Evaluating Rental Real Estate

Evaluating Rental Real Estate

| March 16, 2022

With real estate prices up so much recently, investors have been asking me if it still makes sense to purchase rentals. Also, people are asking me how I evaluate the numbers when I am considering a property for purchase. This blog post will address how I am approaching the current market environment as well has how I run the numbers.

While prices are definitely up, so are rents. In some cases, the new rents justify the higher purchase price. In other cases, the numbers still work, but are just not as lucrative as in the past. For example, about five years ago, we could buy a duplex with a cash yield of over 10%. Today it is hard to find one over 8%, but they are still available. In the past, I would not consider a property for purchase unless after basic costs I was making 10%. Since that is nearly impossible these days, I have lowered my expectations to 8% as the minimum expected return. 

For example, let's say the purchase price of a duplex property is $170,000 and rents are $1,000 per month in each unit. Then you subtract property taxes, insurance, sewers, etc, which may add up to $7,000 per year. If rents are $24,000 and costs are $7,000, the gross profit is $17,000, or 10%. This was how it worked in the past. Now with higher prices in 2022, we may have a situation where that same house is worth $250,000, which is a 47% increase, but the rents are only $1,200/mo, which is a 20% increase. Now our anticipated yield has come down to 8.7%, which is still good in my opinion.

The above conversation assumes there is no mortgage. It keeps the math really simple, but a lot of people use some sort of leverage. Using leverage is appealing because you can control the same $250k property above with just 25% down or $62,500. If all goes as planned, the tenant pays the mortgage off for you over ten years. So in year 11, you own the 250k house free and clear so your return is much better than 8.7% as described above. By using leverage, you have enhanced your cash yield dramatically, but you have also increased your risk. If the property values decline (think 2008) or if you cannot collect the rent (think 2008 and 2020) you are still on the hook for that payment. Early on, we would use leverage and put down 25% for each property. But now, since we have 29 units, we are just paying cash which is ultimately a dividend reinvestment plan. Instead of taking cash dividends, we reinvest them by buying more units. We could leverage up and buy significantly more properties, but I don't want the added risk which the leverage brings. But if you are looking to get started, using some leverage is a great way to get a fast start. 

One thing I have not mentioned is appreciation. Living in Michigan and beginning my real estate journey in 2002, I never experienced any appreciation for a long time. As a result, when I evaluate a property I am focused on income only. If the appreciation comes, that would be great. If not, we believe the income only would be a solid ROI. 

To download my excel file which helps you evaluate your yield, check out my Rental Spreadsheet

To learn more, book a call with me here. I'm happy to offer a second opinion on your financial plan, investment portfolio, or real estate strategy.

This article is for educational purposes only and is not a recommendation for any security or strategy. Consult your financial advisor before investing.