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The myth of cash flow in rental property in the 21st century

Posted by John T. Reed on

For decades now I have watched wannabe real estate investors and beginner real estate investors say their goal was to accumulate enough properties that they could live off the cash flow from them.

Is that possible? Yes, but in the sense that you can live off the cash flow from a savings account.

Let’s make $50,000 a year the target cash flow. The median household income in the US today is $79,900. HUD

Savings account

On 8/18/21 Internet said you could get .5% on a savings account. To get $50,000 a year before tax, the amount in the savings account would have to be $50,000 ÷ .5% = $10,000,000.

That would be taxed at ordinary income tax rates. Such a cash asset would be at great risk of US dollar inflation.

FNMA bond

On 8/18/21, the Wall Street Journal said you could get a 2.358% interest rate on a FNMA bond. At that rate, in order to get a $50,000 annual income, you would need $50,000 ÷ 2.358% = $2,120,441 worth of such bonds. 

That would be taxed at ordinary income tax rates. Such a cash asset would be at great risk of US dollar inflation.

Free-and-clear rental property

The rate of return on a free-and-clear rental property is the rent - operating expenses = net operating  income/the value of the property. 

Operating-expense ratio

This is the key problem in understanding this matter. The operating-expense ratio of residential rental property is 38% to 43%. There are about five or ten sources you can use to confirm that.

The annual Apartment Income-Expenses Analysis published by the Institute of Real Estate Management which is a subsidiary of the National Association of Realtors®.

The annual National Apartment Association Survey of Income and Expenses.

 https://www.realpage.com/analytics/size-matters-investigating-operating-expenses-across-multifamily-product/

https://www.jwbrealestatecapital.com/how-to-estimate-rental-property-expenses/

 https://www.realpage.com/blog/an-inside-view-on-real-estate-profit-margins/ (These are REITs who own apartments. They report operating expense ratios of 76.3%.)

https://www.zillow.com/blog/investing-101-estimating-rental-property-expenses-94824/ These guys say 37.5% to 45%.

Invitation Homes is a publicly-traded company that owns and operates rental houses around the US. For the second 1/4 of 2021, they say they had rent of $490,618,000 and three categories of operating expenses: $175,422,000 + $17,696,000 + $19,828,000 = $212,946,000 leaving an operating-expense ratio of $212,946,000 ÷ $490,618,000 = 43%. https://d18rn0p25nwr6d.cloudfront.net/CIK-0001687229/cfe0d511-8abb-436a-9942-639b44cf3282.pdf

There are also other surveys like MPF research and local apartment associations. Their basic message and my point is the operating-expense ratio is at least 38%.

According to Zillow, the average US home costs $298,933 and rents for $1,000 a month or $12,000 a year. In the most optimistic scenario, a 38% operating-expense ratio, the net operating income on a free and clear property is (100% - 38%) = 62% x $12,000 = $7,440/$298,933 = .249%.

Again, that is the most optimistic return rate on a free-and-clear, single-family home.

At that return rate, to earn $50,000 a year, you need to own $50,000 ÷ .249% = $2,008,032 worth of free-and-clear rental property.

If you buy buildings with two or more units in them, using the REIT numbers, which are likely the most accurate because they have the strictest rules on accuracy, $12,000 of gross rent only yields 22.7% net operating income or $12,000 x 22.7% = $2,724 a year. So you would need almost three times as much rental property—around $6,000,000 to get $50,000 a year income.

Rental income in its early years from a particular building would trigger no income tax to the extent that depreciation deductions offset the income. But those same depreciation deductions subject capital gains from the sale of that property to a recapture tax rate of up to 25%. 

Liars

The bane of beginning investors is that there are literally tens of millions of liars who are claiming they have positive cash flow. There are also sellers and agents who lie about the operating expenses you will have if you buy a property they are trying to sell you.

Basically, they will claim a lower operating-expense ratio than 38%. That is the myth, the lie. They want to fool you and they want to fool themselves. 

Leverage?

They believe they have positive cash flow even though they have taken the free-and-clear return rate I showed above and burdened it with a mortgage payment on a loan with a higher interest rate than the free-and-clear return rate. Unless the mortgage interest rate is lower than the free-and-clear return rate, leverage makes things worse, not better. 

You will be told that leverage makes it all better. Nope. Add the mortgage payment to an income statement with accurate income and expense projections and you will see that the mortgage payments exceed the net operating income. In other words, negative cash flow.

Is it possible to get a good return in real estate?

Yes, but it requires either good luck with regard to future market wide appreciation rates or you must make a bargain purchase or find property with unrealized potential and cost-effectively add value to make a profit above-and beyond lucky market-wide appreciation. 


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