Creating Assets out of Liabilities - Rental Properties

Profit From Owning Residential Rental Properties.

By Outram J. Hussey

Because I have invested in residential properties for over  30 years, many have asked me about the investment advantages as well as about  contractual and management challenges.  Many times, before answering,  I try to assess the temperament of the person, leadership qualities and the ability to manage outcomes effectively. 

Why is this important? 

Because investment property, to be a good investment depends not only on the numbers but also in good management ability. So, if you are ready to take on the challenge, you will find that residential rental properties can lead to wealth, independence and freedom. Before going any further, however, I must state that I am not a real estate lawyer or an accountant  who specialize in rental/investment properties and thus you must seek such professionals for legal and tax advice before undertaking such investments.

Why The Investment?

When you own a home and live in it you carry a liability. That is, you take money from your income and pay another (The Bank) for its use. In other words, you pay the bank for which your home is an asset, and for you a liability.  For the home owner,  it is not an investment, at least not the type we are about to discuss, and yes, for the average person a home  will overtime become the single most important investment .  For the purposes of this blog, however, we are setting out how the average person can transform the liability into an asset by renting . An asset (capital) works for you. Once this is done you would have effectively become an investor. This sound all wonderful and good but there are strict guidelines to follow to realize the benefits.

Other Investors

Be cognizant of the fact there are other investors that also invest in residential property such as professional out of town investors or local investor groups. For whatever reason they turn to residential property to edge their investment bets,  these groups  assess  rate of returns and conduct their negotiations and acquisitions accordingly. Many of these are not Passive but Active investors. We will discuss this again later in the blog. Be careful if competing with these groups as their investment needs may be different from yours. Know what you want to achieve and negotiate to your best interest.

The Magic of Income Property

Many discover very quickly that rental property makes money (rental income) and carry expenses such as taxes, insurance, mortgages, repairs etc. They also discover that the IRS allows them to depreciate the property (Building, not land) over 27.5 years. That is, the IRS say that properties lose value over time and they allow you to write off that as a loss. The IRS also allows you to write off mortgage interest on your mortgage as well as travel expenses, operating expenses etc. but not capital improvements.

The Magic Of Appreciation.

As an investor you want to always assess future appreciation. That is, the property’s potential to increase in value over time. If you buy right, appreciation can be significant. If you buy wrong, it may not be good.  Therefore as an investor, rental property has the potential to reduce your taxes, provide income, increase your asset base, edge against inflation and put you in the driver seat of your own investment portfolio.  It should be noted that this do not apply to flipping properties. The IRS considers rental property income to be “passive income” and it is only in passive income that these so called tax loop holes exist. If you are aggressive and get into flipping, that is referred to as “Active” income and does not get the same perks.

Management

Once you decide to invest in rental properties there are important requirements to follow, such as:

• Have a properly executed contract drawn-up  by an experienced attorney in these matters
• Ensure the property passes a rigorous property inspection
• Ensure there is no mold or other environmental issues.
• Ensure that Lead Paint issues and notifications etc. are properly addressed.
• Be active in good management principles, if not, hire a property manager.
• Address issues promptly.
• Maintain proper accounting records.
• Utilize an accountant skilled in these matters to do your taxes.
• Ensure all Fair Housing requirements are met.
• Ensure your Rental License is current.

Tracking The Efficacy Of Your Investment.

 As an investor you will begin to track your investment. This means managing expenses, keeping vacancies to a minimum, assessing tax advantages and brackets and tracking returns on the invested dollar.  If you decide to sell you will need to figure taxes and its impact on returns. When dealing with investment properties we usually refer to the calculations as “Running The Numbers” In our case we will need to” Run The Numbers”  to show the Return on the Investment (ROI).  Recognize that many first time home buyers wanting  to move-up, may purchase another property, rent the first and repeat the process. In so doing they enter the investment arena and will ultimately do better at investing by proactively calculating their ROI. Given that many people ask what is the ROI and how can it be figured, I thought is best to give a simple example as follows.

  

ROI for Real Property (When financed via a mortgage)

For this scenario let’s figure a 20% down payment on the sale of a house for $240,000.00.

In addition, let’s say we will be paying (out of pocket)  $48,000 ($240,000 sales price x 20% down payment), plus $14,000 for remodeling and closing costs, for a total of $62,000 (out of pocket expense) The amount therefore financed is $192,000 ($240,000 - $48,000 down payment), and if we were to place a  30-year loan at 4.0%  the principal and interest (P&I) would be $916.64 per month.  If the taxes and insurance comes to  $450 per  month,  then our  total monthly  payment would be $1,366.64. Lets say the tenant pays rent each month for 12 months, then each month we would realize a positive cash flow of $733.36 ($2,100.00 rental less $1,366.64 mortgage payment). 

Multiply $733.36 x 12 and the annual cash flow = $8,800.32. To find the ROI (Return On Investment) divide $8,800.32 by $62,000 (cash in) which equates to 14.19 or 14.19% ROI.  Therefore, the ROI from the annual cash flow is 14.19%. Remember ,however that the mortgage payment included for principal pay-down which actually builds equity into the deal every month.  By printing the amortization schedule you will notice that a total of $3,094.24 would be paid over the 12 month period toward principal (equity). Therefore by adding the $8,800.32 (Cash Flow) for 12 months to the $3,094.24 (Principal pay-down or equity build-up)  we get  $11,894.56. Recognize therefore that instead of an ROI of 14.19%, the  ROI is increased to 19.18% . 

Finally, your accountant will factor in the depreciation on Line 18 (Schedule E) of the IRS Form 1040. This is listed as an expense which  may allow for income losses further boosting your ROI. Remember to always check with your accountant regarding tax/investment  issues.

Young investors and sadly even mature investors need to be reminded constantly of tracking the key elements that makes a successful investment. That is, always be conscious of the relationship between acquisition costs, terms of the agreement (loan type, rate, time, points etc.),  carrying costs, potential for appreciation and taxes. Each of these affect the ROI over time and a movement in one element means a change in another to maintain the desired ROI for the investment objective.