Over the last 50 years, the S&P 500 has yielded a compound annual growth rate of 9.41%. With returns like that, why would anyone consider investing elsewhere? I know several people who have made a great living for themselves renting out properties, so I thought I would run the numbers to see if it is better to invest in the stock market or the real estate market by building a real estate snowball.
To buy a primary residence with a great credit score, you need to have at least 20% of the property value as a down payment to avoid paying private mortgage insurance (PMI). To buy an investment property, banks are even more strict.
In Denver, a pretty average city as far as real estate goes, a 2 bedroom unit has an average price of $240,000. For a 20% down payment, you need to have $48,000 in cash ready to go plus fees. And that’s just the start.
Assuming you can buy the property, at current interest rates (let’s use 3.25%) your monthly payment is going to be about $1,100 per month with taxes. You also have to assume some repairs and upgrades will need to be made over time, so assume $2,500 per year for that.
So, all in, your annual ownership cost is going to be about $15,700 per year to break even on a cash flow basis.
Income and Margins
Average rents in Denver vary widely by area, but I’ll use my neighborhood as a proxy. I have seen rents range from $1,000 to well over $2,000, so let’s say $1,600 is the average rent for a two bedroom in the area to be conservative.
At $1,600 per month, you keep $500 per month from your renters. $500 per month is $6,000 per year. Not bad, right? But you have to take out the $2,500 in repairs so you really only keep $3,500 per year.
That gives you an annual return on your initial investment of 7%. Not bad, but still below the average 9.41% of the S&P 500 not including property value changes and equity building.
But let’s say you do really well, keep your place occupied with good tenants, and can reinvest your income and pay down your property loan quickly with the revenue from your renters. Over time, you can save up enough to do it again. It will take 13.71 years to save up enough to buy another property, but maybe you can save a little extra and buy another and another. Eventually you could make a full time living on property investments.
To make $50,000 per year from rental properties in this scenario, you would have to invest $714,000.
You Can Probably Do Better
I used “average” home and “average” rent to build this example, but you could probably do a lot better if you put some time into it. What if you could find a two bedroom property around $135,000 instead of $240,000?
You would only need to put $27,000 down. And your rent income would be lower, but so would your costs. If you could make $500 per month in profit and keep expenses low and were able to keep $6,000 per year. That would be a 22% annual return! At that rate, you would only need to invest $227,000 to earn $50,000 per year.
The risks, costs, and income are going to be different in each market, but you can see how this could turn into a lucrative investment and even a income.
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Turn It into a Real Estate Snowball
In the past, we have seen how debt snowballs can pay off loans and credit cards quickly and how a social lending snowball can turn into a 10% annual return investment that feeds itself. Real estate can do it too.
If you can put down $54,000 in the last scenario, you can potentially earn $12,000 in annual revenue. If you keep it in savings, it will take less than 3 years before you have enough to add another property. At that point you are making $18,000 per year. In less than two years you can buy another property and generate $24,000 per year. Pretty soon you have another property, and another.
Getting to a point where you can retire with a nice, growing cash flow is not unrealistic.
Have you ever invested, or considered investing in, real estate? Do you think this scenario is plausible? Please share your thoughts, comments, and critiques in the comments.
This post was originally published on May 22, and updated on September 30, 2019.