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Calculating the ROI for you rental property


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2012 Dec 1, 5:12am   19,257 views  47 comments

by BayArea   ➕follow (1)   💰tip   ignore  

Hi folks,

There are several different ways to approach the ROI for an investment property. Many look at the capitalization rate which is the (yearly rental income after expenses) / (total value of the property). However, for a small scale investor like myself who isn't purchasing all in cash, it's more interesting to identify ROI based on the equity or amount I'm investing up front, therefore capitalization rate loses some of it's meaning to me. I don't care what the return is when compared to the purchase price since I didn't put up the full purchase price to acquire the property.

If I am to look at the ROI of my investment property after 1 year, I need to take into account the total amount I've invested in that year (down payment, mortgage payment for the year and all associated expenses for that year) and compare it to the effective rental income. I.e. divide the effective rental income by everything I have invested during that year. Isn't that my true ROI (ignoring any appreciation or depreciation of the property)?

I'm wondering if any of you are willing to share your spreadsheet analysis on how you calculate ROI and why you use the method that you do. I have attached mine. But again, this uses capitalization rates and net returns based on the purchase price.

I'm more interested in the ROI based on the amount invested upfront. In other words:

(Net Cash Flow from rent) / (down payment + finance payment + all expenses)

And lastly for the long time investors, what ROI meets your criteria for pulling the trigger on a property?

https://docs.google.com/spreadsheet/ccc?key=0AqeJiYMCktN-dC0zcFppdFYxVnd0cWFVTlJnZ0RkMmc#gid=0

#housing

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1   Patrick   2012 Dec 1, 5:22am  

You're talking about leverage to increase your returns.

That works, but at the expense of increased risk. Even a small decline in property values can wipe you out all your returns if you're highly leveraged. Or a small increase in interest rates could be nearly as bad.

2   BayArea   2012 Dec 1, 5:27am  

Patrick, I'm not sure I am following you.

What's being leveraged here more than any financed real estate investment out there?

Also, gold star if someone can study my spreadsheet and shed some light on the following:

My example shows what most people would consider a decent real estate rental investment. It shows a 9% gross return, 6.5% cap rate, and 2% net return.

Now, even with a 2% net return, I'm eventually going to get my gross rental income taxed! Yes, the mortgage interest, depreciation, repairs, etc can be deducted. But once I get taxed on that $26,400 rental income tax, won't it completely wipe out any of my gains?

Can someone explain to me why my spreadsheet example would be a good investment?

3   Patrick   2012 Dec 1, 7:06am  

BayArea says

Patrick, I'm not sure I am following you.

What's being leveraged here more than any financed real estate investment out there?

If you are borrowing money to make an investment, that's using leverage.

If you own your investment outright, that's zero leverage.

As Warren Buffet says: the only ways that rich people get poor are "liquor and leverage".

Leverage means DANGER that you can lose way more than you put in. Buying stocks are margin is a good example. If you borrow to buy, you can easily lose all your capital and then some. But if you own the stock outright, your losses are limited to what you put in.

Think of it this way: if you can increase your ROI using borrowed money, there is an equal and opposite chance of losing that much more as well.

4   taxee   2012 Dec 1, 10:45am  


As Warren Buffet says: the only ways that rich people get poor are "liquor and leverage".

He forgot about cleavage.

5   taxee   2012 Dec 1, 10:52am  

The Professor says

maintenance costs, deadbeat tenants, and declining rents. Plus the fact of consumer inflation and stagnant wages.

Just a little counter party risk living in your depreciating asset with a pit bull and a gun. Let's hear it for the rentier class.

6   REpro   2012 Dec 1, 2:55pm  

Here are my suggestions to your spreadsheet:
1. In initial expenses add :closing cost plus make ready costs
2. Reduce income by loss to vacancy (typical 5%) but vary from market
3. Operating expenses 10% are fine if you manage by yourself, knows how repair and house is very young (no older than 10 years)
4. In income side add yearly principal reduction

Professionally IRR is calculated which include also holding period, yearly increases and sales costs.

7   stanpownall   2012 Dec 2, 7:18pm  

I agree with REpro about ROI calculation but as we see that is not the only metric used by all investors. That is an individule choice. My approach is to look at ROI and cash return both in todays marked and at brreak even cash fkow with rents reduced by 20%.

Between stagnent wages, a topsy-turby world and the Socialist Republic of California I expect the California market to decline further over the next five or more years as companies and people leave Califiornia.

8   REpro   2012 Dec 3, 1:27am  

stanpownall says

Between stagnent wages, a topsy-turby world and the Socialist Republic of California I expect the California market to decline further over the next five or more years as companies and people leave Califiornia.

I feel more confident investing outside of CA, where businesses and people flock. Unless it’s a killer deal. CA may become next Greece for US. Many current investors in CA are short term minded.

9   BayArea   2012 Dec 3, 10:15am  

Interesting. What is the max depreciation rate/amount that may be used in CA, anyone know?

10   RentingForHalfTheCost   2012 Dec 3, 10:23am  

robertoaribas says

If you bought a cheap home that you could afford,

As if these people existed. Get real.

I went by a highly congested area of the bay area freeway system today in rush hour. For 55 cents you can use your fast-track to jump in the commuter lane and save yourself about 10 minutes of bumper to bumper. As I was cruising 60mph past stopped cars of all kinds (BMW, Lexus, Porche, Mercedes) it was a good reflection of what is happening. Everyone is so leveraged to get into that 1m+ home that 0.55/day is valuable to them. This can not end well folks. Stay tuned and get prepared.

11   David Losh   2012 Dec 3, 11:08am  

Let me interject a little something that kind of got mentioned, but glossed over.

Will the property hold value?

You may be getting a great return on a property that is less than desirable. Some investors buy these with an LLC and when the going gets tough the property, or properties, go back to the bank.

That is something we experienced in 2008, 2009.

So, are you buying some one else's problem, and hoping to make it work?

Do you have an exit strategy?

When you sell, if you sell, or if you have to sell, will the value be there?

12   David Losh   2012 Dec 3, 11:28am  

E-man says

make money when I buy

To buy what you can sell that day for a profit which includes all fees, coming in, and getting out, used to be my rule, but that has changed.

That is exactly the problem today, is what can you sell without taking a loss?

If your return on investment is only tracking the 2% appreciation figures, you're kind of screwed.

13   RentingForHalfTheCost   2012 Dec 3, 12:21pm  

robertoaribas says

yes, you cannot discriminate based on family status, age, religion, race, color, country of origin or sex.

Just don't rent to a gay caucasian divorced 50 yr old male that preaches Scientology. His movies suck. Outside, of that do what Roberto does. Focus on the possibility of rent payment. ;)

14   REpro   2012 Dec 3, 1:16pm  

BayArea says

Interesting. What is the max depreciation rate/amount that may be used in CA, anyone know?

Depreciation is calculated on improvement value not land value, which in CA can be substantial. Example: You purchased house for $300K, land value is $120K. You will depreciate yearly $180K/27.5=$6,545, straight for 27.5 years.
Land lording is a business so most states also keep tax hand open. E.g. in CA you will pay min. $800/y to state and $150/y to San Jose city, regardless if you make a dime of profit or not.

15   BayArea   2012 Dec 3, 1:36pm  

RentingForHalfTheCost says

I went by a highly congested area of the bay area freeway system today in rush hour. For 55 cents you can use your fast-track to jump in the commuter lane and save yourself about 10 minutes of bumper to bumper. As I was cruising 60mph past stopped cars of all kinds (BMW, Lexus, Porche, Mercedes) it was a good reflection of what is happening. Everyone is so leveraged to get into that 1m+ home that 0.55/day is valuable to them. This can not end well folks. Stay tuned and get prepared.

Perhaps. Or maybe it's because they don't know about the program. I certainly didn't until I read your post above. With $4.50/gal gasoline, I don't think those luxury car owners are as set on saving that $0.55 as you seem to think.

SFace says

From my perspective, you rent to who you want, just never say it.

That's what I was getting at. Although the laws may exist, who is going to prove that I didn't rent out my property to someone because they were black and not because of another reason like I didn't like their credit score or their reference wasn't convincing enough.

David Losh says

Will the property hold value?

So, are you buying some one else's problem, and hoping to make it work?

Do you have an exit strategy?

When you sell, if you sell, or if you have to sell, will the value be there?

I guess this comes down to whether you believe the market has hit bottom or still has a ways to fall. Most reasonable people at this point believe we are not far off from the bottom, and perhaps even have seen in in certain areas. The usual perma-bears will disagree I'm sure.

If the rent is conservatively 2x or more of my mortgage payment + prop tax, then I'm all for it, regardless of whether or not I believe that there is an appreciation upside in terms of equity around the corner. If I am cash flow positive, my risk is minimized.

Exit strategy? If I'm cash flow positive, an exit strategy isn't as critical for me.

16   REpro   2012 Dec 3, 1:36pm  

BayArea says

Somehow that weather and the coastal views have always kept people stretching themselves to be here.

...and just before Jan.1 they should start practice: “bread is meat”, “less is more”.
No wonder why big investment firms focus investment on the smallest and cheapest houses.

17   REpro   2012 Dec 3, 1:47pm  

My rental criteria are written on an application, period.

18   BayArea   2012 Dec 3, 1:48pm  

Roberto, when the smoke clears I'm as fair as you are and just trying to get some perspective on the topic. Nothing more, nothing less.

19   BayArea   2012 Dec 3, 2:03pm  

good point as vacancy can absolutely obliterate gains.

20   REpro   2012 Dec 3, 2:25pm  

Only three states out of 50 are true champ in population growth: CA, TX & FL, where TX & FL have no state tax.
https://www.google.com/publicdata/explore?ds=kf7tgg1uo9ude_&met_y=population&idim=state:06000&dl=en&hl=en&q=california%20population#!ctype=l&strail=false&bcs=d&nselm=h&met_y=population&scale_y=lin&ind_y=false&rdim=country&idim=state:06000:48000:12000&ifdim=country&hl=en_US&dl=en&ind=false

21   REpro   2012 Dec 3, 3:00pm  

SFace says

Partnership and sole proprietor does not have the tax since it is not separate legal entity

As long as schedule C appear in your income tax return, you are in busines. Business pay taxes.

22   RentingForHalfTheCost   2012 Dec 3, 11:37pm  

robertoaribas says

ok, fair enough. You know, you rent to a family with small kids, they move in, the kid makes friends in the school... you could have just got yourself 5 or more years of no vacancy! worth the gamble of some spills in the house, in my opinion!

As long as you are not favoring the family with small kids. That would be discrimination against the rest of the applicants. ;)

You find me someone who truely doesn't discriminate, and I'll show you an appreciating house.

23   David Losh   2012 Dec 4, 12:11am  

BayArea says

If I am cash flow positive, my risk is minimized.

There is a lot here in this thread that is kind of alternative universe. Small rental investors have several problems today that were low risk before 2006.

Number one rents are too damn high, and number two is that property prices have stabalized. Stabalized is very different than hitting bottom.

Property prices are propped up by massive government interference. We all know that, but ignore it. That's not perma bear talk, it's a fact, and you really have no idea where property prices will go now that the President has been re-elected, or that Congress has other things to do.

Just because you have cash flow doesn't mean you are making money. Real Estate is an over all package.

24   David Losh   2012 Dec 4, 12:12am  

E-man says

set up a LLC

People set up LLCs so they can walk away from the property if they need to. You saw a ton on that in 2008.

25   David Losh   2012 Dec 4, 1:28am  

robertoaribas says

rents are too high.

I don't see where inflation happened, or will happen. I see massive speculation in commodities due to these historically low interest rates, and increase in corporate profits, and massive cash reserves, but I don't see inflation.

As a matter of fact I would say, even with China moving ahead as a trading partner, that the United States is a very safe haven for money. We have a stable government, low taxes, and are very business oriented.

Where would you want your money?

What I would say is that investing in corporations may be a safer bet than housing units. I think housing is being over run by huge corporations that have plans for each community.

robertoaribas says

that is propped up?

Yes, that is propped up. In a true foreclosure market properties sell for cheap. It depends on the property, and depends on the location, but no, I don't call $80K in Phoenix cheap.

robertoaribas says

Actually, cash flow means you are making money

No it doesn't. You can cash flow all day long, and lose money.

robertoaribas says

People set up LLC's to limit their liability

Like with the mortgage. Your renter is an insurance issue, and you are pointing out correctly an LLC does very little good for the majority of people.

Sorry, Washington is a non recourse State.

26   BayArea   2012 Dec 4, 7:25am  

David Losh says

Property prices are propped up by massive government interference. We all know that, but ignore it.

Do you know who just got re-elected? Mr. Artificial Prop himself. Sure, prices are being propped up to some degree, but that's not changing anytime soon. So what's the other thing that can have a heavy handed influence on prices? Interest rates. I can't see those budging much either.

I'm not sure I stand to gain much by waiting around for artificial props to subside, our accounting laws to change forcing banks to unload foreclosures right away or realize loses immediately, or for interest rates to rise...

27   David Losh   2012 Dec 4, 8:00am  

BayArea says

Do you know who just got re-elected?

President Barrack Obama just got re-elected, and he is the one that saved our economy by borrowing massive amounts of money.

Well, I think the long term strategy is to get the Republicans out of the House, and have a super majority that can fix a lot that went wrong.

One of the things that went wrong was banks having control of the housing market.

The shift is, with our government buying up Mortgage Backed Securities at the rate of $40 Billion per month, soon to be $80 Billion per month, control of the housing market transferring to the government.

You don't like it? You say you would rather have banks dictate the terms of the housing market?

Well, get used to it.

Corporations will play nice, money will be made, and housing will go back to that sleepy little payment you make each month for a place to keep your crap.

28   RentingForHalfTheCost   2012 Dec 4, 8:10am  

robertoaribas says

6 more years like that, and i'll have precisely $0 of my own money out there, and still own the properties... care to explain the big risk of that to me?

The risk of not getting 6 more years like that. ;) 1 year of a gov't that doesn't buy its own bonds to pay itself and your properties lose 25% and you have a hell of a tenant retention problem. Add to it, your properties tax bill keeps coming, as well as maintenance. There is always risk, the trick is to manage it. From your writings, I think you have managed yours well, but that doesn't mean you are not worried. I know many bay area owners/investors that were not so smart.

29   Mobi   2012 Dec 4, 10:16pm  

David Losh says

The shift is, with our government buying up Mortgage Backed Securities at the rate of $40 Billion per month, soon to be $80 Billion per month, control of the housing market transferring to the government.

The entity who buys the $40 billion MBS per month is called Fed, which is a semi-government BANK. Don't you know their committee are mostly made of bankers? At this point, the interests of the federal government and the big banks are so interwined so I won't bother to seperate them.

30   David Losh   2012 Dec 5, 12:33am  

Mobi says

the interests of the federal government and the big banks

Yeah, banks have relied on governments globally to continue those profits. We all borrow money. Our government is borrowing money to buy Mortgage Backed Securities.

Who's in charge now?

Banks have run rough shod over the global economy for thirty years, and from my point of view they cashed out in 2008.

I look at Barrack Obama as a smart guy. He could have crashed the economy, blamed the Republicans and put us into default. He didn't. He borrowed, and every body was happy to play along. Barrack Obama has propped up the entire banking system ever since, but it means nothing to what is coming.

Consumer debt is neck, and neck with our federal deficit. Consumer spending makes the world go around. There is no China without consumer spending. Europe is trashed, Russia is suffering, and those emerging markets are getting hip to the fact they will never be able to repay what they have borrowed.

What's a banker to do?

The bank will play ball with whatever hair brain idea Obama comes up with next. I think that housing will languish as other things take a bigger role in our economic future. People will get a chance to pay off debt, and banks will agree with that as a survival mechanism.

31   Mobi   2012 Dec 5, 1:13am  

robertoaribas says

you don't know what you are talking about... People set up LLC's to limit their liability, say a tenant gets hurt and sues them, the tenant is renting from the LLC, and could only attach the one property. (unless they pierce the corporate veil, which is much more common than the llc gurus talk about)

Very interesting comment here. Obviously, landlords try to set up LLCs to limit the liability. But let's say you have a house under a LLC and you still go into the house to do repairs YOURSELF. If something happens and the tenant takes the legal action, can you really shield yourself through the LLC?

32   Mobi   2012 Dec 5, 1:18am  

David Losh says

The bank will play ball with whatever hair brain idea Obama comes up with next. I think that housing will languish as other things take a bigger role in our economic future. People will get a chance to pay off debt, and banks will agree with that as a survival mechanism.

I kinda agree with you. They still work with each other now but time will come when government wants to take full control and use some unorthodoxical methods to "solve" the problem (before it melts down) and banks will have to go with that. But I am not as optimistic as you that they will make the "right" choice. I guess we will find out.

33   FortWayne   2012 Dec 6, 1:04am  

Just be careful with your depreciation deductions, they do have to be legitimate.

34   FortWayne   2012 Dec 6, 1:06am  

Mobi says

Very interesting comment here. Obviously, landlords try to set up LLCs to limit the liability. But let's say you have a house under a LLC and you still go into the house to do repairs YOURSELF. If something happens and the tenant takes the legal action, can you really shield yourself through the LLC?

It will not protect you from a lawsuit. Having an LLC does not give a person free reign to do as they please. Members of any Limited Liability type of enterprise are still held responsible for their own actions, especially the owners/directors of an LLC since they are responsible for all the debt of the venture even in case of bankruptcy.

The limited liability part here is only if you are a small shareholder, your liability is only what you put into the company. For example Roberto creates an LLC, and you come in as a minority partner and invest 5,000 into it... you'll only be liable up to 5,000 if the LLC screws up. If you do something bad on your own, that limit no longer applies.

35   Mobi   2012 Dec 6, 2:20am  

FortWayne says

It will not protect you from a lawsuit. Having an LLC does not give a person free reign to do as they please. Members of any Limited Liability type of enterprise are still held responsible for their own actions, especially the owners/directors of an LLC since they are responsible for all the debt of the venture even in case of bankruptcy.

Very good points. If I were to own several LLCs and one of them screws up, would the liability spreads through other LLCs?

36   Mobi   2012 Dec 6, 2:24am  

E-man says

Anyways, people keep setting up LLC for the wrong reason. The attorneys, state and CPAs get to make money while the people don't get any protection.

I am thinking about setting up LLCs but these are exactly the things I am afraid. Where can I find good/objective advides besides CPAs/attorneys?

37   FortWayne   2012 Dec 6, 2:48am  

Mobi says

FortWayne says

It will not protect you from a lawsuit. Having an LLC does not give a person free reign to do as they please. Members of any Limited Liability type of enterprise are still held responsible for their own actions, especially the owners/directors of an LLC since they are responsible for all the debt of the venture even in case of bankruptcy.

Very good points. If I were to own several LLCs and one of them screws up, would the liability spreads through other LLCs?

No. But if you are personally liable for something, LLC's don't matter. It is still you that will be liable, not the LLC.

38   FortWayne   2012 Dec 6, 2:53am  

Mobi says

I am thinking about setting up LLCs but these are exactly the things I am afraid. Where can I find good/objective advides besides CPAs/attorneys?

Talk to a CPA, you have to have a good reason for an LLC. A good CPA should explain to you the advantages and the costs of an LLC. Usually just to rent out a house an LLC is a waste of money.

39   David Losh   2012 Dec 6, 10:38am  

For God sakes, builders set up LLCs, as do investor groups. In theory there is cash flow, and assets to cover losses.

In 2008 everything stopped, and hundreds, if not thousands of LLCs defaulted.

If you have onesy twosy kind of thing going on, it's not worth it.

40   David Losh   2012 Dec 6, 11:37pm  

E-man says

If no, then why bother.

Exactly.

However some investor groups get together with a hair brain idea, or two, that they want to seperate out from the family home.

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