The Reality of Real Estate (Part Two)

As noted in my blog from two weeks ago, (http://knwm-llc.com/reality-of-real-estate/) I am under the impression people tend to ignore real estate when thinking about their investment portfolio.  My prior article focused on the factors to consider in the case of a family’s residence. In this article I’ll discuss the starkly different world of investing in rental real estate.  I will detail what I think are the main points for consideration but the bottom line is this:  I believe people need to think about investing in rental real estate as a small business.  And as the Wall Street analyst in me will tell you, with a business you need to start with a focus on cash flow.  After nailing down a solid cash flow model, we then need to consider the more abstract but maybe equally important issues that folks should consider- those being your “hourly rate” and liquidity.  In short, I think there are advantages and disadvantages to the rental real estate investment model.  However, after netting these factors all together, I believe it is usually not in the best interest of families to use tangible, rental real estate in a significant portion of their portfolio unless they are will to put forth substantial amounts of time & effort to run what is at the end of the day, a small business.

Part 2: Rental Property

As noted in the first installment of this two-part series on real estate, when most people think of investing or their financial plan it is usually within the construct of the “portfolio”.  By most accounts, the concept of “the portfolio” usually pre-supposes some mix of stocks, bonds, mutual funds and other securities currently housed in various accounts.  But what must be considered in a family’s “portfolio” is the relative balance of real estate, not only on the family’s “income statement” (or more importantly, cash flow statement) but also their balance sheet.

While rental real estate is different than residential real estate, one thing in common is its ability to hedge inflation.  To summarize from my last blog, leveraged real estate usually acts as an effective hedge against rapidly rising inflation.  This is critical to balancing the total portfolio as I believe real estate acts as a decent buffer and offset to elevated inflation which typically has a negative impact on fixed income and sometimes equities.  We can certainly put this in the “advantage” column but only if a family is not already properly hedged with their residential real estate exposure, which serves the same inflation hedge purpose.

With that commonality aside, let’s dig into the issues with rental real estate:

Cash Flow Model:  When considering a future investment or analyzing the viability of an existing investment, I believe the clarity derived from a simple cash flow model usually helps make this a truly “bottom line” decision.  This can be done with a simple pencil and paper and does not require a fancy spreadsheet.  Basically, we are trying to reconcile cash flowing in versus cash flowing out.  We can first start with the positive side of the ledger – the cash coming in from our monthly rent checks.  We then subtract all the expenses.  In its simplest form, the equation would look something like this:

+ Rental Income

– Mortgage (principal & interest)

– Insurance

– Property Taxes

– Utilities (not paid by renter)

– Maintenance costs (landscaping, snow removal, manager costs if applicable)

    CASH FLOW YIELD

Of course there are tax implications to think about here also, including the deductibility of these expenses and depreciation expense but for now, I prefer to focus the discussion on what impacts a family’s checking account every month: cash flow.  So to put this in context on a rental property with a value of $300,000:  Let’s say the rental income for this property is $2,000 per month or $24,000 per year and expenses total $1,500 per month or $18,000 per year. That means this property is yielding a net of about $6,000 in cash value on an asset value of $300,000.  Said differently, the property is yielding about 2% in cash per year.  If we add in another 2% of property value growth, we could argue the “total return” is about 4% but again, that 2% return from property appreciation is not cash flow it is simply an estimate of the property value and as we all know, property value estimates can vary widely.  How do you feel about owning this versus a high quality equity fund yielding the same cash flow, with better liquidity and no day-to-day management?

An alternative method to derive yield is to use the denominator as the equity value (i.e. $300,000 property – $200,000 mortgage = $100,000 equity) but I prefer the more conservative method as the asset backing the loan has an uncertain value.  Finally, I would suggest an annual contribution to a separate rainy-day fund for large improvement projects (i.e. new roof, new furnace, etc.) but using the most simplistic model, we will set that aside for now.

Small Business:   As stated in the opening of this post, I believe a rental property should be viewed as a small business given the potential time & effort involved.  First, we need to consider the administrative work involved with the accounting and bookkeeping as described in the section on cash flow.  In addition, families need to consider how much time they will need to spend keeping the property in working order.  This includes commuting time, cutting grass, painting, repairing the proverbial “leaky toilet”, etc.  Keeping track of this time and dividing by the cash flow yield may lead to the conclusion that the $6,000 in annual cash flow (to use the above example) isn’t worth the 2 hours per weekend of work (for example) as this essentially means you are “working” for an hourly rate of $60 per hour.   Is your free time worth more or less than that?  Alternatively, you could decide to “outsource” these functions to a management company, but of course that expense cuts into your cash-flow yield.

In addition, one needs to consider the risks associated with finding and keeping good credit-quality renters.  This is no small feat.  Not only is there a credit risk from having to collect every month, one also must be concerned with a business relationship gone wrong and the permanent damage a disgruntled renter could do to a property before fleeing.  There’s also the legal entanglements of evictions, not to mention the stomach-churning decision to “throw out” a family with young children, which almost no one wants to do.

Liquidity:  Putting the financial hat back on, one must also consider liquidity of this asset in the portfolio.  Rental properties cannot be sold simply with a click of a mouse, like a high volume stock with sub-$10 commissions on the trade. As with a residential property, selling a rental property can take months.  If the owner were facing an immediate need for a financial emergency, this would mean either selling the property well below fair market value, having to sell other assets at less-than-desirable levels or having to tap into retirement accounts, with tax and penalty implications.  Again, if a family owned a $200,000 of equity in rental property with a $1,000,000 net worth, this means that 20% of their net worth is essentially illiquid.

Raw land = Speculation:  The last “financial” consideration deals with some people’s desire to own raw, undeveloped land.  I believe this is merely speculative bet and should not be employed unless a family has substantial liquid assets outside the property.  The reason is that raw land yields nothing except negative cash flow and an investor is essentially betting that the property appreciation portion of the asset will “someday” over-ride the annual cash flow burn (taxes, insurance, etc.) associated with owning this property as by definition, it has no rental income.  This is equivalent to owning a commodity like gold or copper (which yield no dividend or interest income) with two notable differences.  First, much like the comparison to owning a stock, there are no taxes and insurance to pay on that ETF (unless it is sold for a gain).  Second, it’s much easier to sell a gold ETF on-line than it is to pay a real estate broker a substantial commission and wait months for the property to sell.

So to wrap up- am I completely against owning real estate outside the residence?  No- I just think there are many other financial building blocks a family needs to have in place before pursuing this path.  In addition, folks need to enter this endeavor with their eyes wide open as owning rental real estate usually requires time & effort outside of the “day job”.  My “day job” is to ask those thought provoking questions and provide the proper context for where rental property falls in a family’s broader portfolio.  Again, this goes way beyond standard asset allocation as real estate investing can have a substantial impact on a family’s net worth.

One Comment

  1. I believe your article does an excellent job stating the reality (cash flow in return for headaches) for most individuals owning a single rental property with a mortgage. I would like to add that unless your renter is paying you cash and you are not reporting it to the IRS, you are on the hook to pay taxes on that rental income. You would be able to deduct mortgage interest on the rental property and the property tax but that may not equate to much on your bottom line tax bill. Good post. Thank you.

    Reply

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