How to Evaluate A Rental Property
How We Became Landlords: The Story of Our Rental Property
When I met my husband in Athens, Georgia, I knew he was special.
I wasn’t expecting to meet anyone that night, but when I arrived to meet our group for dinner, he looked up at me with his clear, genuine, blue eyes and time stopped. After an hour of conversation, I was smitten.
When it’s right…you know.
It was like that, later on down the line, when we found our first place to buy together. He was an officer in the Army and I was a freshly minted doc about to start residency in Nashville. We decided to we wanted a little place to call our own.
Now, most people will tell you buying a house in residency is a bad idea, and I’d probably agree with them.
What if you don’t like the program? How do you know the town well enough? What will you do with the house when you leave in just 3 years?
Our thought process was this- we both wanted to own a few rentals for passive income, so we thought we’d start buying now. We were responsible and made our house buying budget based on my husband’s salary alone. And, we already knew the town a little as my husband had been living 40 miles away near Fort Campbell for a year or so.
So, when we looked at real estate, we evaluated property through the lens of buying a house that would make a good rental down the line.
Searching for a Rental Property
Excitedly, we started our hunt and our lovely realtor took us around town. We saw some nice places but not “the one.”
Then, Josh (Mr. TFP) found this cute little place right in the heart of the city, close to everything, and with a nice large yard.
We couldn’t believe our luck!
We asked our realtor to take us there. Initially, she balked. It wasn’t a “good” neighborhood.
We decided to look anyway, and sure enough, we passed some payday loan places…a pawn shop…a very shady looking apartment complex.
But then we turned on our street and it was breathtaking- a quiet street with tall, mature trees and nice looking single family homes. The home was a nice 3 bed/2.5 bath and the backyard had a view of the downtown skyline.
We were in love.
We drove around the neighborhood several times to make sure we were ok with it, and it looked pretty docile.
We decided to go all in.
Josh financed us with a VA loan and we closed with nothing down.
In fact, we got a check at the closing- we got our earnest money back.
The VA loan is a great tool for military families. Like a doctor loan, the VA loan provides the opportunity for service men and women to buy a house with no money down, no private mortgage insurance, no prepayment penalty, and competitive interest rates.
It is a pain in the behind to get approved. But, once you’ve jumped through the hoops, the government takes care of you.
So, move in day came and we lovebirds were so excited to start building our nest.
After moving all day and without a kitchen set up, we decided to have some pizza delivered.
Everything was going well… Up until I gave them our address.
I finished with my zip code and the person on the phone hiccuped, “Oh I’m sorry, we don’t deliver there.”
“What do you mean?” I asked.
“The neighborhood is too dangerous.”
What the what? We did our due diligence and checked out the neighbors before we moved in. I was sure their information was outdated.
And in some sense, it was.
They thought the neighborhood was a Class D neighborhood. But it had actually improved to a Class C! Sure there were occasional drive by’s and park shootings a couple of blocks over, but my immediate neighbors were amazing people with steady jobs and strong desire to improve the neighborhood. They are still great friends, even after we have moved.
Here is what I mean by neighborhood “class.”
*cred to Paula Pant
Class A: You know THAT neighborhood that everyone wants to live in, but few can afford. New houses, best finishes. Generally close to Panera breads, Starbucks, and Whole Foods.
Class B: Middle class, regular people type neighborhoods that are safe and quiet. Slightly older homes, dated finishes. Close to Dunkin Donuts, Aldi, and Kroger/Price Chopper.
Class C: Lower income, old homes, lack infrastructure, higher crime. Close to pawn shops, payday loan places, dollar stores, Save-A-Lot.
Class D: You wouldn’t walk through this neighborhood alone, even in broad daylight. This is the other end of THAT neighborhood- the one that everyone tells you to avoid.
Evaluating Our Rental Property
When my husband and I left Nashville for the coast, we kept the property as a rental, as we planned.
Buying in a Class C neighborhood that had so much potential was the key to our success. We bought the place in 2012 for $142k. It’s now worth around $311k according to online estimates.
The neighborhood still has tons of potential. There is lots of development and infrastructure improvement planned here in the next 10 years and the hottest restaurants are opening up down the street. So, the value is likely to continue to skyrocket.
But the house’s value is theoretical. It’s not our money until we sell it. Counting on future value increase is basically gambling. Sure, we have a good chance of coming out ahead. But, it is looking like we are headed for a downturn in the near future. The way to evaluate the money in a rental property is in the rental income.
So, I sat down to analyze the numbers of whether we should keep or sell the property.
How good of a rental was this place when we moved out in 2012 and how good of a value is it now?
A couple of ways to evaluate a rental property, when buying initially, are the One Percent rule and Cap. Rate.
The One Percent Rule
The 1% rule is that in order to make a good rental, the property should rent for 1% of the house’s value. For example, a $100,000 property should rent for $1000/mo to make a good rental. This is just an estimation, of course. But, it’s an easy point of reference to start from.
Our house initially rented for $1795 in 2015. When we bought it in 2012, the rental value was about the same. so $1795/ $142,000= 1.2%.
The Capitalization Rate
The capitalization rate (cap rate) is calculated by dividing the Net Operating Income from the property’s value. This calculation is not based on financing, so mortgage is not taken into account.
To estimate the Net Operating Income (which is gross rents- expenses), you can estimate that 50% of rents will go to expenses such as utilities, vacancies, maintenance, etc.
For our property, the yearly rent was (1795*12)= 21,540. NOI would be 21,540* 0.5= 10,770. So Cap rate is 10,770/142,000= 7.5%. Average cap rates in Nashville are around 5-6%, so this place looked pretty good!
So the property was a pretty good rental when we started renting it. We’ve had a property management company manage it and take care of the daily nitty-gritty details: calls from tenants and the maintenance stuff. The tenants have paid their rent reliably. So, overall, we feel pretty happy with this setup.
But now, my family and I are on a mission to get out of debt.
When we bought, the place was a good rental but we didn’t count on the value of the place more than doubling in 5 years to $311k.
We still owe $125k on the rental. But, we have somewhere around $180k of equity in it.
It is now renting for $1950.
So today, by the 1% rule, we are at 0.6% = 1950/311000.
The cap rate is 3.7% =(1950 x 12 x 0.5)/311000).
That’s not doing that great on the 1% rule or the cap rate.
The way to fix this would be to either raise the rent (which I think the market would support- we have had stable tenants and didn’t want to raise it on them too much too quickly) or sell the property for one that cash flows better.
The way to evaluate whether to keep or sell now is the return on equity (thank you everyone on the Passive Income MD facebook group that suggested this).
The return on equity is calculated by the net yearly income divided by the equity.
Our Return on Equity now is 6.5% = (1950 x 12 x 0.5)/180,000 That’s not a terribly good number. The stock market has done a lot better in recent years (10-12%).
Using the Numbers to Our Advantage
We are currently renting our primary residence. Our plan now is to pay off the my student loans by June this year, and then save a 20% downpayment for our next primary residence…Which should take about 8 months at our savings rate.
So, I’ve been mulling this master plan- what if we sell the Nashville house and put the proceeds towards buying our primary residence.
There are a couple of glitches here. If we had lived in the Nashville house for 2 years out of the last 5, we could have not paid any capital gains tax. But unfortunately, we moved out 4 years ago, so we would have to pay capital gains tax (which would be around 26%). So with $180k equity- 5k in improvements for sale – 10k in closing costs- 46k in taxes leaves us with 119k of net gains.
There is a provision called the 1031 exchange which allows rental properties to be traded without paying capital gains tax. So, if we keep the rental and sold it later, we could buy another rental- maybe a multiunit building- and not have to pay any capital gains tax.
I wondered if the 1031 exchange would apply if we bought a duplex in NY instead. So the plan would be to for us to live in one half and rent out the other. Some really nice townhouses can be had here for 300-400k. So with the around 200k after selling the Nashville house, we could either save up the difference or finance the difference. I asked Dr. James Dahle and Dr. Peter Kim this question and the answer was that a 1031 could be done for the rental unit- that would be treated as a separate sale. If we can do this, we can be completely debt free in less than 2 years! That would be quite the feat- going from over ¾ of a million dollars in debt to completely debt free, including the house in 4 years!
I always shoot for the sky.
The Other Side of the Coin
There are a couple of glitches to this plan.
1) My husband doesn’t want to sell. He thinks the house will continue to go up in value and thinks we should keep it because what’s the rush? It’s true, we do have time and will make out fine either way. But, if we’re debt free in a couple of years, we can have more freedom to adjust our work schedules the way we want them, spend more time with the kids, and generally this is my whole goal with money- to be able to do what I want when I want! I don’t want a bazillion dollars. I just want my freedom and that’s why I want to be debt free.
So this whole post was an elaborate plan to convince him to sell… ha.
2) We want to stay in the rental business and in the Nashville market. Our plan after becoming debt free is to build a stream of passive income from paid off rental properties. I would love for those properties to be in Nashville as there is no state tax (as compared to the taxes in New York!) and Nashville is a booming town. So, keeping the rental would mean keeping ties with the management company, the contractors, and realtor we will need to get into the market further.
3) Tax advantages. The government likes rental property ownership and rewards landlords with tax benefits. We get to take depreciation on the property, which is $15k-18k each year. That is free incentive money from the government. We also get to deduct our mortgage interest.
So, for now we’re keeping it until our current tenants’ lease is up. In the end, I’m not sure what we’ll decide but this whole process of learning how to evaluate the rental has been a good learning exercise for me. We thought we were doing great with the rental but the Cap rate, 1% rule, and Return on equity calculations made me think. So, that’s all for this crazy lady’s money ramblings for today.
I hope this case study has helped some of you!
Let’s crowdsource.. What do YOU think we should do?