Investing in Rental Houses: Balancing Risk & Return

Mike Nelson
Mike Nelson

There is a relationship between return on investment and risk.  In the stock market some investors are willing to purchase ““Penny Stocks”.  There is a chance these investors can generate very high returns on their investment.  But there is also a high probability that these investors will lose every penny invested.  Conversely some investors purchase Treasury Bills knowing that the return on investment is very low but then so is the risk.

As you analyze your potential return on investment make sure that you analyze how much risk is involved and how much risk you can afford.  In my opinion, investing in rental houses is a great way to “get rich slow”.  With a reasonable down payment, 20% – 40%, an investor can take advantage of leveraging the investment while still generating a positive cash flow that significantly reduces the possibility of having to feed the investment from ordinary income or savings.

My technique: is to open an interest bearing checking account for the rental properties.  I start with a reasonable reserve for each house purchased.  I make the mortgage payments for the rental houses from this account and deposit the net rental proceeds into this account.  I use professional management so all of the operating expenses are handled by the property manager and I get the net direct deposited to this account.    The properties are generating a positive monthly cash flow most of the time, so these positive amounts accumulate and earn interest.  When the time comes that I need to spend more than the monthly rent will cover, these reserves are available.  I don’t need to come out of pocket to put money into the house.  For example, when I need to “turn” the property between tenants and it requires new paint, and/or new carpet, then that house will not have a positive cash flow for that month.  But, having accumulated several months of positive cash flows during the normal operation of the property, I have the funds in the rental house bank account to pay these bills without having to dip into my savings account and without impacting my monthly household budget.  As the cash balance continues to grow in that rental property account, I will have another down payment available to purchase another rental property.

So what is a “reasonable return” and a “reasonable” amount of risk?

Each investor needs to decide that for themselves.  Today I can earn interest at my bank at a rate of .75% (not much).  With a 30% down payment on a rental house I can generate an IRR (Internal Rate of Return) of 15% to 20%.  That 30% down payment, with mortgage interest rates in the range of 4% – 5% for investor purchases, will give me enough of a positive cash flow that I should not need to use any of my savings or monthly paycheck to support the investment.

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