Long-term Results of Buying a Rental Home

There are a lot of millionaires that made their millions from real estate.  It is an investment that you can have control over and for some it can be easier to understand than the stock market.
    The benefits of owning a rental house is that you have someone else helping you pay your expenses, you have the principal on your rental mortgage reduced each month, you have capital appreciation, you have control over the investment and your debt to equity ratio can be 5:1.  When you add all those together you turn a mediocre investment into a great investment.
    After the first year, your long term expenses will remain relatively stable and predictable (if you put a monthly amount aside for upkeep).  Over the long term after each month your principal will be reduced and your house will raise in value.
    The house in the example below could rent for $1,350, but we decided to factor in $50(3.7%) a month for vacancies and $50 a month in hopes to attract a great long term tenant.  In this market it would be hard to find a house that wouldn't have negative cash flow.  For a $249,900 rental home with a 3.2% mortgage rate and a 35% marginal tax rate you would need to rent the house for $1,668 to breakeven on the after tax cash flow.  Initially there is negative cash flow, but the principal reduction and house appreciation more than offsets the initial after tax negative cash flow.
    The benefits of your rental house first starts by increasing your net worth, then eventually will produce positive cash flow and/or an exit event.


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Credit Card Nerd Math

Below we have a chart with the potential results of owning a rental house for the long term.  The house is located in Winnipeg.  The house was bought for $249,000 with a $49,800 (20%) down payment, starting with a five year fixed term mortgage with a 3.2% interest rate.  The home insurance, annual upkeep plus property taxes is $5600 a year.  The house will rent for $1250 a month.
    The assumptions we made were;
a 3% annual increase in rent;
a 3% annual increase in property taxes, home insurance and upkeep;
a 35% top marginal tax rate;
a 2% annual increase in value on your rental house;
an interest rate increase to 3.5%, 4% and 4.5% after 5, 10 and 15 years to show the effect of increased mortgage rates;



Buying a Rental House

Year

Rent

After Tax Cash Flow

Net Cash In (Out)

House Value

1

$15,000

($3,260)

$53,060

$254,898

5

$16,883

($2,744)

$64,829

$275,910

6

$17,389

($2,740)

$67,569

$281,428

11

$20,159

($2,182)

$79,292

$310,719

16

$23,370

($1,519)

$88,016

$343,059

20

$26,303

($885)

$92,519

$371,388

25

$30,492

($34)

$94,416

$409,987

30

$35,349

$14,399

$26,496

$452,659

35

$40,979

$16,692

($52,241)

$499,772

40

$47,505

$19,351

($143,520)

$551,789

50

$63,843

$26,006

($372,007)

$672,628


The value of the house with a 2% annual increase in value after 20, 30 and 50 years is $371,388, $452,659 and $672,628 respectively.



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A Wake Up Call

In the example above, it will take close to fifty years before the amount of after tax earnings will match up with the appreciation of your rental house after the capital gains taxes have been included.
    In the example above we showed that initially you will have a negative cash flow after taxes.  Don't worry too much, you would still be increasing your net worth.  In the first year you will need to put in an additional $3,260, but your mortgage debt would have decreased by $5,304 and the value of the house would have increased by $4,998.  The cash flow is important, but you shouldn't discount the value of appreciation either.  Buying a rental home with a smaller rent yield can pay off in the long run if you are buying in an area with more potential appreciation.
    Why did we use After Tax Cash Flow?  You will be generating positive taxable income even though you are putting additional cash into your rental home investment.  The reason why you can have positive taxable income and negative cash flow is because a good portion of your mortgage payment is going towards your principal, which is not a tax deductible expense.
    Important Note: Every market, every house and every location is different.  What works for one rental home in Winnipeg might not work out for a different rental home in Toronto.  The above is for illustrations only and does not guarantee you that buying a rental house will be a good investment for you.