Rental property #1: My Real Return after 6 months

In today’s post, I discuss my “Real Return” from my first rental property acquisition.  This was a small 3 bedroom home in Birmingham, Alabama that I purchased in mid 2019. I was excited to get started, and this turnkey provider had inventory available for purchase immediately.  I had first hand reviews of the quality of their construction work, but also heard some worrisome things about their property management. Not to be deterred, I forged ahead.  

I quickly ran into issues…

Warning: Brutal honesty ahead!

When I started my blog, I made a conscious choice to take a position of brutal honesty with my posts.  For example, when doing a detailed breakdown of our annual expenditures, I included some of our more ridiculous indulgences, like our membership to a beach club and my Tesla Model 3 car payment.  

These things might not fit into your typical narrative of a FIRE-seeker, but perhaps it makes sense in the context of moFIRE.  I’ll be the first one to admit that as a surgeon in a dual-income household, our income affords us more luxuries than most.

It’s also worth noting that I write from a position of financial strength, as noted in my post about our investment portfolio that I described earlier this year.

But as I’ve outlined in our 15 year plan to financial independence, it’ll still take monstrous saving and investing to achieve moFIRE.  Taxes are a big drag on our investing, which is one of the big reasons why I chose to include real estate in my investments.  

Read more: Tax benefits | Why I’m investing in real estate over stocks – Part 2

Now as I report on my growing real estate empire, I plan to keep to the same level of brutal honesty.  It’ll be more helpful to you, my reader and fellow investor, and it will also keep me from deluding myself about the overall success (or failure) of my investments.  

Calculating my Real Return from Rental Property #1

As I discussed in my last real estate post, it takes a few extra steps to calculate your return from rental real estate as opposed to index funds.  

To review, here are the steps:

  1. Calculate acquisition costs
  2. Calculate profit with your Is and Os  
  3. Set aside reserves
  4. Calculate your strict return 
  5. Add in bonus return to get your Real Return 

So read on below as I apply these steps to Rental Property #1.

Calculate acquisition costs

The easiest way to understand how much I spent to purchase the property is to examine the “closing disclosure” from the mortgage.  

The total amount of money it cost to purchase this property was $23,888.

In chart form, here are the various elements.

As you can see, it takes a good chunk of change to purchase a house, even an affordable house in Alabama.

Calculate profit with your Is and Os  

To calculate my (projected) profit, I need to figure out the money that’s coming in each month (my Ins) versus what’s going out (my Outs).

“Ins”

Money coming in is easy to calculate.  For this home, it’s just the monthly rent, which is unfortunately only $810.

When I purchased the house, the turnkey company had projected a rental income of $835/month.  This put the projected monthly income at 0.91%, which fell just short of the “1% rule,” but still okay. 

More reading about the 1% rule from the Afford Anything blog.

After it didn’t rent for over two months, I grew concerned, and ordered my property manager to start dropping the rent.  

After three months of vacancy, the property finally rented at $810 a month.  By this time, I had lost patience and fired my original property manager.

  • Annual “ins” = 3 months @ $0/month (vacancy) + 9 months @ $810/month
  • Annual “ins” = $7,290

“Outs”

Here are my projected costs for the first year, below. 

“Outs” for first year
Homeowners Insurance$695
Management fee (10%)$729
Mortgage$4,872
Property taxes$774
Total$7,070
  • Ins – Outs = Profit
  • $7,290-$7,070 = $220

Hmmm…  not much profit.

Set aside reserves

The reserves that I usually set aside include 8% of rent for vacancy (equal to 1 month), and 8% of rent for maintenance and capital expenditures.  

Since I started out the first year of ownership with 3 months of vacancy (25%), instead of just 1 month (8%) as I had projected, I’m not going to set aside any more reserves for vacancy.

Reserves for first year
Maintenance/CapEx (8%)$778
  • Subtract reserves from your profit
  • $220 – $778 = -$558.

Yikes.  A negative number.  Those extra 2 months of vacancy were a killer!

Calculate your strict return

  • Strict return = Profit / Acquisition costs
  • $-558 / $23,888 = 0.023 * 100 = -2.3%

I agree.  That negative number is quite nauseating.  

Add bonus return to get your Real Return

As discussed in the last post, bonus return includes all the intangible ways that owning leveraged real estate grows wealth.

The things that I recommend counting include mortgage paydown, appreciation, and tax savings.

Bonus return for first year
Mortgage paydown$1,038
Appreciation (2%)$1,840
Total$2,878

Mortgage paydown: I use this free mortgage calculator to generate the amortization schedule that shows how much my mortgage will be paid down in the first year.

Appreciation: A conservative appreciation rate for a linear market like Birmingham is about 2%, or just keeping up with inflation.  

Tax savings: I won’t have much positive income to report this year. What little there is will be deducted away by depreciation. Since this is such a small figure this year, I’m going to ignore this bonus.

  • Real Return = (Profit + Bonus return) / Acquisition costs
  • ($-558 + $2,878) / $23,888 = 0.097 * 100 = 9.7%

Analysis

  • Strict Return: -2.3%
  • Real Return: 9.7%

To be honest, I’m not happy at all with these numbers. I didn’t expect that my property would sit vacant for 3 months before being leased to a tenant.  This was much longer than my projected vacancy. With leveraged real estate, you still need to pay the mortgage even if there is no tenant paying you rent.  This murdered my expected returns.  

I can blame the long initial vacancy on the property management company that came with the turnkey company, but I was warned about them. Lesson learned.

I also selected a property where the margins were too thin to withstand Murphy’s Law and the extra 2 months of vacancy. In retrospect, I should have found a different turnkey company where the rents were higher or the purchase price of the home lower.

The silver lining

Let’s take a break from the pity party and consider that when bonus return is taken into account, my projected Real Return is almost 10%.  Mortgage paydown and appreciation are also non-taxable events, so there is no portion of this gain that will be going to Uncle Sam.  

I should also acknowledge that it really matters how you massage your data here.  If I had lumped the 3 months of initial vacancy into my acquisition costs and started my projection from my first month of occupancy, my numbers would look somewhat better (about a 15% Real Return).  Some would argue that I should do this, and just call those first few months “stabilization.”

But I feel it’s more honest and helpful to you, my reader and fellow investor, to leave the calculations as they are.  

The future

Even though this first purchase isn’t performing so well as an investment (so far), it did its job to get my real estate empire underway. It gave me some much needed momentum and experience that I’m taking with me to the next deal. I also thankfully have a lot of reserve funds to ride out any cashflow worries with my first property.

As I hinted in my last report of my rental empire, I’ve got some exciting things in the works, including the purchase of a duplex and another single family home.  I hope to have a higher Real Return to report from these investments!

So stay tuned, there’s a lot more to come!

–TDD

Should I give up on real estate after this experience or forge on ahead? Comment below, and subscribe to see how this all ends up!

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xrayvsn
2 years ago

Thanks for sharing the true numbers which allow someone to see that not everything always goes according to plan.

I think once you have a tenant locked in the subsequent years should have less downtime with vacancy (if lucky the tenant will just renew lease).

Wish you much success for your beginning real estate empire.