Case Study: How My First Rental Property Returns 40% Annually

Case Study: My First Rental Property Yields 40% Annually

Dude, did you see that title? My rental property yields 40% annually. Pretty crazy huh?

Sound too good to be true? Let’s break down the numbers and show you how in this first case study of Blue Spark Investments. In the future we will be bringing you more case studies on investment properties we’ve purchased or analyzed to help you grow as an investor by analyzing these deals with us and seeing how the numbers work. It will boost your confidence in how to find a good deal. It will help you pull the trigger and jump into real estate investing if you’re on the fence.

How in the hell do I make 40% annually from a rental property?

I grew up in the Midwest, and more specifically, I grew up in Northern Indiana. Home prices in my city lag the national average when it comes to price appreciation but what do you expect. It’s the Midwest.

I don’t purchase my rental properties for price appreciation.  I buy them for the cash flow they produce. My goal in life is to retire early and live off the cash flow income that my rental properties provide. I’ll never have to touch the principal like someone would investing in the stock market.

In the Midwest, I target properties that produce $500 a month in cash flow from a $30,000 investment.

Do the math and you’ll get an annual cash flow of $6,000 on my investment of $30,000 for a return of 20%. Pretty good right? Yes, slowpoke, divide $6,000 by $30,000 and the math says 0.20 or 20%

But wait..

That’s not 40% annually?

Right.

That is my target when I set out hunting for investment rentals to invest in. The property I bought at age 20 was a better deal than my target goal, hence why I’m making double my target return of 20%.

For my first property, I partnered with my father who is a long time investor in rental property in my city and works full time as a real estate broker. He’s in the market daily and sees properties come and go.

What a great resource to have right? You need a realtor on your team to help hunt for properties for you to save you the time especially if you’re new and would rather a professional bring you properties to analyze.

This turned out to be such a good deal that of course my father wanted a piece of the pie and we decided to partner on it 50/50.

The house was 1,800 square feet, 2 stories, 4 bedrooms, 2 bathrooms, and had a garage.

Can you guess the purchase price?

$30,000.

It’s ARV, After Repair Value, which it could fetch from a home buyer on the market once all fixed up was $75,000. In other words, we got this house for a steal at $30,000 which is more than 50% off its market value.

So why would someone ever sell a house this cheap?

That’s the beauty of real estate investing. There are motivated sellers out there who have different needs and problems that you have to solve for them. In our case, the owner was a landlord and this property was being rented by his long term tenant for a rent well below market rents. He wanted out of the landlord business and decided not to fix up the property before selling it. He was content selling the house for a cheaper price to get out of the business and not have to deal with the headaches of evicting a tenant and the costs of repairing the property. Who knows what unexpected surprises he would have found that would have cost him an arm and a leg.

So to the landlord, it made sense to just stick a low asking price on the house and hope another investor came buy and bought it off him with cash and quickly.

My father, as a real estate broker, heard of this property being listed for sale and jumped on it for us.

We determined its ARV of $75,000 and rent comps in the area were about $900. We ended up getting $925/month from the tenant who currently rents it to this day.

I knew it was going to be a good deal right away because it fit the 2% rule for analyzing rental properties which states that you should aim to rent your property for 2% of the purchase price. Two percent of $30,000 is $600/month and we were clearly going to achieve an even higher rent than that placing us at almost 3%.

But you can’t forget repairs, aka, the renovation to clean the house up. The old tenant was renting for $450/month and the house condition justified why the landlord wasn’t raising rents on his tenant. But if we wanted to charge a new tenant $900/month this place would need to be fixed up and livable.

Plus by renovating the house, we would create forced equity into the property which is simply the Market Value of the house minus our total costs to purchase and fix up the house.

Renovations cost us about $10,000 as we did many of the fixes ourselves and only outsourced a few things like electrical updates and refinishing the hardwood flooring.

We had purchased a home warranty on the house so we got to replace several things much cheaper than if we had to buy them all on our own without the warranty payment assistance.

One of the items we bought under warranty included a new water heater, which can run $800 brand new without the warranty.

Overall, we were into the property for roughly $37,000 by the time we had it ready to rent. This included the $30,000 purchase price and $7,000 in renovations. The remaining $3,000 of our $10,000 was set aside for the roof repairs at a later date. All in cost, $40,000 for investment analysis purposes.

Analyzing This Rental Investment Property

Okay so now you’ve seen the basic numbers and processes of this property. Let’s get into the actual number crunching and show you how the math works out.

We start from the top of the Profit & Loss statement and work down.

  • Rent: $925/month
  • Vacancy: $0/month
  • Taxes: $50/month
  • Insurance: $80/month
  • Property Management: $0/month
  • Repairs: $25/month
  • Net Income: $770

Rent: We are getting $925/month and will likely raise rents in the future to further increase our cash flow. The most recent rent comps show we could get $950-$1,000 if we want to.

Vacancy: It’s a single family home that is rented out to a tenant so there is no vacancy expense. Sure you could stick one month in for kicks and giggles but being real, it’s occupied.

Taxes: Luckily property taxes in the Midwest are fairly cheap and this property was purchased at a low price so the new taxes on it didn’t change much.

Insurance: Pretty straightforward. Pay around $1,000 each year for the policy.

Property Management: We self-manage all investment properties our family has thanks to my father owning several and managing them for years as well as for other out of state investors. This makes my income truly passive each month which is the lifestyle I’m after! Otherwise, property management would be one month’s rent and take $77/month (10%) off our cash flow.

Repairs: These are very minimal since we just completely updated everything in the house before renting it out to the tenant. Of course there will be unexpected things that pop up which is why I went ahead and budgeted $25/month and $300 total for the year in repairs. My father gets a lot of items at good deals and installs them himself to save costs of hiring.

Net Income: $770/month to be split between the two of us since we are 50/50 partners in this deal. This leaves me $335/month for my share of the net income and an annual income of $4,020.

Calculating the Return on Investment

When we bought the house for $30,000, you can calculate my 50% share of the cost to be $15,000. I already knew ahead of time we had estimated about $10,000 in repairs, which ended up being very accurate, and so I calculated my down payment based on the total cost this property would cost to get ready to rent, which was $40,000.

I decided I wanted to put 25% down and finance 75% on a loan. I put $5,000 towards the purchase of the property leaving me $10,000 to be covered by a loan as well as my $5,000 share of the renovation expenses.

So I’m sitting $5,000 into this investment, with a loan of $15,000.

My loan payment is $140/month and we won’t get into the terms of the loan because it’s private financing. Being 20 years old when I bought this property, I couldn’t qualify for a traditional bank loan so I had to seek private financing which is proof for those of you who make excuses that you can’t invest because you don’t have money. Partner up with someone who does!

Back to the math..

Subtract the $140 per month loan payment from the $335 per month net income and you get a cash flow of $295 per month. Annually, this is $3,540.

How do you calculate return on investment in real estate?

To calculate return, you have to take the net cash flow total you end up with in your pocket and divide it by the amount of cash you personally invested into the deal out of your pocket.

In my case, my net cash flow after paying all expenses and loan payment is $3,540. My out of pocket cash investment was $5,000.

This gives me a return of 71% which far exceeds the 40% we mentioned in the article title.

Fooled you. But being realistic, there will probably be additional expenses not accounted for above which leaves me margin before I really am making 40% and no longer 71%.

This 71% is just the “dividend” return on investment. You also have to consider the fact that we were all in to this house for $40,000 and its market value is $75,000 leaving us $35,000 in equity. My share of equity would be $17,500 which is nearly 3.5X my investment of $5,000 so add that 350% return onto the dividend return of 71% and things start getting crazy.

They call these investment properties Unicorns.

I love rental properties for the cash flow. You can get a far higher return than you would from dividends in the stock market which pay a small 1-3% annually. Real estate pays a historical annual dividend of 9% if you use all cash, according to the historical cap rate and a Harvard professor who came into class everyday saying the answer on the final exam is 9. Read the Forbes article I just linked to.

Overall, realize that cash flow is completely independent of the increase in a home’s value when investing in rental properties. Appreciation is like icing on the cake but we don’t invest for it. We invest in a house for the cash flow. The value of my rental could go up 30% or down 30% and could have no affect at all on my cash flow.

If there is a huge down turn in the housing market, it could cause lower rents. However, the housing crisis in 2008-2009 didn’t cause rents to drop significantly and the Midwest is a less volatile market unlike major cities who see houses and rents fluctuating at greater scales.

As long as I own the rental home, the cash flow keeps coming in. During a crash in the stock market, companies will cut staff and cut dividends to save expenses. In real estate, people still need a place to sleep at night and will rent from you keeping your dividend coming in. Lastly, as inflation goes up, so do rents and my income. When my mortgages are eventually paid off, my cash flow increases even more as well as my return.

I hope this article gives you some motivation to jump into real estate investing and shows you the comparison between stocks and real estate. If you want further proof as to why I advocate investing in cash flowing real estate instead of the boring stock market check out these articles:

  • Article 1
  • Article 2

As a farewell disclaimer, my results are not typical. This was a unicorn property and they do not come very often but if you have good knowledge of your market you can find undervalued investments out there that exist. As high as my returns were, you can still find other investments with 15%, 20%, and 30% annual returns if you search for them.

The number one key is the purchase price! When you get into a property cheap, the return is high. The more you spend, the lower your return since return is based off your initial investment into the property. Find motivated sellers who will sell their property at deep discounts and you’re off to a good start.

Use these rules of thumb to analyze rental property:

  • The 2% Rule: How to Determine What Rent You Should Charge
  • The 50% Rule: How Much Should You Estimate for Expenses

 

Be great, study hard

Nick Foy

2017-11-15T08:15:16-04:00