Is Rental Income Really Passive and that Good a Deal today?
Jan 24, 2024One of the largest competitors to the stock and bond markets is real estate. In the United States alone, real estate is worth $47 trillion in June 2023, according to Benoit Properties.1 Owning real estate has been the cornerstone of the American Dream since the Pilgrims landed four hundred years ago.
However, it is not something that happens overnight and the amount of effort and work and sweat and tears required to maintain a property always seems to be understated. I read countless blogs and ‘influencers’ who tout the passive income streams and roads to riches that owning rental properties (and Airbnb’s today) produces.
What is often missing is the amount of work required to build that portfolio and the real returns they produce.
From screening tenants to collecting the rent, the huge maintenance outlays, eventual upgrades to the interior, and managing the local ordinances and HOAs, the demands of owning real estate are a significant undertaking.
Outsourcing Real Estate Tasks: A Cash Flow Killer?
The advent of the internet has allowed many real estate investors the ability to outsource a lot of these tasks to minimize the workload. However, remember that in doing so, it gets your farther away from your goal: cash flow positivity.
One of the biggest misnomers I see if that the rental income needs to cover the mortgage payments from month to month. However, in reality, it should not only cover your mortgage payment, but insurance, property taxes, and all the operational expenses including a sinking fund to cover the rare, mega expense (think new roof or furnace).
Most of the ‘retail’ real estate investors that I see drastically underestimate these expenses. I once had a client say that he didn’t add in property taxes (or any taxes on the property) because they are a ‘cost of civilization.’ I kid you not.
Today, with interest rates as high as they are, cash flow positivity from a home purchase is going to be extremely difficult. That is because a $500,000 today with a mortgage rate of 7.0% and 20% down will have a monthly payment of $3,411 including $155 for insurance, $505 in property taxes, and $80 in HOA fees].
Just a couple of years ago, that same payment would have been $2,326 even when using the same assumptions for insurance and property taxes but lowering the mortgage payment to 3.0%.
The real estate investor now must bump rents by approximately $1,100 per month just to cover the added interest costs let along the massive increases we’ve seen in maintenance, labor, and materials to repair homes (Paint inflation has been almost 25% for each of the last three years, according to Architectural Digest Magazine).2
Passive income positivity is a key ingredient to creating a sustainable real estate investment that produces a return for your time and capital.
The Truth Behind the Numbers
The last piece of the story is another misnomer I often hear – that the value of the property goes up consistently. You often hear of a person buying a home and then selling it years later for big gains.
However, this is difficult to assess because you never have the full picture. How much did the homeowner put into the property? Did they make massive upgrades to the interior? Did they get lucky and nearby property was developed making theirs more valuable? Did they happen to buy at just the right time?
Unless you have their spreadsheet of ALL the money and sweat that they put into the home, the rate of return is likely to be less than it appears.
I found this to be VERY interesting. Recent data shows that most of the gains in home prices from 1973 to 2014 came from them getting larger.
According to The Zebra, a homeowners insurance website, the median home size for newly constructed homes has increased 150% since 1980. At the same time, the median household size has decreased by 16% since 1940.
The average American now lives in 2.4x the amount of square footage as their EU counterpart.
Source: Census Bureau, as of 01/24/2024. Graph illustrates the average median square feet for new-single family US houses compared to average household size
I did some research and found that good rental properties are hard to find given the demand for rental income today. A lot of that has to do with Airbnb coming into the fray. Most “economical” housing in the state of Colorado is still well above $350,000 and will generate no where near the rental income to be cash flow positive in year one.3
I estimated a cap rate of 3.53% in my Denver area rental research.4 That is 1.5% below the current money market rate of most brokerage houses.
Of course, the most common response from a real estate investor is, the home appreciates in value over time. True.
The S&P 500 has a dividend yield of 2.1% and appreciates in value over time by almost twice that of the average home in the United States.5
And maybe most importantly, you can invest in the S&P 500 without having to do anything but a couple of clicks once. Then you can enjoy retirement or other hobbies rather than unclog a toilet or change a burnt-out lightbulb for that income
Sincerely,
Mark Asaro, CFA
2 https://www.architecturaldigest.com/story/does-paints-pricing-surge-have-an-end-in-sight
3 Based on Zillow searches for potential rental income vs. sale price of home.
4 Assumes $500K purchase price, $2,500 rental income/mo. $375 Property taxes per month, $50/mo pro mgmt. fees, $155/mo insurance, $50/mo leasing fees, $150/mo utilities, and $250/mo repairs and maintenance
5 https://www.noradarealestate.com/blog/average-home-appreciation-over-30-years/
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