We have talked a lot in these posts about how to invest in single family rental homes in the Dallas, Fort Worth, Denton area. I ask my readers to get a mentor first if they have not done it. I’d like to take a step back and talk about the advantages of investing in single family rental homes, as I get asked that a lot.
First, some of what I discuss here could apply to the general topic of investing in broader real estate but I am specifically talking about investing in single family rental homes. One single family rental home is a bundle of investments – not just one. Here’s why:
1. Buying at a discount: If you have read my posts, we talk about buying distressed properties at a discount, fixing them up and having a handsome equity before the property is even placed into service as a rental. This equity is the first way you grow your wealth as a result of investing in single family rental real estate. For example, if you bought a property for $80K, spent 10K in closing, holding and rehab costs and the property appraises for $130K, that’s a 40K increase in your net worth for fairly minimal amount of work.
2. Cash Flow: We talk about renting your property after fixing it up. We don’t sell the goose that lays the golden egg before we collect some eggs for ourselves. If done right your rent should cover your mortgage, property taxes, insurance, warranty, maintenance, marketing and vacancy costs giving you a positive cash flow every month. If we take typical numbers, say $1,400 rent, $700 mortgage payment, $250 taxes, $150 for vacancy and incidentals, $100 for insurance and warranty, that gives you a $200 positive cash flow every month. If you plan for just a 5 year hold period, that’s a $12,000 boost to your bank account.
3. Equity Growth: If you have an amortized loan (not an interest only loan), every time you pay your mortgage, a part of that payment goes towards your principal. Your single family rental home is like your savings bank where you make a contribution every month. Based on your loan amount (say 100K), interest rate (say 5%) and term (15 year fixed), this could be about $5,000 a year to start with and gets better each year. With a 30 year note this equity growth will be lower but your cash flow would be higher.
4. Appreciation: Agreed that this is speculative and you may not see this. However, remember we are buying distressed properties at a discount. Even if the market simply returns to a non distressed state, that is appreciation for us. Your agent can help you look at historical appreciation in the subdivision and area you are buying in. Using a conservative $1.50 per sq ft appreciation a year results in a $3,000 growth for a 2,000 sq ft home. Appreciation potential for real estate over a long period of time does exist despite what might have happened in 2008. Also, we are talking about the Dallas, Fort Worth, Denton area. This area did not see a rapid, unrealistic appreciation in the boom. It will experience some downward trend due to the national correction but there isn’t any statistically significant data to predict a crash here. With single family rental homes you are also somewhat protected from a downturn in asset value – I will explain towards the end of this article.
5. Tax Assessment: There are several tax benefits to investing in real estate. You should discuss your specific case with your tax adviser or accountant. In general, for tax purposes, a single family rental home is considered a depreciating asset every year. This depreciation is documented as an expense. For example, if the property’s improvement book value is $100,000; using a straight line depreciation for 27.5 years you get an expense of $3,636 a year. If your total annual cash flow from this rental home was $2,400, your taxable income from this house is negative. Even though you had an actual cash profit, you get to declare a paper loss. I make this point here merely as an illustration. Get specific details from your CPA or tax attorney. So how did you make money from this tax assessment? If you made $2,400 as extra income at work or using stocks or other interest providing investment, you would have to pay tax on that $2,400 (either as earned income or passive income). With a single family rental home as your investment, you declared a paper loss and so did not pay any tax. Assuming a 25% tax bracket that’s $600 savings. In addition, you get a paper loss of $1,236 ($2,400-$3,636) that you can deduct against other gain where allowed. At the same tax 25% bracket that would be a $309 savings. Again, get with your CPA or your accountant to discuss your specifics.
So, from our example, the total net worth growth in a year of owning this single family rental home is $40K (equity) + $2,400 (cash flow) + $5,000 (equity growth) + $3,000 (appreciation) = $50,400 (not accounting additionally for the $600 tax savings or $309 tax offset).
There are other minor ways you make money using the methods we talk here. As you purchased your property as a distressed property, you will first reduce your property tax appraisal by giving them the closing papers (HUD-1). Rents tend to increase over time and you will have the opportunity to increase rents every lease period. If you have a fixed mortgage, this will likely result in an increased cash flow. As your equity position in properties grow and your net worth grows, you will be able to secure better deals on lines of credit and loans with lower interest rates and closing costs.
So, with our discussion on leverage in mind, ask yourself this: What other investment allows you to make money at least 5 different ways using other people’s money?
Single Family Rental Home Investment – The Ultimate Self Hedge
I mentioned this briefly while talking about appreciation above. A single family rental home investment, when done right, has an innate ability to protect itself. Here’s how: What’s happening when no one is buying houses? No houses are selling. It’s a buyer’s market. You get good deals when you buy in a buyer’s market. Now, we are buying distressed properties in a buyer’s market. So you would expect to get really good deals. It’s key to have a good mentor and a good agent so you know how to locate and capitalize on such deals. Now, if no one’s buying, where are they living? Yes, you answered right. They are renting. So what’s happening to rents? As volume of renters go up, rents go up. When rents go up, your cash flow goes up. The value of your asset as an income producing one goes up.
Now, what happens when houses start selling and selling like hot cakes again? Every one’s buying. It’s a seller’s market. If every one’s buying, not many are renting. Rents start going down. Your cash flow goes down. But, what happens to your property value? In a seller’s market, property values are high. Your single family rental home’s value is also high. Not because it is an income producing asset but because it is a home – something real where someone wants to live in. So you may be able to sell it for a handsome capital gain (remember you bought a distressed property in a down market) or refinance and pull some cash out to offset for lower cash flows.
So, regardless of an up market or a down market a single family rental home, if done right, contributes positively to your net worth year after year. It’s your own personal hedge fund!