114 comments

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!

 

 

  • Jimmy June 18, 2016, 2:05 pm

    Glad this topic was brought up. I’m new to this blog, but I’ve apparently been a Mustachian for some time without knowing it. I follow most of your general advice already. Though for me it wasn’t as much cutting costs as it was not increasing them. I was unemployed for a long time, now I’ve been working for 2 years and making an above average pay. I decided from the start that I would keep my costs low and save as much as I could.

    When I was unemployed, and also when I was a student, and when I started working as well – I was renting a room. So I was a tenant in the same apartment as the landlord. My experiences has varied, but mostly it worked out well. Now I’ve turned it around. I now own an apartment and have a tenant. So my housing is almost free.

    My next step is to upgrade to a bigger apartment so that I can increase the number of tenants. I’m thinking 4 or 5. In the past I’ve shared my housing with both 1, 2, 3, 4 and 7 others. And with the vast majority of those people, it has worked just fine. And I think this could be a good alternative for anyone who can’t afford 2 houses. And for anyone who don’t need a lot of space, since all I’ll have is a room. But that’s good in another way – there’s no risk of buying unnecessary stuff, because I have no place to put it!

    I live in Stockholm, Sweden. Stockholm is the fastest growing city in Europe right now, and the housing-prices grow with it – 13% in the last year. There’s no lack of available tenants, so I think my chances of finding responsible ones are very good. I’ll mainly be looking for students.

    Any thoughts on this kind of renting?

    Reply
  • TK October 14, 2016, 9:31 am

    I know this is 5 years later (and I’m glad I stopped by) but I believe your initial “Cap Rate” calculation is incorrect. The number you calculated is (loosely) the Gross Rent Yield (Annual Rent / Acquisition cost). Cap Rate is “NET” Operating Income / Purchase price. If you have no expenses, then these two are the same, but surely you have some expenses (taxes, insurance, maintenance, something) that reduces the Gross Income to a Net.

    Thanks & regards,
    TK

    Reply
  • Jill November 2, 2016, 10:35 am

    My husband is a MMM follower and I am new here. We are looking into ways to create some tax benefits (primary reason) and potentially gain some future retirement income through rental properties. We live in San Diego, which is one of the most expensive real estate markets in the USA. The rental market is very strong and we do not have enough rentals to go around, thus very high rents. I’ve been trying to determine if this would be a good market to invest given the strong rental market (about 60% of the population rents), expected population growth and continued housing shortage. I’ve been reading that rent should be 1% of purchase price and cap rate > 7%. This would be impossible in San Diego due to the high cost of real estate. I’d like to know what the bottom line is that I should consider. Investors are still gobbling up properties here so I would expect that these guidelines are not what they are using.

    Reply
  • Michelle January 4, 2017, 2:25 am

    Really enjoying your blogs, even if I am stumbling through them much later than most! I am an IT professional too but made my money investing in rental properties. What I have found is that people who succeed with rental properties, treat them like a business. Whilst they are not as demanding as a full-time career, if you think you can sit back and do nothing but collect money then you will likely fail. The most important thing you can do is spend time and energy ensuring your tenant is a good one before taking them on. Time spent at this point, even staying vacant is cheaper than problems and the expense you will face with bad tenants and the eviction process. Also, regular checks of the property are vital from a tenant and maintenance checking perspective. These things help you to recognise the bad tenant that slips through your nets so that you can deal with it sooner rather than later. Deal with it, you must. My husband had holiday homes which was an interesting twist on a similar idea. We both sold up our properties and bought a farm together. We have a mortgage, but it’s not huge. We are both totally over constant house renovations and painting, to be fair!

    Reply
  • Marie February 15, 2017, 3:14 pm

    MMM:

    My husband and I have been religiously reading your blog for the past few weeks and are excited to grow out our mustaches — we’re planning to accelerate our Exit Strategy to Early Retirement.

    We are landlords ourselves and own 6 rental units since 2010, which have averaged us 25% cash-on-cash. Our yearly spending is around $40-$45K (CAD) and pre-tax family income at $250K. We are working hard to reduce our current cash hemorrhage (lease busted our car, replaced public transit with walking, limiting travel), but we obviously have much more work to do!

    What are your thoughts on building up a much smaller nest egg (we’re thinking $100-$200K) and grabbing hold of as many rental units as we can to get that rental cash flow >$50K per year? Once we’ve surpassed the required cash flow for our yearly spending we would quit our day jobs (also 2 engineers here!), work on a few side gigs to bring in bonus nest egg dollars and move where living is cheaper.

    We’re predicting that rising interest rates could bring us back to the day jobs if our investment portfolio is not diversified enough. We would love your input on this!

    Thanks,
    Mustaches-in-Training

    Reply
  • Keith Loomis June 1, 2017, 9:59 am

    What about closings costs, property taxes, when appliances break, homeowners insurance, pest control, home repair??
    Where does all of this fall in the original example?

    Reply
  • Bianca June 18, 2017, 7:32 pm

    I have been trying to lower my housing expenses to no avail in NYC. I was thinking about buying a tiny house and renting it out in Dallas, TX with my mother managing it.
    What do you think of that situation? The purpose would be to create some passive income even while continuing to rent in NYC?

    Reply
  • Amy July 6, 2017, 7:32 pm

    Hi MMM,

    I am interested in dabbling into the real estate game and getting a couple of rental properties. I am just waiting for the inevitable market crash to swoop in and get some nice units to rent out. Is there a book on these topics that you would recommend?

    Reply
  • Leif Merikson February 12, 2018, 12:43 pm

    Hi there,

    Can someone please explain in detail on how 480$ profit was calculated by MMM?

    I get the 250$ part, but what about 230$?

    Thanks alot
    LM

    Reply
    • Jacob Braaten February 13, 2018, 12:47 pm

      Leif, the $230 portion comes from paying down principal on the $160,000 mortgage, as not all of the mortgage payment is interest and taxes, a small portion is principal. This $230 isn’t seen in the bank account, it accumulates as in equity in the home, which could then be tapped by either refinancing the home, selling it or taking out something like a HELOC

      Reply
  • Joe June 24, 2018, 8:35 pm

    MMM,
    I’ve been reading this blog for years and never commented. I wanted to tell you that when you posted this, I knew immediately that I would do this one day. Through your blog I found biggerpockets, and my wife and I just bought our first house in February- a Duplex in a bikeable area near a downtown that needed some work. The lower unit (in which we now live) was a disaster, but I did about 75% of the work with only the help of a friendly neighbor. To reduce the time spent renting, we paid someone to do some more complicated stuff. I really can’t express how much of a positive impact your blog has had on my life. (PS the only reason I could afford any of this was through eliminating lots of joyless spending and feeding a Vanguard account instead.) This house will make a huge difference for us financially, and working on it has been super fucking fun, even when it’s also terrible. I’ll likely never make it to a Mustache Meetup or to MMM headquarters, but I needed to thank you for this blog. Thank you for writing this.

    Reply
  • TJ Stevens August 27, 2018, 5:31 pm

    Hey MMM,
    Longtime reader, first comment. Thank you for all that you do. I’ve read your entire archives twice! You’ve really helped change a lot of my life.

    In terms of rental properties, I was wondering if you had any advice on possibly buying a place to rent to a lower-income parent (my mom) who couldn’t otherwise buy a place for herself.

    Of course, in an ideal world, I’d just buy a place fully for her … but right now, I can basically afford a down-payment and maybe a bit of monthly assistance. Then I’d need her help in paying her own mortgage. She has a fixed income that could cover something like $750 per month.

    My mom has been a lifelong renter and since I’m making some decent money these days, I scan a lot of real estate listings on her behalf, but I haven’t been able to take the plunge. I could probably afford up to a 40k down-payment for her.

    But do you think this is a good idea and do you have any recommendations on making this work?

    Thanks!
    TJ

    Reply

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