How to Evaluate Rental Property ROI | Real Estate Investment Checklist

Today, we're going to be evaluating how to determine the value of a rental property and if it is a good investment. I'm going to walk you through the numbers so that you can do this on your own. Hey, my name is Casey Weade, I'm CEO and founder here at Howard Bailey Financial, I'm also a certified financial planner practitioner, and we're here to discuss rental properties.

Now, why are we having this discussion right now? Well, my wife and I and our family, we just got done visiting one of our rental properties. We own a couple of different rental properties. We'll be looking at those numbers specifically today. So we went up, we visited our rental properties and we had a great time, but it's just not what it used to be.

One, the rents have dropped significantly. We have one property where the rents have been cut in half over the last couple of years, another one where we've actually been running negative rent over the last couple of years. So negative net rent at the end of the day, after all costs are covered. And then we also had some headaches. Like you do with any rental property, you expect to have some headaches, but there's been some turnover with the property management company and we've just had some issues, some maintenance issues, some cleaning issues, some staffing issues and said, I don't know if I want to deal with this headache anymore. Is it something we even want? And as we're evaluating this in the car ride home, we pretty much made the decision that, yeah, we should definitely sell at least one of these.

However, I never make decisions like that. I always run the numbers. I talk about that with you all the time. It's important that we run the numbers to make a good decision. Long story short, we're keeping both rental properties. But I'm going to show you how we came to that conclusion. So let's jump over the spreadsheet. Now, this spreadsheet I warn you, it's rough.

You know, this is literally me coming back running some numbers on a spreadsheet, looking at historicals and sharing with you what I did. So this is just what I did. Obviously, as I said, we could include a lot more in this analysis. We're just looking at it from a high level, and I think this gives you enough the it's a great starting point for you as you're evaluating rentals. And I will say long story short as well, owning rentals today is a much more difficult business in this interest rate environment and that's what you're going to see as we start looking towards, well if we sold these properties, we'd have to reinvest them. What kind of deal would we get? Or if we wanted to go out and buy another rental property, what kind of return could we expect? And how much rent do we need to generate? What kind of capital appreciation do we need to see in order for it to be a good investment? So right here we're looking at the first of the rentals that we purchased. So this was purchased around I think seven years ago roughly. So we've owned this rental for quite some time, somewhere between 6 or 8 years or something along those lines.

So as a result, we've seen a lot of capital appreciation. The second one that we're going to look at, we only purchased in the last two and a half years. So we haven't seen any capital appreciation, maybe 1% if we're lucky, over the last couple of years. And so that appreciation rate has slowed. But I don't think it's going to stay that way forever. So looking at this one in particular, you know, this is one that we purchased several years ago, put 20% down and it had a value of probably $700,000 roughly at that point. And now in the year 2024, as I said, our rents have gone down. Now our net rent is running about $45,000. So net rent is what we're getting after we pay the property manager. So we're paying the property manager a higher fee. In this instance, we're paying a pretty hefty property management fee. You know, well over 20%. And that's because it's in a resort area. You might say, well, 20, 30, 40%. That's really high. That's really not that high when you're looking at resort area properties, you typically are going to spend quite a bit more.

Now, if this was a single family home and it had a local property management company managing it, then yeah I would expect a significantly lower take from the property management company. Now we do have a pretty good deal, I feel, on property management that net rent coming out to about $45,000 a year, and then we have interest. So the interest here, it's just a simple interest calculation.

I am taking our 3.5% mortgage, which was clearly a heck of a deal. You have a 3.5% rate on a mortgage. That's $450,000. And we have a total value today that's 1.35 million. So it's doubled in value over the period of time that we've owned this property. Our mortgage remaining is still about 450,000. We're paying a little less than this.

It's about $15,000 a year in interest though. And then we have our taxes and insurance. So our taxes and insurance are about $20,000 a year. Then you just have some miscellaneous expenses that come up throughout the year when you own a rental property. We have to fix the hot tub, or we have to repair the flooring or some type of damage that that may have occurred throughout the year. And we find that that typically hovers around an additional $5,000 over and above what the property manager may be taking out of this number up here. And then we have HOA dues. So there's a homeowner's association of paying about $4,000 a year for that. So our net rent, at the end of the day it's a break even, right?

So I'm at -250. I'm breaking even on this property. Now the second one we're going to see, we're doing much worse than break even. We're losing money. When we look at the net net rent, if you will. Now is this still a good deal? So our mortgage rate at 3.5%, the mortgage at 450, the value of the home at 1.35. Now, if we wanted to sell that property, we're going to have to pay a sales commission. We're probably going to pay 6%. So I'm going to say, well, how much are we actually going to get out of this property if we sell it? Well, we're going to have to pay a sales commission and probably be around $80,000. And that means we end up with $819,000. And so what are we yielding in rent right now? Well, it's a break even, right? -250 a year. Just call it even. It's -0.03% per year. But that's really a break even. Now I would expect a conservative capital appreciation rate of 4% per year at 4% per year. I'm taking 4% times 1.35, the value of that property.

That means my annual capital appreciation is about $54,000 per year. $54,000 is my capital appreciation. And that means that my return on investment is 6.5%. So well, wait a second, it's only appreciating 4% per year. Yes, but that is on...that 4% is on a much larger amount of money that I get to keep than my net equity.

So if my net equity is 819, but the value is 1.35, this 54,000, it's all mine. Because all that appreciation is going back to me. Yeah, this is where debt becomes so valuable, because now that 54,000 is the total value's appreciation. But I only have 819 in it, that's the value of having a low interest rate mortgage here. And that shows that my capital appreciation rate is about 6.59. Take out the little bit of loss because I'm not generating enough rent right now. So I'm still averaging about 6.5% a year. Yeah. This isn't of this isn't the the best deal right. At 6.5% in this interest rate environment, I'd probably be better off just selling it.

Get rid of the headaches, invest it somewhere else. But there's a lot of tax advantages involved in owning rental real estate as well. And I also believe I'm working with a property manager to boost the rents. I think we're going to generate significantly more rent if we can get just half way back to where we used to be.

Let's say that we generate 65,000 in our net rents next year. And now I'm back to a 9% annualized return. And we just increase those rents, not even back to where they have been historically. So I say, you know what? I'm going to keep that property. That's just a deal that I'm not going to get again, I'm not going to be able to replace that 3.5% mortgage if I want to go reinvest these dollars and invest in another property. Now let's look at the the second property here. Now, the second property, as I stated, this is one that was only purchased in the last couple of years so very minimal appreciation, the value of that property we bought, it was 1.7. It's now 1.75. So a little bit of appreciation.

Not much, right? Right there. And that's largely due to higher interest rate mortgages today. Now my net rent here is higher. It's about $60,000. The interest though is significantly higher because I have a huge mortgage on this property, a $1.2 million mortgage at a higher rate of 4.75%. My interest is $60,000 a year, taxes and insurance and about $20,000, miscellaneous expenses a little bit higher at six grand, HOA is the same at $4,000. My net net rent means I'm losing $30,000 a year on this property. I have to put in $30,000 a year because it's not covering itself. That's not generating enough rent in order to pay for all of those expenses. In other words, it's not cash flowing, and that's what we really want properties to do is cash flow for themselves.

As I said though, it's getting much more difficult in this interest rate environment. So let's look at the bottom line. So now if I sell this property, I'm going to pay $100,000 sales commission. I'm going to net $445,000. My yield right now is -6.5% per year. It's -30,000 over my 445 net equity. Now my capital appreciation, If I only get 4% per year, which I still think is very conservative, our capital appreciation 70,000. But that 70,000 is on 445. I'm getting a ton of capital appreciation on a smaller investment. This is why my capital appreciation ROI is double digits. It's 15.73% per year. Now I have to deduct my net net rent from my capital appreciation. I'm still running an over 9% return. And again, I think we can also do some things to boost this rent. And again, it's very tax advantaged. Now what if I wanted to do this in today's interest rate environment? I would have to assume I'm going to get at least a 7% rate on a new mortgage. So let's just change one number. We only change that 4.75 to 7%. Now I've got a 7% mortgage on on a $1.2 million mortgage.

That's $84,000 in interest, significantly higher. And now my capital appreciation ROI is still fantastic, right? It's 15.73%. That number is not going to change. But because I'm losing so much because of that rent, that mortgage interest is so high, now my return is only 3.5%. That's the value of this property today is the difference between my total return currently, and if I sold the property and went and invested it in another rental property, I would need to generate significantly more net rent or expect significantly more capital appreciation for that to make any sense.

In order for these deals to get done today, I think you have to put down a lot more money, which excludes a lot more people from the market, which is also going to exclude that it's going to reduce the level of capital appreciation we've seen in these properties over the last several years. So today, what would we need to do? If you put if you paid the whole thing off and you paid cash at 1.75, so you don't have any mortgage whatsoever, now you're earning 6%, that might be viable, especially if you think you can boost the rents, if you think capital appreciation can be a little bit higher. But if you're just looking at it today and you don't think you can do those two things, I think it's really hard to justify. With the risk free rate that we have today, we can probably invest those dollars and have less headache and generate, at least in the much in the same way of rate of return that we're getting already.

So I hope this has been helpful for you. Yeah, I would love to hear any questions or comments that you have for me. If you want help running some of these numbers for yourself and digging it in and applying it to a broader retirement strategy, that I would encourage you to call the number on your screen. Schedule a complimentary visit virtually or in person with one of our personal financial advisors, and we can help you run these numbers and so much more, and elevate your confidence for this stage in your life.