Let’s say you buy a SFR for $35K and spend another $25K in rehab. Your investment in this property is $60K. You own the property free and clear. If the property sits vacant, your only ownership costs are taxes, insurance, utilities and the seasonal yard maintenance. Let’s say all these avarage out to $100 per month.
If you put a tenant in the property at $700 per month, you can transfer the utilities cost to the tenant, but you add wear and tear and minor repair costs to your overhead. Let’s say your rental costs you an extra $50 per month on the average just for the repair costs and extra preventive maintenance. So now, your ownership and operating expenses come to $150 per month when your property is occupied.
It costs you to fill a vacancy, too. Advertising costs, leasing costs, mileage to show the property, tenant screening, legal fees all have their costs. Let’s say these direct costs average $300 each time you have a vacancy. Amortize this to $25 per month. The indirect costs for your vacancy is that you have no income for the month. If your typical vacancy is two months because you are in a soft rental market, then you have to allow for $1400 less income in any given year. Let’s amortize the vacancy allowance over the year which will reduce projected rental income by $117 per month.
Now adding up all your direct and indirect costs, you are only putting $433 in your pocket each month from your $700 rental income. If you outsource property management, expect to pay about 10% in management fees, so now your net operating income is reduced to $363. If your property is in a planned unit community or a condo association, HOA/COA dues will take another bite out of your net operating income.
Let’s say you just have this one property which you decide to manage yourself and you don’t have any homeowner’s association fees. Your net operating income of $433 per month is your cash flow because you own the property free and clear.
Over the course of 15 years, you would expect to experience at least one major system replacement. A new heat pump system replacement might run $4500, a new roof could be $7000. Major appliances break down and need replacement too. A brand name heat pump system should last about 12 years. a roof should last about 25 years, and your major kitchen appliances (range, refrigerator, dishwasher) should give you about 10 years service. If you replace all the kitchen appliances just once, you will most likely spend 1800 by the time you pay for delivery, installation and haul away the old stuff. If you contribute to a replacement reserve account each month to take care of these major replacements as they come up, you would set aside $70 each month from your net operating income, so now your effective cash flow is reduced to $363 per month.
Over the course of a 15 year holding period, $363 in monthly cash flow will put $65340 in your pocket – just $5340 more than you have invested in the property. Let’s say that after your rehab, your property will appraise for $85K. If your market appreciation averages 5% per year over the next 15 years, then your property should be worth $161,270, for $71, 270 in appreciation. When added to your cash flow, your $60K investment has given you a $136,610 return over your 15 year holding period (roughly a 15% annual return on your investment).
Now let’s see what happens when you sell the property with owner financing. Let’s say you sell for the full appraised value of $85K with a $5K downpayment. You agree to finance $80K at 9%, interest only for 15 years. The buyer’s monthly payment to you will be $600 per month, or $108,000 over 15 years. At the end of 15 years, your buyer refinances the loan and pays the $80K mortgage balance.
You collected $5K downpayment, $108K in interest payments and another $80K when the loan was paid off for a total of $194K if the loan ran the entire 15 years. If your loan is a 15 year amortizing loan, your total will be less because of the declining interest payments over the life of the loan. When you subtract the $60K you initially invested in this property, your total return on 15 year financing is $134K.
As I see it, carrying paper and holding the property give about the same total return over the same period of time. Carrying the paper gives you about the same return without the landlording issues. Holding the property indefinitely lets you reap even greater rewards from future appreciation.
Carrying the paper does have one advantage over holding the property for rental income. You get your initial investment back faster when holding paper. In my rental property example, with $363 monthly rental income, it will take 13.7 years to recover your $60K investment. By carrying the paper, with $5k downpayment and $600 per month income, you recover your $60K investment in 7.6 years.
If you wanted to keep repeating the process, you can double your production twice as fast by carrying paper. If you project out 16 years, you could have two rental properties in your portfolio generating $726 in monthly cash flow, or you could hold the paper on four loans with a total income of $2400 per month on top of the down payments you will have received.
All this assumes that your buyers let the loans run to full term and don’t refinance after a couple of years. If this happens then you have to buy, rehab and sell another property to keep your income stream alive. If you are a rental property owner, the income stream could be perpetual (you just have to keep your units filled)
Each strategy has its own merits. You just have to decide which best suits you and your long range goals. You may want to start out holding paper for the quicker turnover and higher short term income, then evolve into a rental property owner for the perpetual income stream for your retirement years.
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