Help your clients evaluate residential rental property

By Bob Morrison

Few fee-only financial planners would argue against holding real estate in a client’s portfolio of assets. However, articulating why it is good to own residential rental properties and understanding the math of evaluating that real estate is not intuitive.

Pros of investing in real estate

U.S. demographics and economics point to rental real estate as a great investment. People are not able to qualify for mortgages as frequently as in the past as student loan debt is soaring. Student loan debt in the U.S. went from $760 billion in 2010 to $1.7 trillion in 2020. This means that people will have to wait longer to own homes. Also, millennials are marrying later, having children later (and having fewer children), and don’t like to be tied down. Renting is a perfect option for this demographic. Baby boomers are renting more in secondary markets to see if they like a new location before buying homes in a new area.

Inflation is real estate’s best friend. What better asset class is there to fight inflation? Investing in the U.S. housing market is an excellent inflation hedge, as well as a way to generate consistent high income and total return. Housing prices and rents increase to match inflation.

Real estate allows for a tax benefit, depreciation, that does not require the owner to spend cash to use it. Intuitively, depreciation makes sense because a business or person buys an asset, and it depreciates or declines in value over time. However, real estate tends to increase in value, particularly over longer time horizons. The tax code actually allows a reduction of income through depreciation on an appreciating asset. Depreciation is so good it should be illegal.

Real estate can also be a great estate planning tool—and a way of avoiding the depreciation-related tax hit from selling real estate. I look at real estate as similar to permanent life insurance. The investor has access to equity (cash value), and the product is meant to be held until death.

I believe that real estate as an investment should be a long-term proposition. I even tell clients it should be held until death. Unlike a life insurance policy, real estate gets a step-up in basis, and all that great depreciation that we were able to take as an expense through the years gets wiped away clean at death. The heirs can then sell the real estate with zero tax impact even though the property may have been fully depreciated from a tax perspective.

Here’s another example. If a married couple has at least two properties, I like to have each spouse solely own one property apiece. If one of them dies, the other inherits the property and gets a step-up in basis. The surviving spouse can then sell the property tax-free or re-depreciate the property at the fair market value at the date of death of the spouse if they hold onto the property. This is a very powerful tax benefit and estate planning vehicle.

Clients may have goals of funding college for kids or supplementing their retirement income. Aligning the income from rental property may fit well for a client with these goals. Think about a zero-coupon bond and the par value coming due when a client needs the proceeds. The same concept can be applied to the income from real estate to pay for future goals.

Another benefit is access to equity. A partial cash-out refinancing may provide much-needed funds to allow a client to start drawing a pension or Social Security at a later date to allow these important benefits to grow.

Cons of investing in real estate

It is ironic that the tax code calls real estate investing “passive.” It is anything but passive. It takes work and can be inconvenient. Finding good tenants, maintaining a home, and repairing items can take a lot of time.

Real estate is also cash-intensive. Vacancies happen and expenses need to be paid. Repairs such as furnaces or roof replacement are not cheap. These need to be planned for and should be expected.

If a rental property needs to be sold, it can be very expensive, as all the depreciation that was taken will need to be “recaptured.” Depreciation needs to be taken in as ordinary income and can be taxed as high as 25%. There are options to do a 1031 tax-deferred exchange of a property. These should be explored, but the rules and parameters are complex.

Evaluating real estate

There are three ways to measure success in real estate investing: cash flow, building equity, and appreciation. An advisor should be prepared to discuss each with clients.

A client wants to rent out their current home and purchase a new home. Let’s assume the client paid $400,000 five years ago for the home and put down 20%, or $80,000. The house is worth $475,000 today, and the client has $190,500 in equity today ($75,000 in equity from the appreciation over the last five years, the original $80,000 down-payment, and $35,500 in principal payments over the last five years).

The client has a monthly payment of $1,807 broken down as follows:

• $1,349 monthly principal and interest payment ($16,188 annually)
  • $638 in principal payments
  • o   $711 in interest payments
• $250 per month in property tax ($3,000 annually)
• $208 per month in insurance ($2,500 annually)

If the client charges monthly rent of $2,400, their monthly cash flow is $593 ($2,400 rent less the payments listed earlier). If you annualize the $593, it adds up to $7,116. To determine the yield, you divide the $7,116 by the equity in the home of $190,500. The cash flow produces a yield of 3.74%.

The second component in the evaluation is the building of equity. By making the monthly payment and having someone else cover this for the homeowner by paying rent, the owner generates additional equity in the property. Approximately $638 per month of the mortgage payment is going to equity. Annually this amounts to $7,656. If we divide this number by the equity, it produces a yield of 4.02%.

If you combine the returns of the cash flow and of building equity through the mortgage payments, this is called a cash-on-cash ratio. Our cash-on-cash ratio is 7.76% (3.74% return on cash flow, plus 4.02% on monthly mortgage payments). Industry standards say an investor should have a cash-on-cash ratio of 7% to 10%. Larger, corporate real estate investors will only look at deals of 15% or higher. This has become more difficult with rising inflation and rising real estate prices.

Appreciation of the property over time is the third and last way to measure the financial success of a real estate investment. According to Black Knight, a long-standing real estate and mortgage analytics company, annual home price growth has seen a 25-year average of 3.9% as of the beginning of 2020. In our example with a current fair market value of $475,000, an expected annual increase in value of 3.9% is $18,525. This $18,000 increase produces a yield of 9.72% on the equity at the start of the year.

The cash-on-cash yield of 7.76% and the increase in appreciation of 9.72% produces a total return of 17.48%.

 

Investing in real estate may not be for every client, but it is good to talk about the pros and cons with your clients if they are considering this type of investment and understand how to evaluate the return for a client.

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Bob Morrison CPA/PFS, CFP^®, is president of Downing Street Wealth Management LLC in Denver. Bob is a fee-only planner specializing in estate and tax planning for pre-retirees and retirees.

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