Rental Investing – Two Variables with One Goal

Rental property investing has been a wonderful path to wealth and a comfortable retirement for many.  Thousands of websites, tens of thousands of books, seminars and courses are focused on how real estate investment can be the path to wealth for the average American.  I’m a real estate investor, and it’s been very good to me.  However, in many cases there is not enough information to help the investor investigating rental property investment to balance the risks versus rewards.

No, I’m not writing a scam article, nor am I criticizing the general enthusiasm for rental property investment.  I do want to help the aspiring rental investor to understand that there are two components of return on investment, and they are not fixed in time.  The ROI goal of rental property investment involves:

• ·         Positive monthly cash flow for the entire period of ownership.

• ·         Appreciation in value for a significant profit when the property is sold.

There are some benefits enjoyed by rental investors not available in stock market and bond investing.  There are tax breaks, including deduction of expenses, depreciation, and the ability to postpone or even avoid capital gains taxes completely.  There has been a lot of news coverage about growing rental demand and increasing rents, so it is easy to get excited about buying a rental home and enjoying that monthly bankable cash during the years ahead.

In many cases we’re also buying at a discount to current market value, locking in some equity at the closing table.  We expect decent value growth, even at low single digit price appreciation expected in the future.  An online calculator tells us that buying a home today for $150,000 and enjoying only 3.5% per year in value appreciation, we would have a home worth more than $197,000 in eight years.

Once we start throwing out numbers like this with a positive monthly cash flow of let’s say $400, a quick simple calculation shows that we would enjoy somewhere around $82,000 over an eight year ownership period.  This is great if we could just stop time in relation to our costs and economic conditions.  We can’t do that, so taking a realistic look at possibilities before signing the purchase contract is wise.

While we can say that inflation actually could help our property’s appreciation, we could see offsetting damage to our cash flow that wipes out that benefit.  The key is to understand the costs involved in rental property ownership and management.  The only one that we can count on remaining constant is the principal and interest portion of our mortgage.  However, other costs that are escrowed in the payment and influence cash flow are taxes and insurance.  Costs of rental property ownership include:

• ·         Real estate taxes
• ·         Insurance (casualty and liability)
• ·         Professional management
• ·         Vacancy and credit loss
• ·         Repairs and maintenance
• ·         Marketing/advertising

You can count on inflation and these costs rising over time.  You cannot count on being able to raise rents enough to overcome cost increases.  While you may raise the rents to do that, you could lose your gains due to increased vacancy losses to competitor properties.  

What about that appreciation component?  The 3.5% example is considered realistic by many market analysts, but they don’t have a crystal ball.  Real estate is local, and every market carries some local economic risk.  Major employers move, and people move to where they can get work.  OK, I’ve just popped the balloon for some who are considering rental property investment, but that’s not the goal.

Just understanding the risks is the first step in getting your desired return on investment.  Don’t use the “best-case” numbers to make your decision.  Discount that expected monthly cash flow for possible erosion in the future.  How much of a discount?  I can’t tell you that, but some adjustment for unexpected but inevitable cost increases is a good thing.  It will be far better if you’re pleasantly surprised by a greater than expected return in a few years.

You’re making a decision during a moment in time, but your deal evaluation calculations should take a long term approach adjusted for an uncertain future.  Rental property investment is still a reliable path to wealth creation.  It’s just a path with some twists and turns you should anticipate.

Buying a Home? Know Hard Costs Going In

Surveys of potential home buyers, particularly first time buyers, are telling us that many could use a little more knowledge about two of the largest costs of ownership.  Everyone needs a mortgage and insurance is necessary as well.  Your lender will require that insurance premiums be escrowed in advance to be certain that the money is there when they are due.  Mortgage interest with a long term fixed rate is at least predictable and stable, but too many new buyers aren’t aware of how their credit rating influences their mortgage rate.

The Mortgage and Credit Scores

Transunion, the credit rating agency, recently announced the results of a survey of potential buyers.  The survey of those planning on or considering buying a home in the next 12 to 18 months, found that while nearly 74% believe it’s important to check the accuracy of their credit report, only 45% or fewer correctly understand that their credit score measures:

 

·         The amount of debt that they hold.

·         The risk of them not paying back the loan.

·         Their financial resources available to pay the mortgage payments.

Many believe that their payment history and on-time payments would be the only or the major factor in whether they get a mortgage or not.  Also, too many fail to understand that the risk measurements influence the mortgage interest rate they’ll be offered.  Small increases in the rate result in mortgage payment increases that can result in being denied a loan on a home they believe is affordable for them.  In fact, only around half could identify the aspects of the home buying process affected by credit scores: interest rate (52%), the amount they can borrow (53%) and their mortgage lending terms (50%).

When it comes to improving credit scores before applying for a mortgage, around a third of consumers surveyed thought that simply increasing their income would have a significant effect on their scores.  And, 28% thought that closing old accounts would help a lot.  Both of those things do have some influence on scores, but not nearly as much as many consumers believe.

Only around half of survey respondents understood that their credit score directly influenced the amount they can borrow, the interest rate they would be offered, and the terms of the mortgage.  Only around a fifth of consumers correctly identified three months as the correct time before applying for a mortgage to check their credit score.  Almost a third of respondents believed that one month before was sufficient time.

Insurance Premiums and Deductibles

The majority of consumers understand that raising the deductible on a homeowner insurance policy will reduce their monthly premium.  However, far fewer of them understand that deductibles offered vary by state and even in how they’re offered (flat dollar or percentage).  Insurance is a must-have, and lenders will require advance payments into escrow to fund premium payments in the future.  They will not allow a policy to lapse in order to protect their investment.

Why do deductibles vary by state?  The first and most obvious reason is that the terms of insurance are controlled at the state level.  They typically average somewhere between $250 and $5,000 per claim.  One study found that raising the deductible from $500 to $2,000 could reduce policy premiums by as much as 16%.  So, many home buyers understandably want to run their deductible up to reduce their monthly outlay.

However, that monthly savings varies a lot by state, with the 16% number being a national average estimate.  In some states like Texas, it can result in a savings of only as much as 6%.  In North Carolina that increase from $500 to $2,000 could drop premiums as much as 41%.  When lenders are approving mortgages, the cost of insurance factors into the amount they’ll loan on a home based on income and expenses of the borrower.

If you’re about to gear up to buy a home, start planning early for credit evaluation and insurance cost estimates.  You want to get prepared and have a firm understanding of what your lender is checking to determine what they will approve for your loan.