into another house that was closer to work, I had more than one person tell me that we should rent out the house. When I told them that it didn’t make any financial sense, they looked at me like I was the guy from The Goonies.The experience of everyone telling me it would be a “good idea” to rent out our first house really drove this point home: many landlords have no clue what they’re doing and have tricked themselves into believing they have a good investment.
Ever since the financial crisis of 2008, it seems as though everyone is renting out a house that they bought at a higher price than what it was worth in 2010. Others aren’t under water on their houses, but still choose to rent because they believe it is going to build wealth.
Don’t get me wrong. Some people have purchased rental properties that have been fantastic wealth accumulators. But there are more people out there that have unknowingly done the exact opposite. You’ve hopefully heard before that your home is a terrible investment—the topic has been covered by so many people that it would be boring for me to repeat here. If you’re interested in it, Google it. I’m going to show you that even if you were to rent out your home, there’s a decent chance it still isn’t a good investment. Renting out your primary residence often times doesn’t work out.
Let’s use a real-deal example that will show why renting can be a terrible choice. Mary Moneybags owns a house that would sell for about $225,000. She bought it in 2010 at $200,000 with 20% down at 4.25%. MM has about $80,000 in equity. Some of that was equity from the down payment ($40k), some if it came from the principal portion of her mortgage payment ($14,700), and some of it was appreciation ($25,000). We’re going to use that $80k number in quite a few calculations, so remember it!
MM decides that she wants to move. Since she’s been following What Should I Do With My Money and has been kicking some serious financial butt, she actually managed to save up for a 20% down payment so that she can buy a house without relying on her existing equity. Her friends tell her that she should rent out her old house so that she can get some sweet tax write-offs and make some rental income. Donald Trump is in real estate, you know? MM decides to do this and rents out her house for a competitive $1150/month. Her mortgage payment is about $964/month which includes property taxes and insurance. That means she’s going to cashflow $186/month. Booyah!
Let’s check out some more math on this though. MM has $80,000 tied up in this house. That monthly cash flow (and mortgage payment that goes to the principal) is the return on that $80,000 she has in the house. This is widely known as the Return on Investment or ROI. In one calendar year, MM would earn $2,232 from cash flow and about $3,180 of the mortgage payment will go towards principal. Total it out and it’s a nice $5,412 of profit. Not bad! $5,412 out of an $80,000 investment is a return of about 6.8% which is just a tad higher than the conservative 6% we usually use for our stock market calculations. Note that I’m leaving appreciation out of the ROI calculation. This is my way of making this number real–just like I do with the 6% value I use for return on stocks. Don’t let me convince you that real estate doesn’t appreciate much after inflation is factored in. This guy has a pretty good article on it. The bottom line is that it is incredibly risky to count on appreciation.
Most people don’t take calculations that far. Of those that do, many will stop right there with that rosy picture. They don’t take into account expenses. Seriously? How many of you homeowners out there have gone a full year without having to perform any maintenance? What about two years? Five years? How old is your A/C or furnace? What about your roof? How sure are you that your tenant will not flush tampons, huge wads of toilet paper, or diapers down the toilet? Many professional landlords use 40-50% of rents as an estimate for what expenses will be. It sounds high, but think about the likelihood that you’ll need to repaint, repair drywall, replace carpet, evict tenants, and wait out vacancies. It is going to happen.
MM finds this out about expenses little too late, but it still seems pretty manageable: $50 worth of paint, $200 for a professional carpet clean, $250 for an emergency plumber at 2:00 am, and another $250 to get the trees trimmed since they are too high for MMs ladder. A total of $750 for the year. When factoring those expenses back into the equation, MM is at $4,662 profit which sucks her return down to 5.8%. Note that we are now below my conservative value for stock market returns. Going back to the rule of thumb that expenses usually run at 40-50% of rents, you’ll notice that M’s expenses only totaled 5.4 % of rents ($750/(12*$1150)=5.4%). In other words, she got pretty dang lucky during her first year. She will likely face higher expenses in the long run, which will only further eat into her profits. Imagine if MM had listened to the people who said that “you just need to cover your mortgage with rental income”. She’d be in rough shape!
Do you still think I’m crazy for not wanting to rent the house out? All the work of being a landlord is not worth a measly 5% return when I can literally take no action and continue investing in the stock market.
One final thing that I would like to say is that real estate doesn’t always work out to be a bad deal. As I said before, many people have had great success with it. You just need to run the numbers. If you’re looking to invest in real estate, I suggest you check out Bigger Pockets, which has a great deal of information on how to get started and how to analyze deals.