Net Worth Challenge

I usually look at four numbers that make up the total monthly expense of a rental property: (1) mortgage payment, (2) property taxes, (3) home insurance, and (4) improvements/repairs. Note: all numbers below have been rounded up to the nearest dollar

1. Mortgage Payment — We are financing our property with a fixed-rate, 30-year loan. We intend to make a 20% down payment and will finance the remainder. The interest rate is 6.50% and there are no points to pay on the closing date. This means that our loan with the bank will be $73,600 and our monthly payments will amount to $466.

2. Property Taxes — The property has an assessed value that is higher than the contract sales price. While this may not typically mean much, in this case we have a good amount of evidence (sales price, appraisal, comparables in neighborhood) to appeal the assessed value from the county. I’ll talk about this process in the coming months as I prepare my appeal. For these purposes, however, I’ll assume that yearly property taxes will equal the amount paid last year, which was $1,400. This amounts to a monthly payment of $117. My wife and I do not have to escrow this payment, but each month we intend to add it to our money market account to earn interest before the property tax payment is due at the end of the year.

3. Home Insurance — I did not do much shopping around for home insurance on this property because of time issues and the rapid approach of the closing date. Therefore I purchased a policy from our regular homeowners and auto insurance company, which is State Farm Insurance. Our yearly premium is $379, which amounts to a monthly payment of $32. My wife and I do not have to escrow this payment, but each month we intend to add it to our money market account to earn interest before the homeowners insurance payment is due.

4. Improvements/Repairs — Even if the property is brand-new, there will still be periodic improvements and repairs that need to be made. I put aside money each month into an “improvements/repairsâ€? fund for my rental property. Through my own calculations I have determined the need for $77 a month into this fund.

Adding these four amounts together gives me a total monthly expense of $692. At the very, very least I will need to rent the property for this amount. I have every intention of listing it for a higher price and I believe the neighborhood can support a monthly rent of $830. At that rental amount, I would have a cash-flow of $138 per month. My cash-on-cash rate of return for the year would be 7.89%, assuming full rental throughout the year. If I included the principal paydown, which is the amount of the bank loan that gets paid off each month, my rate of return for the year would be 11.77%. Please note, I’m using my down-payment PLUS anticipated closing closes when determining these rates of return.

Cash-Flow Profit per Month:
$830 rent - $692 monthly payment = $138 cash-flow

Total Cash Investment:
$18,400 down payment + $2,600 closing costs = $21,000 cash investment

Cash-on-Cash Rate of Return:
($138 cash-flow x 12 months) / $21,000 cash investment = 7.89% return

Rate of Return, including Principal Paydown Numbers:
(($138 cash-flow + $68 monthly principal paydown) x 12 months) / $21,000 cash investment = 11.77% return

There are three key elements I’m leaving out of my calculations. The first is that I’m assuming full rental throughout the year. In reality, this will not always be true. To come up with more accurate numbers, I should assume a certain level of “vacancy” in the rental property. This would LOWER the rates of return listed above.

The second element is that I’m not taking into account potential appreciation of the rental property. The home should appreciate in value over time. Eventually, when my wife and I decide to sell the property, we will be able to “cash in” on that appreciated value. However, for our regular purposes of renting the property, this element does not affect us much. If we were to estimate a certain level of “appreciation value” in the property, this would INCREASE the rates of return listed above.

The third element is the effect on my wife and my income tax return.  Having a rental property gives us several benefits during tax-time that effectively lower the cost of having and running the property.  If I were to include these benefits in my calculations, this would INCREASE the rates of the return listed above.  However, as the rental property begins to generate positive income after all the expenses are taken care of (and yes, this includes depreciations since we’re talking about income tax returns), my wife and I will have to pay taxes on those profits.  If I were to include these benefits in my calculations, this would LOWER the reates of the return listed above.
Well, there you have it. Those are the base numbers for this rental property. As you can see it is difficult to get a definitive rate of return calculation without making some assumptions.  For this rental property and this neighborhood, I am making certain assumptions that I may not make with other properties — mainly my confidence in keeping it rented the entire year.  I’m sure I’ll have more discussions on this in the future, but for now, wish my wife and I luck as we go into our closing date for this new property!!!