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!