“I am looking to buy my first rental property, a duplex with $1,500 per month income. Asking price is $92,000. When calculating a purchase price, should I consider the return I could get investing the $92,000 (even though most of it would be borrowed) or should I consider the return on my ‘real’ investment, the 10% I put down. I’m up here in Burlington, VT” – Steven Polli
I think you need to look at it a lot of ways. Ultimately, the numbers an accountant would look back on in figuring your success or failure would be the after-tax results from ‘operations’ each year, plus any gain or loss in the value of the property along the way, as a percentage of your “real” cash investment. When mortgage rates are low, as today, this is the leverage that can make real estate so attractive. Say you get the property for $88,500, putting down $11,000 in cash plus closing costs. And say the $18,000 in rent rolls in without complication each year (maybe even inches up over time). And that mortgage interest, property tax, insurance, repairs, and large allowances for having to repaint, reroof, reboiler, repair (redundant, but trust me, justifiably so) add up to $14,000 a year. You are left with $4,000 on your $11,000 investment — and because you will depreciate the property over 27.5 years, part of that is tax-deferred.
(You don’t depreciate the full purchase price, because the land it sits on is worth something and not depreciable. But say you assign $33,500 to the value of the land and $55,000 to the structure — that’s $2,000 a year you get to depreciate for the next 27.5 years. The depreciation lowers your taxable profit by $2,000 each year, though it simultaneously lowers your ‘cost basis’ by the same $2,000 a year, increasing your taxable gain when you eventually sell the property, if you do.)
So the numbers could look great. Close to a 40% return on investment ($4,000 on $11,000) — half of it tax-free (well, tax-deferred). And that’s before allowing for the 3%-5% a year or even more the property might appreciate in value.
But hang on. In the first place, you’re risking more than your downpayment. It’s conceivable the property could go down in value, not up, with you on the hook for the difference. More to the point, don’t compare the 15% (say) you figure you might earn on this annually to 15% from a simple passive investment like shares of some unusually successful stock. You need to be paid for the work! The hassle! The extra paperwork and tax preparation! Sometimes these things go very smoothly (although they are still work) but sometimes not. Owning rental property is more of a part-time job than an investment. How would the numbers work if you decided to charge a phantom $5,000 a year for your work and worry?
So you want to be very conservative in your estimates. You want to be sure you’ve thought through how you’ll handle the accounting, the lawn care, the plumbing problems, the roof leaks, the feuding tenants, their late payments, the eviction process if need be — and so on.
Today’s low interest rates may offer you a good opportunity. And the kind of property you describe does not sound terribly difficult or risky. But I’d look to get a very attractive return and, for sure, a positive cash flow after all costs and repairs (and an allowance for periods of vacancy) before going into this.
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