Get Rich With: Owning Rental Houses
We’re diving into a fundamentally new field here – the field of actually increasing your income, which is quite different from the cutting your spending I usually advocate.
For most people, the cutting works much better because they already have a shortage of free time, and a surplus of income compared to what is actually needed to live a reasonable life.
But for those rare people, perhaps the young and ambitious, or those without children who need all of your free time, it is possible to raise your income considerably while keeping your day job by using the time-honored method of becoming a landlord.
To some people, it sounds like a hassle not worth even considering. To others who have read the Get Rich books on the topic or met a self-made multimillionaire who became wealthy using rentals, the idea is intriguing and desirable. As a small-time landlord myself who has rented out four houses over the years and still has one rental today, I would say the truth is somewhere in between.
Here is a real-world example with some numbers showing the fundamental reason that these things make you money:
- In my town, I can buy a 3-bedroom house in a fairly good neighborhood for about $200,000. I would put $40,000 down on it, and because of of today’s insanely low interest rates, my monthly costs for the $160,000 loan including insurance, property taxes, and a few bucks for maintenance would be about $950/month.
- At local rates, I can rent this house out for about $1200/month.
So every month I am getting this benefit:
$250 of actual cashflow from the rental
$230 of principal on the mortgage gets paid off.
The net profit is $480/month, or $5760 per year. That is a 14.4 percent return on my $40,000 investment, right? Double the MMM official figure for stock market returns?!
But no, it’s not quite the same, because you actually have to do WORK to buy the house and take care of the tenants. I find that if you do a good job getting nice responsible tenants, the total amount of work required for each rental house averages about 1 day per month, or 96 hours per year.
So your hourly rate of pay is about $60 per hour, right? Well, again not quite, because you would have made half of that money if you had just put the $40k into an index fund at an average of 7%. Accounting for that, you’re getting $30 per hour for managing the property, which is still reasonable pay for anyone who is willing to work for $60k or less per year.
But I’ve left out an important part of the equation: Appreciation on the rental house. Because you only put 20% down on the house, you basically own an investment that is leveraged at 5-to-1. That is potentially risky, as many US landlords found out when the property values dropped in recent years. But on average, the statistics say that over the long run your rental house value will go up with inflation: 2-3% per year. So let’s re-run the numbers using a conservative amount of appreciation:
Cashflow and Mortgage Payoff: $5760 per year
Appreciation on House ($200,000@2%): $4,000 per year.
Now you’re getting paid $9760 per year in exchange for investing $40,000 and putting in 96 hours. Doing the same stock-market-equivalent subtraction above, you are earning about $72.50 per hour. Unless you make more than $144,000 in your day job, this should start to sound pretty exciting to you. And if you have the skills to expand your empire to include multiple rentals, you can put in quite a few hours at your new $72.50 rate.
If you collect several houses, you can even quit your day job and have a more-than-full-time income for less-than-full-time effort. At $72.50 per hour, you can earn a comfy $40k family living wage with about 10 hours a week of effort. Several people I know have already done this.
If your area DOES ever have a property boom and home values go up faster than inflation, you can make some even bigger chunks of easy money. In my best experience, I made about $50,000 in appreciation over five years on a rental house, and in my worst experience, I lost about $10,000 over five years on another one (I bought that one in the 2005 housing boom and had to sell in 2010, still part of the current slow period).
And if your area has a higher rent-to-price ratio, sometimes referred to as the “cap rate”, the plan can be even more attractive. In the example above, the rent of $14,400/year divided by the $200,000 price gives a cap rate of 7.2%. In expensive cities, the cap rate is much lower, making rentals a bad idea. But in some cases you can get a much higher cap rate – it usually works out better the less expensive the dwelling is, which is why condos make good rentals. This economy of scale continues all the way to the ultimate rental tool – the apartment building, which can have cap rates over 12%.
The bottom line is, it’s just another way to trade time for money. But if you have the enthusiasm for knowing the good neighborhoods in your own city, finding a good deal on a house, doing minor renovations and maintenance, and interacting with tenants who you reel in with an expertly-crafted Craigslist ad, it can possibly be the highest wage you’ll ever earn – and thus the fastest way to get from Enthusiastic Young Office Worker to Retired Senior ‘Stash.
This is just an introduction to the topic. There are loads of books about this in the library if you want to learn more, or if you want to hear more details from me, think up a question for the comments section!
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Mr. Money Mustache is a family man living in the United States who retired from work, relatively wealthy, at about age 30. After several years of retirement, he noticed that his still-working peers were envious of his lifestyle. They were making more money than he ever had, yet they were somehow still broke. So he decided to write this blog to educate the world on how it is done.
It takes a certain type of person to manage rental property. Here’s a good way to determine if you are this sort of person. Lend some money to your most deadbeat friend or family member.
Now try to get it back. That means repeated calls or visits…”Do you have my money yet? When am I going to get my money?
If that doesn’t work, it’s time to type up something official. “If I don’t get my money, I’m taking you to court.”
Anyway, from my experience, rental income is good income per time spent. However, the dead beats and the picky people are a pain from the beginning but drag on you mentally more and more the longer you are in the business.
Here are a few of my general rules.
Old people on a fixed income are GOLDEN
If they start out with a problem, they are a constant problem
No pets!
Yeah, very true. I’ve had perhaps 20 sets of renters over the years and it seems about a third are absolutely golden, a third are medium-but-okay, and the bottom third have been either very negligent about taking care of the houses, super-fussy (can you change the light bulbs and smoke alarm batteries for me?!), deadbeats and/or scam artists (two evictions even!). But looking back, the bad experiences were preventable if I had been picky about people having good credit scores instead of good excuses for their bad credit.
My favorite type of person to do business with is young nerdy professional couples who just sold their previous home, and moved here for a fancy job and will move on to buying a house of their own after a year.
Hey Mr. Mustache!
Great post again…..I love how the blog is starting to shift into income producing territory. I also really enjoyed the beer post because being in college, things can definitely get out of hand financially when drinking.
Getting into real estate seems intriguing but I almost feel as if it might be better just to sock money into an REIT index fund to get exposure to real estate while receiving monthly dividends (pretty much rents checks) without dealing with banks or renters. However the return would probably quite a bit lower right?
Hey there Riley,
REIT funds are a good way to speculate on the real estate market and benefit if it has unexpectedly high price or rent growth in the future.
I personally do believe US housing will appreciate faster than inflation over the next ten years since the prices are irrationally low (many houses cost less than construction cost even assuming a land price of zero), and the population is growing which should eventually use up the underpriced housing and cause prices to rise.
However, if my theory is wrong, or if REITs are already trading at higher prices anticipating this future growth, then you can expect only market-level returns from an REIT investment – just like a more volatile version of an S&P500 index fund, so you can assume 7% or so after inflation.
But rental houses are a little bit different, because they are a way to get even higher returns on your investment in exchange for more labor. It’s similar to taking on a side consulting job at $72.50 per hour or so, which is also a great idea if you feel energetic and want to get ahead quickly.
The cool thing about doing extra work is that you put in the effort ONCE, save the money, and you benefit for life from the extra employees. As soon as you’re done the work, the effort fades away in your memory, but the money is still there for you to enjoy forever, providing investment returns.
As long as you save the money of course, rather than just buying a bigger car.
I kind of fell into being a landlord backwards and it didn’t work out so well. I had just bought a house in 2007, and about 18 mos later I moved in with my boyfriend-then-husband who also owned a house. I rented mine out.
I bought at the height of the market and didn’t put much down. My PITI was about $1700 and I could only rent it for $1250. I couldn’t deal with managing it so I hired a property manager for another 10% off the top. No problem, I’ll get some back in tax deductions, right? Nope, because I wasn’t managing the property myself so NO deductions for me. Lose, lose, lose.
Now, however, is a much better time to buy houses, and IF you have $$ to plunk down so that your PITI < rental income, and IF you manage the property yourself, you can make money on it.
Otherwise, I don't recommend it.
Good news (actually, it's kinda bad news) is that I am moving back into that house next month, so the hemorrhaging will stop. If I stay in the house maybe 5 more years I might even be able to sell it and break even.
Timing is everything in the housing market, and hindsight is 20/20. Foresight, however, sucks.
Hi Liz,
Yeah, a good cautionary tale. Your situation is definitely common – even my rental houses were mostly places I had formerly lived in. But they were all cashflow-positive… and even would have been so if I had 100% mortgages on the homes. That’s where the rent-to-value ratio comes in. If a person is actually looking to “Get Rich with Owning Rental Houses”, it’s essential that the place starts paying for itself right away – without depending on tax deductions, an unusually large downpayment, or any future appreciation.
This favorable ratio tends to happen more in cities where good family-ready houses are less than $200,000 – since it is common to find young renters able to pay $1200 in rent – as opposed to cities where the houses are $1.4M – where the rent would have to be $8400/month just to produce the same rent-to-price ratio! So it’s not for Silicon Valley Mustachians, unless they want to manage a rental quite far from home.
Just found your blog and really enjoying your posts and really enjoyed this post. However not everyone with a bad credit are bad tenants, especially if they have a long history of paying rent on time despite a bad credit score.
We have rented places with up to 5 dogs and our landlords have always loved us as much as we loved them, paying rent ALWAYS on time, doing our own repairs and being extremly responsable with our pets. I always found my kids could do a whole lot more damage to a rental than our dogs.
However I also have seen those with pets and bad credit that would be a NIGHTMARE to rent to. I would think a long rental history would speak much louder about the character of a renter than a credit score or owning a pet could say about a person.
Keep up this wonderful blog, look forward to following your inspiring posts!
http://frugalfulfillment.blogspot.com/
A Fundamental aspect of the equation is the tax benefits of being a landlord and being able to deduct your mortgage interest (and mileage to manage the property, and for that matter any other expenses involved int he management of the property) from your taxable income. Since someone else is paying the mortgage anyway, this can add up to substantial savings (several thousand per year per property if leveraged appropriately).
You are very right – I figured I may get to write more about it if readers seem interested in rental properties. I definitely love my landlord tax deductions! Also there is of course the 3% per year depreciation you get to claim on the building itself, which is several thousand more. You do have to pay it back when you sell the place, but it is still a nice cashflow booster – effectively like an interest-free cash advance on the eventual appreciation of the property.
A few years ago we made our first attempt at being landlords. We bought a fixer upper but it wasn’t in the best part of town. That was our first mistake because we couldn’t atttract the best kind of renters. We had renters in it for a year (nagging monthly for partial/late payments). My husband hated it but I thought we did ok. They moved out w/o paying the last month but we had the deposit and there was no damage. They had painted a room w/o permission and replaced an outside light with a motion sensor light.
Now we have paid off our mortgage and are debt free. I am ready to try again but my husband has cold feet. This time we could build a small house in our own neighborhood. It should attract good renters and we could keep an eye on it. I wll screen carefully this time around and set the rent low enough that we get plenty of applicants.
Hey Liz Tee, are you sure about this:
“I couldn’t deal with managing it so I hired a property manager for another 10% off the top. No problem, I’ll get some back in tax deductions, right? Nope, because I wasn’t managing the property myself so NO deductions for me. Lose, lose, lose.”
I have a property manager, and while I think there may be a limit I still get plenty of deductions. Did you have a tax professional do your filing?
@Steven – I think she’s referring to the “active participation” rules for deducting rental real estate losses. I don’t think hiring a management company necessarily rules out “active participation” but it is a good idea to read up on it before deducting a loss and getting a love note from the IRS.
What about the returns if/when the bubble finally PROPERLY pops? Not getting back into this one, myself :)
How about doing this on a larger scale? I heard of people who own giant apartment complexes (dozens or even hundreds of apartments!) and can live off the passive income. I assume that they outsource all the management to, well, a property management company in exchange for a small cut of the profits. Have you heard anything about this, MMM? The risks and the initial investment on something like that would be a lot bigger (unless you could pull a Trump and buy with no money down), but the payoff would be tremendous as well. :)
Hi G.L.!
I certainly have heard of it. One of my neighbors is rocking a 300-unit, as mentioned in one of my earlier articles about The Millionaire Next Door. And years earlier in my office worker days, there was another coworker that secretly had hundreds of apartments as well. Apparently to qualify for a loan on one of these buildings, the top factor considered by the bank is the performance of the apartment building itself (rental income, vacancy rate, historical costs, etc.). As opposed to the size of the income of the buyer.
Many people work their way up by starting with just 1-4-unit buildings. There is one particular 6-apartment building for sale right now in my own town that brings in $4200/month (the appts bring in $700 each), yet is listed at only $349,000. That’s a gross cap rate of 14.4% – twice as good as the best rental house I’ve ever had!
But for now I’m content with my existing free time/passive income balance, so I have to avoid the temptation to start trading time for money again, unless it is time spent doing something I really enjoy, like building things.
Ahh, so you were the one with the 300-apartment neighbor! My bad. If you read a lot of PF blogs (or a lot of anything, really), it all starts to blend together. :) Is there any chance you can convince your neighbor to do a guest post and explain the intricacies of his business model?
Good idea. He doesn’t seem like the guest posting type but maybe I can actually interview him instead! The man is very keen on giving financial advice so it could be fun.
We own 5 properties (8 units, one being commercial) and things are going well. We’re working on getting out of debt before acquiring more. The tax benefits have been amazing. I’m a real estate agent so my property manager gives me a break by only charges 5%.
If the 6-unit is a great deal, wouldn’t it be worth it to hire a property manager?
Wow, very impressive rental setup, Mr. Deppen! You are right that a property manager is a good idea for those wanting some relief from the day to day work of landlording.
On the other hand, sometimes the work is rewarding. Like today, for example, when a highly qualified tenant called me personally and asked to get in line to rent my house when the current folks move out in two months. Didn’t even need to put up the craigslist ad this year.. Woohoo!
Nice post MMM! I already own a flat with a cap rate about 10% and appreciation of 50%… i think I just had luck, but looking forward to expand my own little empire.
Hi MMM,
I myself rent a SFH in SF east bay area. I’m looking for a condo as a rental property where I will not live in. I see reasonably priced condos (1/1 or 2/1) near by public transportation, shopping, schools. I can afford to pay 20+ % down payment and the rent will generate positive cash flow from the beginning given that finding tenant in this area is not that difficult. Given my job situation and my wife’s , we can pay off the condo in 5 years. I am thinking of going for 5/1 ARM. However, I’m not clear about the tax implication in that kind of arrangement. If you can cover this scenario that would be really helpful.
Thanks,
AM
This post is well timed since I just got to place my first check into the business bank account from a property we bought a month or so ago.
Exciting to see it’s working for others. Our cap rate is currently 14.8% but it took a long time to find :)
What do you do about assest protection, in case you were to be sued? Have to consulted a lawyer regard LLCs, Umbrella insurance, etc.? Or do you just hope for the best? One lawsuit and you could lose your properties on simply defending yourself.
Thank you for your article,
Jim
There is some good discussion of this over in the MMM forum. It looks like the most savvy landlords place each property (or a small group of them) into a dedicated LLC, then they set up a standard and umbrella insurance policy to cover them. I’ve got appropriate coverage through my low-cost homeowner’s policy.
http://www.mrmoneymustache.com/forum/real-estate-and-landlording/llc/
As your rental portfolio grows, so does the risk of lawsuits. But this risk is still extremely small – remember, to be sued you either have to do something seriously wrong to your tenants (which you won’t do), and/or have a seriously dickheaded and opportunistic tenant who wants to abuse the law. I am not saying these people do not exist, but I am saying they are very rare.
It is much more profitable to lead your life based on integrity and trust, rather than fear of highly improbable events. The fear will paralyze you and you’ll never take any risks, meaning you’ll never succeed in business.
After being through a few court cases locally and learning about mindset that judges use to evaluate the validity of claims, I don’t worry about lawsuits, for anything, at all.
Good post. I just came across it.
The SFH portfolio has just recently been recognized as an asset class by institutional investors. Three PE firms just a couple of months ago announced that they have pledged a total of $2.5B to buy up SFHs. My guess is that in the next couple of years you will see the first SFH REIT. (A few years ago I wondered if there was a SFH REIT out there. I found out there were none.)
I have a 55 SFH portfolio in TX, and I was just contacted this week by a firm that seeks to create a SFH REIT. I was also contacted today by a Canadian investor that is circling money to build a SFH portfolio. A few weeks ago, a firm in LA contacted me for the same purpose.
What this means to the small investor is that there will likely be an “exit” for people who build small SFH portfolios…they may be able to sell their portfolio of homes to institutional investors.
More details on my take: http://bit.ly/zvbP6Y
Happy investing!
B
Wow, you have FIFTY FIVE single family homes? Nice work. That’s a pleasant and profitable business, taken to the extreme. I kind of hope the institutional investment side doesn’t get too strong, because I like the fact that these small local opportunities exist in every town and city, allowing local entrepreneurs to benefit. I view it as a way of leveling the economic playing field for the little guy, since even owning 2-3 rental houses is plenty to provide for a spending-efficient person in retirement.
I’m really interested in this post, and would love some advice on my situation if anyone has advice to share! I live just outside Washington DC but am about to take a job inside the DC border, with a miserable awful commute (by car 20 minutes, plus or minus 2 hours; bus/metro train 1.5 hour; biking not an option b/c deep ghetto) across one of only 2 bridges. When my current lease ends I’m looking at moving into DC…. but I’m noticing that I could buy a 2-bedroom condo for less than renting a 1-bedroom or even studio, within bike commuting distance of my new job. I think a lot of neighborhoods in DC are right at the cusp of gentrifying and having the prices skyrocket – I’ve watched it happen in two neighborhoods (Navy Yard and parts of SW Waterfront) – so I think it’d be a good investment. Even better I could have a roommate to cover (at a minimum) the $1k monthly mortgage, so I could apply my “rent” to principal and kill the mortgage as fast as I can manage. Over time I think it would seriously appreciate, and in the meantime I’d be paying well below market rates on rent.
This is all in theory (well I’m talking to a realtor, getting preapproval, and touring neighborhoods) – has anyone done something like this? Any cautions or heads up on hazards?
Thanks!
superbien – I wonder if you pulled the trigger on buying the condo in DC. You’re probably right about the property values in the city being close to exploding. The DC job market is strong, and I think that the younger generation moving there will value living in the city (especially after watching their parents suffer through that plus or minus 2 hour commute for 20 years).
Thanks for the post MMM. I have a question regarding whether to pay the mortgage down to $0 for a rental property, or should I leave a mortgage on it since I can deduct the interest on Schedule E? At roughly $10,000/year mortgage interest, the tax saving is significant–with it I have a loss on paper, as I’m sure you have had the experience of. Should I resist the urge to pay the house off? Most of the getting-rich-with-rentals blogs would say leverage as much as possible… Keeping taking money out of the equity and buy more. Such an aggressive attitude seems un-considered to me. Would be very interested in your thoughts.
My husband and I rented out his Grandmother’s house to 2 different people before moving back into it and eventually selling. We went through a TON of people, asking all sorts of ridiculous questions like “Can you build a fence around the yard so my 3 large dogs can play outside?” (Umm, no.) “I want to rent this house so I can run a daycare out of it.” (Umm, no.) We even had one woman drive up in a $50,000 SUV, telling us she can’t pay the security deposit. (Umm, no.)
It is FAR BETTER to have the house empty for one more month, to try to find the right candidate, than to rent to the first person who shows up, who then must be evicted, which takes loads of time, time that you are not receiving rent payments. We did a credit check on every single person. Yes, there are people who have bad credit but will still pay their rent on time, but why risk it?
When you find a good renter, do what you can to keep them. Don’t raise rent next year, if they will stay. Buy them an inexpensive present at Christmas.
I have also heard of offering them a rent-to-own deal. If they think they might be purchasing it, they will take better care of it, even if they have no intention of purchasing the place. Let them paint the walls pre-approved colors. Tell them you will buy the paint.
I agree with the no pets thing. Animals pee on the carpet, leave little presents. If you rent to someone with a cat this time, next time, you won’t be able to rent to someone who has allergies. Better to be pet free.
MMM, I love your blog!
MMM,
Love the blog, love this article, but I think I found a mistake in your math! You take appreciation into account and assume it is equal to inflation, which is fair. The problem is that you then compare it to an expected 7% return in the stock market, but that 7% is AFTER inflation. An apples-to-apples comparison would require you to compare the cashflow + mortage payoff + appreciation to a 9% return (assuming 2% inflation). You still end up ahead due to leveraging, but now you’re earning about $64.15 per hour, not $72.50.