A couple of posts ago I talked about the Oldsters buying a house. It has been a while since we’ve been in the mortgage market so, though I try to pay attention to these things, I was a bit surprised at how low mortgage rates still were. We’ve been seeing a lot in the news over the last several months about the Fed raising interest rates, and they have nudged them northward a bit lately, but generally, rates are still very low. But for how much longer?
There is a logical, perhaps even mathematical, connection between mortgage rates and rental property demand. Think about it, the higher the mortgage interest rate, the higher the monthly payment. The higher the payment the smaller the group that qualifies for a mortgage. If one cannot afford to buy a house, then they must rent. Hence, higher mortgage rates should translate into higher rental income. Of course things are never that simple. Each market is different and an over saturated rental market might take longer to see the benefit of higher interest rates, but in general, the theory should hold true.
While my mind pretty much whirrs on financial matters all the time (it’s a blessing and a curse, believe me), I have not given much thought to the rental market over the last decade or so. I know that real estate is one of the many ways that people can create wealth. It always has been (when done correctly), and I’ve read a good bit about it on the various FIRE sites and blogs I frequent (one of my favorites is Paula Pant’s Afford Anything – I find her irreverence refreshing), but I haven’t given much thought to the mechanics as it relates to my personal situation. I just never saw myself as a landlord. It seems like such a hassle. But, after looking at mortgage rates recently, I started looking into the rental market and how an investment might work, and the results were very interesting. First some pretty graphics to hold your attention.
FEDERAL FUNDS RATES
You can see from this graph that interest rates are pretty much at a rock bottom. You can thank the Great Recession and the Fed’s Qualitative Easing policies (you don’t need to understand them, just thank them). Mortgage rates have followed the larger interest rate market down to the point where a 30 year fixed rate mortgage can be had for under 4% and a 15 year fixed rate is near 3%!
MORTGAGE RATES
You can see from the above graph what a historical bargain that is. But what does it mean in relation to rental properties? Ordinarily, when rates are low buyers enter the market. More buyers mean fewer renters, right? Well, not for the last 8 years or so. After the financial meltdown leading to the most recent recession, banks put the brakes on the sub-prime lending market and a lot of folks who could “afford” a house (note the subtle use of quotes implying my true opinion) can no longer get a loan. So while rates are still at historic lows, the rental market continues to do very well. (Note – banks seem to be loosening their policies under the current administration, so there is some uncertainty about whether we could fall into the same hole we did 10 years ago, but that is another post). So what are the practical applications to this unusual situation and what do the numbers show (at least hypothetically)?
Well, let’s set the assumptions (and be conservative), and see what the annual profit/loss would be for an average rental house in my area of Appalachia. First, we have to look at what the interest rate would be for a mortgage being used for the purchase of a rental property. The standards are slightly different when buying rental property than when you are buying your primary residence and generally, you should pay a little more to borrow money, in my experience you’ll pay a premium in the 0.5% range. So let’s be conservative and assume we are going to pay 4.5% on a 30 year loan (about 0.75% above the best residential rate available as of this writing).
Where I live, the area where the favored schools in the county are, has a goodly number of 3 bedroom, 2 bath houses for sale in the $150k to $200k range. These are not in high-end neighborhoods, but are in well established and quiet areas, with access to the best schools.
Let’s assume a purchase price of $175k. As for a rent price, a rule of thumb is 1% of the value of the house and that is about right for this area. That would mean a rent of $1,750 but because we are being conservative in our fact set, let’s assume a $1,500/month rent.
Next, let’s account for vacancy (because no property is ever fully rented all the time). The national vacancy average right now is about 5%, so keeping to our conservative scenario, let’s assume a vacancy rate of 10%.
Taxes and insurance will run about $250 per month here (fairly low property taxes in this area of Appalachia) and we are going to assume a $100/month repair budget. This will allow for something somewhat major, like HVAC or electrical issues, every couple of years or so (we hope that won’t be the case, but let’s plan).
Because rents should rise in an increasing interest rate environment faster than inflation, I’m going to assume 5% annual rent increases, and 3% increases for insurance and taxes.
Also, I’m going to assume that we hire a property management company to run the rental. A lot of the blogging on rental property as a component of FIRE discusses the need to have the income be “passive”. A property management company will find the tenants, collect the rent, maintain the property and just send you a check every month (or quarter). If you decide to manage the property yourself, you’ll have better cashflow (and, probably, less sanity – but not too much less if you choose your tenants well).
So, the fact pattern is:
Property Price $175,000
Mortgage Interest 4.5%
Rent $1,500/mo increasing 5%/yr
Vacancy Rate 10%
Property Mgmt Fee 10% of collected rent
Property Taxes $150/mo increasing 3%/yr
Insurance $100/mo increasing 3%/yr
Maintenance $100/mo
We are going to look at 5 different down-payment scenarios. Each will affect the total amount borrowed and, therefore, the amount of the monthly payment on the mortgage. The down-payment scenarios are:
1) Nothing Down (yes, you can find lenders who will do this);
2) $17,500 – 10% Down;
3) $20,000 – 11.4% Down;
4) $25,000 – 14.3% Down;
5) $35,000 – 20% Down.
The dollar amounts listed below under each scenario is the amount of profit or loss for each year under the terms of that scenario. I’m doing a 10 year look at each scenario, and following the profit number for the 10th year, I’m giving the equity in the property assuming no growth in property value (which is unrealistic, but we are being very conservative with the assumptions). Also, I’m not addressing tax considerations, of which there are both positive (depreciation) and negative (income tax).
Scenario No. 1 – No Down Payment
Year 1 – ($260.40) – our only loss
Year 2 – $343.00
Year 3 – $978.67
Year 4 – $1,648.72
Year 5 – $2,354.94
Year 6 – $3,099.23
Year 7 – $3,883.57
Year 8 – $4,710.05
Year 9 – $5,580.87
Year 10- $6,498.32
Equity in Yr 10 $30,613.94
Scenario No. 2 – $17,500 Down Payment
Year 1 – $803.64
Year 2 – $1,406.64
Year 3 – $2,042.31
Year 4 – $2,712.36
Year 5 – $3,418.58
Year 6 – $4,162.87
Year 7 – $4,947.21
Year 8 – $5,773.69
Year 9 – $6,644.51
Year 10- $7,561.96
Equity in Yr 10 $45,052.55
Scenario No. 3 – $20,000 Down Payment
Year 1 – $955.68
Year 2 – $1,558.68
Year 3 – $2,194.35
Year 4 – $2,864.40
Year 5 – $3,570.62
Year 6 – $4,314.91
Year 7 – $5,099.25
Year 8 – $5,925.73
Year 9 – $6,796.55
Year 10- $7,714.00
Equity in Yr 10 $47,115.21
Scenario No. 4 – $25,000 Down Payment
Year 1 – $1,259.64
Year 2 – $1,862.64
Year 3 – $2,498.31
Year 4 – $3,168.36
Year 5 – $3,874.58
Year 6 – $4,618.87
Year 7 – $5,403.21
Year 8 – $6,229.69
Year 9 – $7,100.51
Year 10- $8,017.96
Equity in Yr 10 $51,240.52
Scenario No. 5 – $37,500 Down Payment (this is 20% of the purchase price)
Year 1 – $1,867.68
Year 2 – $2,470.68
Year 3 – $3,106.35
Year 4 – $3,776.40
Year 5 – $4,482.62
Year 6 – $5,226.91
Year 7 – $6,011.25
Year 8 – $6,837.73
Year 9 – $7,708.55
Year 10- $8,626.00
Equity in Yr 10 $61,553.81
Now we all know that when you run hypotheticals, even with conservative numbers, that the real life experience is going to be different. But the range of outcomes here after 10 years of renting out the property is pretty telling. Whether you borrow the entire purchase price and after 10 years are bringing in $540/mo in cash flow, with equity of better than $30k, or put down the standard down-payment of 20% and have more than $700/mo in cash flow and better than $60k in equity, your rental is a financial success.
A STACK OF BENJAMINS YOU MADE RENTING OUT YOUR PROPERTY
And remember, we calculated a property management fee of 10% of rents in these calculations. You could do even better if you have the personality, and the organization to manage the property yourself.
What is to be learned here? That investing in rental property, when done right, can be very profitable (but we already knew that, right?). But also, that the particular interest rate environment we are currently in may be giving us opportunities in the rental market that may be both short-lived, and not seen again for some time.
Until Next Time – FIRE On!
