THE BLOG

Rental Investing - Two Variables with One Goal

06/09/2015 05:31 pm ET | Updated Jun 09, 2016

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Rental property investing has been a wonderful path to wealth and a comfortable retirement for many. Thousands of websites, tens of thousands of books, seminars and courses are focused on how real estate investment can be the path to wealth for the average American. I'm a real estate investor, and it's been very good to me. However, in many cases there is not enough information to help the investor investigating rental property investment to balance the risks versus rewards.

No, I'm not writing a scam article, nor am I criticizing the general enthusiasm for rental property investment. I do want to help the aspiring rental investor to understand that there are two components of return on investment, and they are not fixed in time. The ROI goal of rental property investment involves:

• Positive monthly cash flow for the entire period of ownership.
• Appreciation in value for a significant profit when the property is sold.

There are some benefits enjoyed by rental investors not available in stock market and bond investing. There are tax breaks, including deduction of expenses, depreciation, and the ability to postpone or even avoid capital gains taxes completely. There has been a lot of news coverage about growing rental demand and increasing rents, so it is easy to get excited about buying a rental home and enjoying that monthly bankable cash during the years ahead.

In many cases we're also buying at a discount to current market value, locking in some equity at the closing table. We expect decent value growth, even at low single digit price appreciation expected in the future. An online calculator tells us that buying a home today for $150,000 and enjoying only 3.5% per year in value appreciation, we would have a home worth more than $197,000 in eight years.

Once we start throwing out numbers like this with a positive monthly cash flow of let's say $400, a quick simple calculation shows that we would enjoy somewhere around $82,000 over an eight year ownership period. This is great if we could just stop time in relation to our costs and economic conditions. We can't do that, so taking a realistic look at possibilities before signing the purchase contract is wise.

While we can say that inflation actually could help our property's appreciation, we could see offsetting damage to our cash flow that wipes out that benefit. The key is to understand the costs involved in rental property ownership and management. The only one that we can count on remaining constant is the principal and interest portion of our mortgage. However, other costs that are escrowed in the payment and influence cash flow are taxes and insurance. Costs of rental property ownership include:

• Real estate taxes
• Insurance (casualty and liability)
• Professional management
• Vacancy and credit loss
• Repairs and maintenance
• Marketing/advertising

You can count on inflation and these costs rising over time. You cannot count on being able to raise rents enough to overcome cost increases. While you may raise the rents to do that, you could lose your gains due to increased vacancy losses to competitor properties.

What about that appreciation component? The 3.5% example is considered realistic by many market analysts, but they don't have a crystal ball. Real estate is local, and every market carries some local economic risk. Major employers move, and people move to where they can get work. OK, I've just popped the balloon for some who are considering rental property investment, but that's not the goal
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Just understanding the risks is the first step in getting your desired return on investment. Don't use the "best-case" numbers to make your decision. Discount that expected monthly cash flow for possible erosion in the future. How much of a discount? I can't tell you that, but some adjustment for unexpected but inevitable cost increases is a good thing. It will be far better if you're pleasantly surprised by a greater than expected return in a few years.

You're making a decision during a moment in time, but your deal evaluation calculations should take a long term approach adjusted for an uncertain future. Rental property investment is still a reliable path to wealth creation. It's just a path with some twists and turns you should anticipate.