Click below to listen to Episode 8 – The Real Yield of Residential Rental Real Estate

Episode 8 – The Real Yield of Residential Rental Real Estate

Learn about the pros and cons of residential rental real estate.

Join Bob and Mary Jo as they talk about residential rental real estate, its pros, and its cons. From maintenance of a rental property to seasonal and vacation rentals, they go in depth to the many facets surrounding this secondary source of income.

Many individuals are interested in residential rental real estate because of the extra income that may be earned. It is quite a popular thing to do and for some people, it works out! However, for many, the results from residential rental real estate (the good and the bad) can be not quite favorable.

Bob and Mary Jo take a deeper look at residential rental real estate property by taking you inside all of the many facets that encompass this topic, including the many risks associated and the comparison of investing in real estate property vs investing in the market.

HOSTED BY: Bob Barber, CWS® and Mary Jo Lyons, CFP®

Mentioned In This Episode

Christian Financial Advisors
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Bob Barber, CWS®, CKA®
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Mary Jo Lyons, CFP®, CKA®

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EPISODE TRANSCRIPT

[INTRODUCTION]

Bob: Welcome to Christian Financial Perspectives, a podcast where we talk about ways to integrate your faith with your finances. This is Bob Barber.

Mary Jo: And I’m Mary Jo Lyons.

Bob: Are you ready to learn how to apply biblical wisdom to everyday financial decisions?

Mary Jo: Join us as we look at integrating your faith with your finances. If it’s your first time listening, welcome to our podcast, and if you’re a returning listener, welcome back.

[EPISODE]

Mary Jo:
I’m really excited about our show today on the real yield of rental real estate. It’s a topic that always generates a lot of interest in a lot of questions from clients.

Bob:
Yes, it does, Mary Jo. I’m excited about it, too, because I’ve been involved in real estate for so many years. I think I’ve told you about this before in the past. What is it now, 34 years of experience in real estate. So, I have a lot of experience in this subject that we’re going to be talking about today.

Mary Jo:
I know it’s kind of near and dear to your heart. You’ve been through this process for yourself personally and helped many friends and clients through this. I think we’ve got a lot of share that’ll be really interesting to our clients.

Bob:
You hit on that right, Mary Jo, and not only me personally, but my dad as well. My dad’s now gone to be with the Lord a couple of years ago, but he was involved in real estate for over 45 years, so you count my dad’s involvement and my involvement. You put that together. That’s a lot of years. I grew up in the real estate industry.

Mary Jo:
Why do you think that this is so popular with people that the idea, I don’t want to say the romance of it because it’s a lot of hard work, but the idea of using rental income as part of their replacement income in retirement, why is there such an appeal to that?

Bob:
I think there’s a lot of reasons for that. One is it’s tangible. It’s something you can touch. You can go see it. You can drive by it. There might be a little bit of prestige with it, also. Of course, all of us have many friends we know that are in the real estate business. What about you?

Mary Jo:
Well, I think that’s true. It’s definitely a popular thing to do, but I think what our point is, it does work out well for some, but a lot of times it doesn’t work quite so favorably. I think today one of the things we want to talk about and explore are some of the risks associated with rental property, but before we do that, I think it makes sense for us to look to the Bible for some wisdom as we always do as we start the show.

Bob:
That’s the best way. I am in total agreement with you. You want to share this scripture that you got out of Luke?

Mary Jo:
Yes, so counting the cost of future plans from Luke 14:28, “But don’t begin until you count the cost, for who would begin construction of a building without first calculating the cost to see if there is enough money to finish it.” I think that one definitely the tone, don’t you?

Bob:
It really does, Mary Jo, and I think that’s what today’s program is so good. This is a fantastic podcast that everyone’s going to enjoy once we get into the meat of it. Because I think with buying residential real estate, I think that’s the mistake that so many people make is they don’t count the cost going into it.

Mary Jo:
And we have a worksheet that we’re going to go over that kind of identifies those costs and does some of the math and kind of talks about the balance sheet if you will, but before we do that, I think it’s helpful for us to kind of go through some of the pros and cons. Interestingly, some of these are both pros and cons, but I think there’s a lot to consider. One of the most is sweat equity. If you’re not a skilled carpenter, if you’re not skilled in electrical and plumbing and all the repairs and maintenance that come with rental property, those repairs can be quite costly. I don’t know about you, but the last time I hired a plumber had to take out a loan.

Bob:
Just to show up, an electrician or a plumber or a roofer – I remember needing to get a small leak in our roof repaired about year and a half ago – and just for him to show up was $150 to $200 and then on top of that is cost for any additional materials and labor. So, it is quite expensive.

Mary Jo:
They are definitely, that’s true.

Bob:
And if you don’t have those skills – because as residential property, things are going to break and there’s going to be leaks and water heaters are going to go out.

Mary Jo:
Yeah. For some people it’s a hobby, kind of what they do to spend their time. They go from working to get a paycheck to building their rental income and repairing that, and they enjoy it. To them it’s not necessarily work. It’s more of a labor of love. But I know my husband is best without a hammer in his hand. I know he’s going to listen to this, but I hope he doesn’t take offense.

Bob:
It’s so funny you say that. Cause I remember when Rachael had to come up to Houston to visit MD Anderson for her cancer, and y’all came home and none of your doors were squeaking anymore. Just so y’all know, when Rachael and I, my wife and I, go to Houston, we’ll stay at Mary Jo and Mike’s house. So, y’all came home and I didn’t think that was a big a deal, but that was a big deal with y’all.

Mary Jo:
He noticed it immediately when he got home. Oh, Bob’s been here cause the door’s not squeaking.

Bob:
Well and I am one of those people. I mean I could take a dishwasher apart and fix it. I can take a washing machine apart and I like doing it, but a lot of people don’t. My dad, as involved as he was in real estate, he couldn’t fix anything either. So tell Mike not to feel bad.

Mary Jo:
Yes. Another big risk is geographical risk. And I know you’ve got a little bit of a story that you shared with me in the past about your dad and his experience with rental houses and income. So, why don’t you share that with our listeners?

Bob:
During the 1970s when we were growing up in Austin, most people probably have a hard time believing this, but the economy in Austin was really, really bad. We moved down to Lake Jackson, Texas, which is kind of around your area, and there’s DOW Chemical down there. My dad was in the real estate business in Austin and wanted to be in the real estate business in Lake Jackson. It was my uncle that lived down there that really spurred us to move our family, and by the way, it was a fantastic place to grow up during my junior and high school years. Just a great place. But during that time in real estate, Dad accumulated a lot of rental homes and dad liked to cumulate the kind of rental homes that the blue collar, hardworking guy that worked at DOW that was the welder and work at the plant could afford.

Mary Jo:
I think that’s what most people try to do.

Bob:
Exactly. He didn’t want to get the high price stuff, he wanted to get the normal two bedroom, two bath or three bedroom, two bath homes. So, he accumulated a lot of homes around the Lake Jackson and Freeport area. And for your listeners in this area, they know all about that area. He accumulated over 40 properties at one point. And what happened was in the late seventies, DOW Chemical had this huge layoff and many of their blue collar workers were laid off. Unemployment went up and his houses went vacant and he had made the mistake of leveraging them, meaning that he had borrowed some money on these homes. And you know what happened? He had to make those payments and he continued to have to pay taxes and maintenance and insurance. And this went on for a couple of years. I saw not just him, but I saw many friends, my dad’s friends and people I’d grown up with and come to know, I saw them get hurt by this dramatically. Not only did that happen, but also the economy was starting to go bad up here even in the Austin/San Antonio area where we’re from. In the mid eighties, I saw the whole thing collapse then. We had a boom up here, and of course we’re having that boom now, but I couldn’t believe that this whole thing crumbled when he had that many rental homes, but he had it all in one geographical location. And that’s what happened. And as you know, the same thing could happen with someone that’s in a high hurricane region or think about all the fires out in California, how you could just be destroyed if you are in one geographical location. So, there’s geographical risks in real estate.

Mary Jo:
What sounds good at first doesn’t always work out that way some of the times, and you want to make sure that you got the time and the physical resources, the financial resources, to handle those kinds of downturns. There’s a passage in Joshua 9:12-14 that I think speaks to this, “This bread of ours was warm when we packed it at home on the day we left to come to you, but now see how dry and moldy it is? And these wineskins that we filled were new, but see how cracked they are? And our clothes and sandals are worn out by the very long journey. The Israelites sampled their provisions but did not inquire of the Lord.” So they really didn’t ask the Lord for his blessings.

Bob:
This is a beautiful passage that you picked here, Mary Jo. I really like this because it really speaks to what we’re talking about today, and things can look real glossy and great upfront, but they didn’t see the cracks and there can be some cracks in this.

Mary Jo:
Right, and another risk that is inherent is tenant risk. What thoughts come to mind for you on that one?

Bob:
I’m looking at some of your notes here and it’s definitely true. No one’s going to care for that property the way that you would and boy that is a major risk. The risk of what kind of tenant. I would really want to look at their long term track record. Are they the kind of tenant that’s going to come in and at the end of six months walk away? You really need to do a background check on your tenants. Now today, I know they’ll do credit checks, but I would find out as much about that tenant as you possibly can and know their background.

Mary Jo:
Some of them can be really needy and demanding. They often pay late.

Bob:
Yeah, that’s the truth. Yeah.

Mary Jo:
Who knows what their friends and family are like and then not to mention their pets. Dogs can be pretty destructive on a property. A lot of them are diggers and chewers. So, you have to take all of those things in mind.

Bob:
Well, I tell you, Mary Jo, I can speak to this one too. As a kid growing up who had a dad that had so many rental homes, when somebody moved out and in between and I was like 14, 15, 16 years old, guess who got to go clean up those rental homes?

Mary Jo:
I can just imagine that crayon marks on the walls, the spill s on the carpet. You pretty much have to start over every time you move a renter in and out with carpet and paint.

Bob:
I can tell you, I saw some amazing things. The worst one was when somebody left some fish in the refrigerator.

Mary Jo:
Oh my. Yep.

Bob:
So I don’t want even want to go into that.

Mary Jo:
And I think that takes us into one of the other pros and cons. That’s if you’re buying in an area for seasonal rentals or a vacation home market. One of the things you have is weather risk. Certainly if you’ve got a lot of snow issues that can be an issue or certainly storms like we’re facing and have faced this last year in the coastal bend area. So, there could be a vacancy as you repair after weather events like that. But also the other thing you have to think about on vacation homes, if you’re buying a property and your intention is to use it as a vacation home yourself but then rent it out the rest of the time, you have to be really careful and you can only use it for two weeks without jeopardizing the deductibility of those expenses. Now, you can go down to do maintenance on it or go up, wherever it might happen to be, and you can justify it that way, but you have to be real careful with that. So, it’s not like you have an unlimited amount of opportunity to use it.

Bob:
Also, you can think about seasons of when your home is going to be rented and when could it go vacant. You don’t want a home going vacant in like October or November or February, March, or April. You want to make sure that you structure your leases around where they go vacant in the summertime or say around December because that’s when people were moving and that’s when people normally want to rent because of the school year.

Mary Jo:
Well, that makes sense. Another one is that real estate, it’s a liquid asset, so it’s not always easy to sell if you got in a bind and you did have to put it on the market to sell it. Depending on what’s going on in that local economy, you may or may not be able to get a quick sale. If there’s an issue with one of the local employers, that could be a problem. And that does happen in certain areas.

Bob:
And I want to emphasize this because the economy has been so good now for so long, especially in the Texas market. Now our podcast reaches across the world and across the United States, but here in the Texas market, when you put a home up for sale if it’s in the right price range, which is below 300, it’s going to sell very quickly. But that doesn’t make it liquid. You still have to have the realtor involved or the title company, the mortgage company. Most people don’t buy real estate with cash today. This is a very strong one.

Mary Jo:
It’s a process that you’ll have to go through, so if the question is, well, okay, whether I should take my money and buy real property and put it on the rental market or should I put it in the market and use it as an investment asset, investments are always liquid because you can sell those and get your money out of them in short order. Usually, your proceeds are available, depending on what kind of investment, within a day or possibly two, sometimes a week at the most, but that’s not always true with property.

Bob:
You’ve got an interesting one on this next one. Real interesting one is transitional neighborhoods. I have a thought about that one, but that is a really interesting one too.

Mary Jo:
Well that’s happening right here, right now in my neighborhood and they just recently rezoned some of the schools. There’s an unfavorable school with a bad reputation that they have now zoned a lot of the residents in my immediate area to go to that school. So, a lot of the parents are pretty unhappy with that. They bought in our neighborhood because of the schools, and now due to redistricting, that has changed. Houses used to sell very quick, but the last two that had been on the market have not been nearly as quick a turnaround. You can hear me sitting here snapping my fingers because I’m thinking quick turnaround, but they have kind of sat there and I’m a bit concerned about that.

Bob:
So let’s zip through these last 10 and then we’re going to get into this worksheet just a few minutes from now. The rental property also requires what we refer to as active management, and somebody is going to have to actively manage that. Either it’s going to be you or you’re going to hire a manager to do it. So, it does require a hands on approach

Mary Jo:
And if you’re a retiree and you want to be traveling and enjoying life and not spending it on things that are going to tie you down, if you don’t hire a management company, then that could be you that’s tied down. So, certainly something to consider. Another pros and cons – a lot of people view rental property as real property – we touched on this a little bit earlier – versus intangible assets like stocks and bonds. So, some people are more comfortable with one over the other. You got any thoughts on that, Bob?

Bob:
No, I don’t. I’m too zoned in to thinking about the next thing here. Well, don’t you just love this? That’s this transparency, isn’t it?

Mary Jo:
But I think it can be a hurdle for some and both have the potential for appreciation, but there is risk. And what about mortgage rates? Even though mortgage rates are rising, we’re still in a time of relatively low rates, but certainly if you finance a home and you don’t have the ability to pay cash, then that’s going to increase your cost. And we’re definitely gonna get into that more when we go through the worksheet.

Bob:
Oh, we go through this worksheet here in just a minute, which by the way, we’re going to have this worksheet available for you. If you’re thinking about buying a rental home, you’ll be able to email us or give us a call. We’ll get a copy of that to you, but when we talk about mortgage rates and mortgage in general, when we put the cost of a mortgage into the math of this, it kills the yield, and most of the times a negative cashflow situation.

Mary Jo:
Not to mention the Bible always cautions us against the use of debt, and in Proverbs 22:27, “Can you do it without borrowing the funds? If you can’t pay it, even your bed will be snatched from under you.” I know that’s one of your favorites.

Bob:
It really is, and debt is always assuming that the future is always going to be bright to pay it back. That is assuming upon the future. We are not saying that debt is a sin. The Bible does not say that debt is evil, but it just warns us that if we don’t have the means to pay, our very beds could be snatched out from under us, and that’s what happened back when we were talking about my dad earlier. He leveraged these properties too much. When they went vacant, he still had to continue to make those payments. I know with you, we’ve talked about how y’all are debt free on your property you had in Rockport.

Mary Jo:
Yes.

Bob:
But those around you, a lot of them weren’t.

Mary Jo:
Well, and that’s exactly right Bob. A lot of those were dependent on rental income, and then the storm came. We’re rebuilding but it’s taking over a year, a year and a half, for that process to unfold. I know now they’re not even going to get back into them probably until January. Those people that were dependent on that rental flow, that has been snatched away from them and some of them are in a world of hurt.

Bob:
I’m ready to get over to this worksheet. How about you?

Mary Jo:
Yes. Why don’t we take a deeper look at those numbers.

Bob:
You might’ve noticed, I just put a number in here on the cost of the property. Here’s what we’re going to do for all of you listening to our podcast. We’re going to go to this worksheet, and this worksheet is one that I built from years of experience. I’ve been using this rental worksheet for 20 plus years. This is something that if you’re looking at buying a rental home, you really want to give us a call and get a copy of this. I’ll tell you, it will really open your eyes as to what the true yield of residential real estate is. We’re going to start off with assuming that you’re looking at a property in the $200-250,000 range and assume that you can rent that property for $1,500 a month or $18,000 a year. We call that our annual gross rental proceeds. So here we’re going to say, you’re going to this $200-250,000 property. $18,000 is going to be your gross, but there’s so much now that we’ve got to take away from that gross proceeds number because you’re just not collecting the $18,000. There’s a lot that comes out of that that really goes into your actual bottom line net yield.

Mary Jo:
It makes me realize maintenance costs and what a big chunk that is. So, you got to talk about painting, roof repairs, plumbing, electrical, heat, and air. Well, if you don’t have heat and air in a house, especially air conditioning here in Texas, you’re gonna have a hard problem renting that house and then flooring and just overall maintenance gutters, that type of thing. So, I think we’ve estimated $2,000 on maintenance.

Bob:
Yeah, we did. And I will say, a lot of you that are listening to the podcast, maybe you’re thinking, well, I’m going to go buy a brand new home. So you may not have that cost for five or six years, but at the end of five or six or seven years, you’re going to have something like that occur. And it can quickly be a $10,000 or $12,000 repair. And there’s your average of $2,000 a year. So, immediately off that $18,000 gross proceeds, take $2,000 out. So, now you’re down to $16,000.

Mary Jo:
Well, and again, if you have that destructive tenant, that could be sooner than 10 years.

Bob:
It most certainly could.

Mary Jo:
And you’ve got to be insured against liability. So, that comes at a cost. We’ve estimated $250 for that annually, and property taxes, that’s a big one.

Bob:
That’s a big chunk. Yeah, and I went out and did my research on this for $200-250,000 home. That’s going to be about $4,500.

Mary Jo:
You also have to have a homeowners insurance, your property and casualty insurance policy on that property. Wouldn’t you say that’s about $1,200, Bob?

Bob:
Yeah, I think that’s very reasonable.

Mary Jo:
And then what about those months when it might sit vacant? You’ve got a tenant change over, somebody moved out unexpectedly due to a job transfer or divorce or something like that, and then you’re stuck with a vacant property for a month or two. So, we’ve just kind of come up with $800 as a potential for that cost.

Bob:
We’re renting this home that we’re assuming for about $1,500 a month, and you are going to have that happen every year or two. You’re going to lose either a whole month or at least half a month while that one renter moves out and another one moves in. So I think this is actually a very conservative number that we’re using. Probably should be higher, but we’re going to put $800 in there to be on the fair side.

Mary Jo:
Even if you have noticed that your tenant is moving out, there is going to be a period of vacancy.

Bob:
Now, don’t worry, I don’t expect all of you, as you’re listening to our podcast, to be adding these numbers up in your head. We’re going to tell you what this final number adds up to here in a minute.

Mary Jo:
There is a lack of diversification, which comes at a cost. So, geographical diversification on your home, typically that’s a single occurrence risk. That’s my insurance talk.

Bob:
Yeah, yeah.

Mary Jo:
Don’t mean to use that lingo.

Bob:
Well, it’s actually in the worksheet, so that’s okay.

Mary Jo:
You got one renter, one market, one location, but if there is a natural disaster of any kind or a local employment situation, there could be a cost with that, but we’re not factoring that in. We’re just putting it out there for discussion’s sake.

Bob:
Exactly right, and then there’s the annual marketing cost of finding a renter. If that renter moves out, we didn’t put that cost very high at all because we’re assuming that you can rent for one or two year period, maybe in a three year period without having to find another renter, but we did put a couple of hundred dollars in there on an annual basis on average.

Mary Jo:
And if you are going to be hiring a property manager or you’re taking on that task yourself, your time is worth something as you go through that and you’re going to incur certain expenses. So, we’ve estimated that to be $1,200.

Bob:
There were two more costs that we didn’t put in here. They’re on the worksheet, but we’re not talking about them today, but you would add another cost if you have a mortgage and you go borrow money to buy the rental property. There’s going to be that annual cost. People don’t think about this one, Mary Jo, whatever down payment you put on rental property, which usually is a requirement of 20% down. So you got to think on a $250,000 house, that’s $50,000 that you’ve put down that’s no longer making you say a 4% or 5% return. You’ve got to put that number in there, too, because that money’s not making you money any longer, but we didn’t put those two elements in there at all. Mary Jo, you’ve got to think about what your time is worth for the management of the property. A lot of people, they’ll hire a property manager to do that, but your time is worth something, and if you’re going to spend an hour or two or even five hours a month, you’ve got to pay yourself something. Your time is worth at least $20/25 an hour. That can add up over a year, and we’ve put $1,200 for the annual cost of what your time is worth for management or what you would pay to a manager.

Mary Jo:
And we’ve talked a lot about the use of that money, whether you take money from a down payment to put on it and you finance the remainder of the balance in a mortgage, or if you pull out the entire cost of the property out of your investment portfolio. That’s coming at a cost because you could have been investing those assets. So, whether it’s the down payment or the entire principle of the mortgage, you’ve got to factor that in.

Bob:
Now are we ready for the drum roll?

Mary Jo:
Let’s do it.

Bob:
Of the annual total expenses for this house that you paid around $200-250,000 for, you have an annual gross rental proceeds of $18,000 the annual total expenses,

Mary Jo:
$10,150

Bob:
$10,150

Mary Jo:
So what does that make our net profit?

Bob:
Again that expenses total $10,150. That makes our annual net profit $7,850 on that $200-250,000 rental home, giving us an average annual rate of return of 3.14%.

Mary Jo:
You know you’re doing a lot of work for 3.14%, and I think if you look historically, the market’s done a little bit better than that.

Bob:
I think so too, and when you look at the liquidity of the investment, especially if you’re having to borrow money, this is what we talked about earlier in the beginning of the program. The things you’ve got to consider is that if you have a mortgage on top of this that’s coming out of that, that yield is less than 3, it’s probably a negative yield when you count all the cost.

Mary Jo:
I think that there are some serious costs to consider, and we want to remind our listeners that if they want to get a copy of this worksheet, they can reach us at Christian Financial Advisors where they’ll find it on our website. You can also give us a call at 877-71-TRUTH or (877) 718-7884 to request your free copy. I was just going to also mention the podcast website. That is christianfinancialpodcast.com you can request it there as well.

Bob:
And I want to say right here at the end of the program, I’m not against buying residential rental real estate. You may think that after hearing today’s show, but I’m just wanting you to count the cost. Back to that scripture that we started from that was in Luke 14:28, “But don’t begin until you count the cost.”

Mary Jo:
I’m just playing devil’s advocate, and you’ve heard that old saying many times, feast or famine. What have we seen happen after periods of prosperity in many communities? You just look around the countryside and in our own towns and cities, and there are lots of them where things have deteriorated over time. So, you’re making a pretty longterm commitment when you buy property.

Bob:
That’s going to do it for today. I want to thank you for listening to our Christian financial podcast for this week.

[CONCLUSION]

Mary Jo: You’ve been listening to Christian Financial Perspectives. Join us as we explore more about how to apply biblical wisdom to your financial situations.

Bob: To make sure you don’t miss any of our podcasts, you can subscribe to Christian Financial Perspectives on iTunes, Google Play, or Stitcher. To learn more about integrating your faith with your finances, visit out website at ciswealth.com or call 830-609-6986.

Mary Jo: That’s all for now.

[DISCLOSURES]

Comments from today’s show are for informational purposes only and not to be considered investment advice or recommendations to buy or sell any company that may have been mentioned or discussed. The opinions expressed are solely those of the hosts, Bob Barber and Mary Jo Lyons. Bob and Mary Jo do not provide tax advice and encourage you to seek guidance from a tax professional. Investment advisory services offered through Christian Investment Advisors Inc. DBA Christian Financial Advisors, a registered investment advisor. Past performance is no guarantee of future returns and returns or losses will fluctuate over time.