From the Excalibur Homes video series “What Landlords Need to Know,” with Mike Nelson
Today I’m going to cover a question we get all the time from clients and prospective clients: “Is my property a good investment?”
Many times, the property in question isn’t a rental yet. Quite often an owner comes to us and says, “I live in a house with a very low interest rate. I’m moving to my next property because I’m upgrading, or because my employer is transferring me. I’d like to keep this house as a rental. Would it be a good rental property?”
The honest answer is: it depends. There are a lot of considerations here.
Start with your buy box
When Excalibur works with a landlord, we start by sitting down with that investor to develop what we call a buy box. That conversation covers questions like:
- What sort of yield are you looking for?
- How much risk tolerance do you have?
- How much cash is available?
- If the property needs renovation, are you able to do it?
- Do you already have financing in place, or will you need a new mortgage?
- Is this a property you already own?
That last question matters more than you might think, especially when the property is your personal home.
The personal-home example
Let’s say your personal home is worth $800,000 today and you only have a $300,000 mortgage on it. It would be very easy to get a good cash flow off that property as a rental.
But you’re probably not going to get a very good yield, because you have a whole lot of cash tied up in one rental house. Another option would be to sell your personal home, which under the IRS tax code you can often do with no capital gains tax, and take that $500,000 in equity and buy two or three rental houses instead.
Yield is more than monthly cash flow
One thing to remember is that your yield on a rental property is not just a function of your monthly cash flow.
When it comes to rental houses, most of your gain is going to come from appreciation as the property grows in value. Another factor is how much of the loan balance the tenant pays down for you over the years. Every month they make a rent payment, and you use that money to make the mortgage payment.
When we run a cash flow analysis for a client, the number that really matters is the internal rate of return, both unlevered (no mortgage) and levered (with a mortgage). That internal rate of return reflects three things together:
- How much the property appreciates
- How much you receive in cash flow
- How much your mortgage balance goes down over the time you own the property
We look at all of those considerations and work with the client to determine the best path forward.
When a good investment gets older
Another situation we see is a landlord with a 10- or 12-year-old property that works fine today. But every capital component of that house has a certain life: the roof, the furnace, the air conditioner, the appliances, the water heater.
What often happens is that a property that started out as a good investment gets older, and over time you end up putting a lot of cash into replacing the roof, the furnace, the air conditioner, and the water heater.
Here’s the challenge: you don’t get more rent for replacing the roof. The tenant expects the roof not to leak. They don’t care how old it is. They’re not a buyer. They expect the air conditioner to keep the house cool. They don’t care how old it is either.
So when you start putting a lot of money into capital expenditures, or CapEx, that takes a lot of cash out of your pocket. It might add value to the property if you were selling it, but it may not add a dollar of rental income.
Knowing when to move your equity
That’s why, from time to time, we reach out to an existing client and explain: this property worked well five years ago, but you’re now entering a window where it might be a good idea to think about selling it. Using a tax-deferred exchange, you can do that without paying capital gains tax, and move that equity into one or two newer rental properties that will be a better investment.
The bottom line
Don’t be too emotionally attached to the property or the address. Be attached to the yield you want to earn. Then we can work with you to help you achieve it.