Rental Properties & Breaking Even

11 Replies

Hi,

I am new to real estate, reading what I can, watching BP webinars, etc. I have yet to decide on the route of REI I want to take, but I'm positive it will be in the residential rental market.

I am having trouble grasping a concept and it may just be because I haven't read enough yet to have it click.

It seems it would take quite a while to break even. For instance:

House: $140,000

Total out of pocket: $40,000 (down payment, closing and rehab)

Assume a $500 cash flow, which, from what I have read seems like that is optimistic.

From those numbers it would take 6-7 years to break even. That's obviously assuming you don't take into account appreciation.

To me that's a long time to $40k, and if I want to do what I see so many other people say, buy one rental per year, that's a lot of cash being floated before you are in the black.

I have seen articles on cash out refinance, but you would still need to have enough equity built up to stay within the LTV for the refi, right?

When we are ready for our first buy, we will likely use our HELOC from our primary residence for the down payment, but pulling cash out of the rental to do the second buy would require substantial appreciation (in theory). Not to mention, it would compete with needing to pay the HELOC off.

Thanks for any insight.

@David Graham  how much are you expecting this $140k home to rent for?  If you follow the 2% rule it would need to rent for $2,800 a month. 

most investors use the compound strategy - buy low, rehab, either rent/sell. if you rent, use cash out refi to pull what you put in, and repeat.

instead of cash flowing $500 on a house, they cashflow $200 after refi, but when they have 10 houses, that's $2,000.

get it?

$500/mo x 12 months = $6,000 net income

$6,000 income / $40,000 investment = 15% return + appreciation + principal reduction + tax benefits

That will be a tough return on investment to beat with any other asset class.

Getting the $40,000 back in cash is not breaking even, it is doubling your money.  You still have the original $40,000 in equity and now have $80,000 in net worth (excluding the principal reduction).  $40,000 compounded at 15% per year = $1,145,000 in 25 years.

You mention rehab...if you are rehabbing, you likely will increase the value of the house beyond your purchase price of $140,000.  Let's say for conversation sake that the value increases to $150,000:

$10,000 + $6,000 income / $40,000 investment = 40% year 1 return + principal reduction + tax benefits.

Many BP investors purchase, rehab and refinance all of their original investment out of the property right away and repeat the process (i.e. use the same $40,000 over and over again).

Hope this helps.

@David Graham , what you really need to do is to do your numbers very carefully.  That will help you see what is a good deal and what is a bad deal.  There are a lot of ways like cap rate.  What would your return be if you paid cash, then deduct your expenses and see what you net is at the end of the year.  Ex.  Buy house for $80K then put $20K into repairs, rent it for $1K a month, and have annual expenses of $3,600, so net income is $8,400 so a cap rate of 8.4.  Cap rate is usually only used for commercial, this is just an example.  Another way is cash on cash return.  Buy a house for $80K, put $20K in fix up, but you only put $16K down, so your total outlay is $36K.  You have a 30 year mortgage at 4% so your monthly payment is $382.  Same rent, same expenses, deduct $4,580 for mortgage payments, and your net is $3816.  Your total outlay is $36K results in a percentage return of 10.6%.  Your money earned a 10.6% return.  If it was in a CD you would earn about .04%.  Plus you earned about $1,400 in principal paydown.  You hopefully have a property that has a decent chunk of equity, lets say it is worth $120K, and hopefully it will go up in value every year.

Returns vary a lot from one area to another, just like sale prices and rental rates.  After one year of renting you should be able to refinance to 80% of value, so say $96K, so you can get $36,400 out to use for your next purchase.  You only owed $64K since you put down $16K, and you paid your mortgage down $1,400 in the first year.  So $96K -$62,600 = $36,400.  You only had $36K into it.

Now your payments jump up to $458 per month, so you only made $2,904 this year, or about $240 per month.  Now there is a broad rule that your expenses run about 50% of your rent, so actual expenses could be $6K per year or $5K per year etc.  If expenses are $5,600 per year you get a cap rate of 6.4%, a cash on cash of 5% because your net is $1816, or $150 per month.  If you refinance you only net about $906 per year or about $75 per month.

What if you bought it for $80K and it only needed $10K of repairs?  What if you bought it for $50K and put $40K into it?  You must know the numbers and run them.  I hope that helps.

First, thanks for so many responses and so fast! All great information

Maybe my problem is I am thinking of properties closer to turnkey. Not one that is necessarily going to be bought way below AVR because in my mind it was a property that doesn't need much work.

@Jason Smith  - It was an example scenario I'm just playing in my head to make sure I'm understanding.

@George P. - I can understand that for a property that needs to be repaired so you have a higher AVR, building equity quickly. But what about a property that's fairly turnkey and bought near or at market value? I see where the idea is to buy the property 10-20% below market, but what if it's a market and still provides a good CCR as a rental.

Let's say you have 20% equity going into it if it's at market value. Correct me if I'm wrong, but the max LTV for an investment property refi is generally 75%. 75% of the appraised value would have to be the original purchase price ($140k in this case) in order to pull the full investment ($40K) back out.

That means the appraised value would have to increase to ≈$186,667. That would take 5-6 years at a ≈5% appreciation per year. Not including pay down.

@Chris T.  - Thanks. Will do.

@Mike Dymski - Agreed on the return. However, getting my initial investment back is important as I am not made of money and would need it to buy another property.

Yes, the equity is great, but unless I can pull it out it's not working for me. From my understanding I can only refi up to 75% LTV.

Maybe rehab wasn't the right word. I was thinking light work like interior paint, carpeting, maybe appliances. I wasn't thinking of anything major. Or do those things add more value to the appraisal than I am thinking? Again, I might need to get away from thinking of turnkey properties where I can't build equity into it and buy it way below AVR.

@Jerry W. - Thanks. Great information.

Thanks again everyone.

that's why you can't grow when you do turn key investments. you are buying an updated prop at market value getting market rates.

is the return better than Chase? yes. will it beat the Dow? arguable.

will it take 5 yrs to break even? yes. 

can you grow? not with the money from that rental since funds are tied. get funds from another place.

For those routinely pulling their initial investments out to fund acquisition of more property, what level of leverage are you comfortable with?

What kind of reserves do you hold for vacancy, repairs, and CapEx?

What's the exit strategy? Acquire a large portfolio quickly with cash-out refinancing, then eventually tap the brakes on growth and let tenants pay down the debt over 25-30 years? Sell properties when RoE gets too low?

There seems to be a lot written on this strategy from the standpoint of someone in full growth/acquisition mode, but I haven't seen much scenario planning over a timescale of 10, 20, or 30 years.

Originally posted by @David Graham :

- Agreed on the return. However, getting my initial investment back is important as I am not made of money and would need it to buy another property.

Yes, the equity is great, but unless I can pull it out it's not working for me. From my understanding I can only refi up to 75% LTV.

Maybe rehab wasn't the right word. I was thinking light work like interior paint, carpeting, maybe appliances. I wasn't thinking of anything major. Or do those things add more value to the appraisal than I am thinking? Again, I might need to get away from thinking of turnkey properties where I can't build equity into it and buy it way below AVR.

6-7 years return of capital is pretty quick.  Think through your other investment choices where that is possible and the list will be short or nonexistent.

Not being made of money is all the more reason to invest and become made of money.  Another $40,000 is nothing to a rich person but it sure the heck is to us.

The original $40,000 in equity is certainly working for you.  It is generating $500/mo in net income that is paying for groceries, gas, mortgage payments, new investments, etc.

Turnkey properties are a good investment but if your goal is to grow faster, you will need to use a different strategy.  Leverage has already allowed you to use $40,000 to make a $140,000 investment (can't do that in other asset classes) and now you can ramp it up further by adding value and creating equity rather than buying turnkey.  Many BP investors have $0 original investment in many of their rentals.  I'm putting $3k into each unit and adding $15k in value on a property right now.  Another strategy is to use other people's money rather than your own.

Good luck with your decision.  You are asking the right questions.

Originally posted by @Keith Anderson :

For those routinely pulling their initial investments out to fund acquisition of more property, what level of leverage are you comfortable with?

What kind of reserves do you hold for vacancy, repairs, and CapEx?

What's the exit strategy? Acquire a large portfolio quickly with cash-out refinancing, then eventually tap the brakes on growth and let tenants pay down the debt over 25-30 years? Sell properties when RoE gets too low?

There seems to be a lot written on this strategy from the standpoint of someone in full growth/acquisition mode, but I haven't seen much scenario planning over a timescale of 10, 20, or 30 years.

I think you summed it pretty well. Many investors in linear markets or who own properties in good locations can maintain reasonably high leverage without taking on undue risk. Many of these markets only dropped 5, maybe 10% in the recession and the LTVs are lower than that now even at reasonably high leverage. Keep in mind too, many investors have $0 or very little initial capital at risk in those rentals. Many BRRR investors, as they get larger (or when the market is hot), will sell off the higher touch or lower producing properties and that is currently going on in our market today. And, as you said, many pay down mortgages as they reach their goals or work towards retirement. It's the American dream in action.

@Mike Dymski @George P.

Thanks for the information. That's where I needed clarification. My thinking was correct based on turnkey. In order to grow fast, most likely avoid those and pick up investments where you can create equity. Got it.

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