I was poking through some of the properties in the Historic Phoenix Districts and I came across one that caught my attention, much like it would many people.

Aside from owning your primary residence free and clear and reaping the increasing valuation over time, there are two ways that I can think of off the top of my head in which you can invest in a single family home. In both instances, the purchase price of the home determines the ultimate return on your investment.

Method 1 – The Flip

The goal in the flip is fast turnaround. You need to know what to buy, where to buy it, when to buy it, for how much, and the cost of reconditioning. You also need a lot of cash on hand. It’s a venture that requires that you spend time doing your due diligence to ensure that when you sell the house, you actually make money. Don’t be too quick to purchase a $40,000 home thinking you can turn around and sell it for $140,000 (it’s happened dozens of times in the Coronado District) and walk away with $100,000 in pure profit. You’ll be spending quite a bit of money and time reconditioning, remodeling, and marketing the property. Sales commissions alone could run you nearly $10,000, and you’ll need to have a great team of contractors who do honest, quick work at a fair price.

Method 2 – The Rental

This is my preferred method. My real estate philosophy is to own as many paid-for homes as possible to generate passive income, and increased property value over time.

The rental is also a tricky beast. One might think the following:

“I’ll buy a house that needs minor repair for $50,000. I’ll put $10,000 into repairs, and then rent it for $600.00/month.”

Obviously location is going to play a part in how much you can charge for rent. Now, let’s make a mistake in calculation. Based on the above numbers, I could make the mistake of dividing my total cost ($60,000) by the monthly rent ($600.00). If I do this, logic would tell me that it will take 100 months, or 8.3 years to get my $60,000 back.

That’s nice, but not true, because we’re working with something called “Net Operating Income” which is what you’re left with after you pay your expenses, which you MUST consider before you go crazy buying that property.

So what are the operating expenses?

If you pay cash for the property, your expenses will be less, and you’ll also be able to choose your tenants wisely, because you won’t make desperate decisions under the pressure of a mortgage payment.

The First Expense will be property taxes. When you own your house free and clear, you still have to pay annual property taxes. They are never the same year after year, and as the value of the house goes up, so does the tax bill. I’ve looked up the tax bill on a property in Phoenix with an approximate value of $50,000, and the total for the year is about $1090, give or take.

The Second Expense we’ll take into account, is property insurance. We must insure the home. We don’t insure the tenant’s belongings, we only insure the home for the cost to rebuild it. In our current market, we can buy homes for less than it costs to build them, so determining this number is going to be dependent upon a long interview with your insurance company, and it will be affected by your credit profile, as insurance companies definitely take this into account. Let’s say, for gits and shiggles, that your annual insurance bill is $350.00 for $100,000 in coverage.

The Third Expense you’ll need to consider is your annual repair bill. If you think you can get away with renting your house out without expected repairs and deferred maintenance, then you’re delusional. You WILL have repairs. A roof WILL need to be replaced. A water heater WILL go out. Set aside 10% of your annual rental income to cover expenses. That’s $720.00. It may be conservative, but I feel better that way. One would rather err on the side of safe, than not. If it’s not all spent, put the difference in a reserve account and save it for larger repairs and emergencies. I don’t typically endorse a home warranty, but if you want to calculate it into your expenses, add $350 per year. That rounds out to $1070. With a warranty, the annual repair bill could be lower, as some of the repairs will be covered by the warranty.

Quick recap. We’ve racked up 3 expenses now:

Taxes – $1090 +/- per year.
Insurance – $350 +/- per year.
Repairs – let’s call it $1000.00.

On to the rest…

The Fourth Expense will be the vacancy rate and it will vary depending on the health of the rental market and the location of the property, condition of the neighborhood, etc. Vacancy must be calculated because you WILL have months in which you have no tenants. Calculate 5 to 10 percent of the annual gross rental income. In this case it will be $360 – $720 per year. This may not become a realized expense, or it may be larger one year over another. It truly depends on the performance of your rental.

The Fifth Expense will be property management. If you choose to have a property management company handle the acquisition of tenants, collection of payments, and facilitation of repairs, you can expect to pay somewhere in the area of 10% of your gross rental income. That’s another $720 per year.

So lets do the math on all of these costs:

Income – $600/month = $7200.00/year.

Expenses (annual)

Taxes – $1090
Insurance $350
Repairs – $1000
Vacancy – $720 on the high side.
Property Management – $720+

Total annual expenses: $3880.00 +/-

Are you starting to see how this works? And these are very rough estimates. So how do we calculate a) the amount of net operating income we’ll have at the end of the first year, b) the time it will take to recover our initial investment, and c) the annual return as a percentage.

The NOI (Net Operating Income)

Simply subtract from the gross rental income ($7200.00) the annual expenses ($3,880.00) and you’re left with $3,320.00.

The Time It Will Take to Recover the Initial Investment

Divide your initial investment by your NOI. $60,000 divided by $3,320 = 18 years.

The Annual Rate of Return

Divide your NOI by the total investment. $3,320 divided by $60,000 = 5.53%, not including increased property value.

As you can see, what appeared to be a really cheap way to get into the market to invest in a rental could suddenly not be worth the time and effort. You could cut corners to maximize your annual return, but that may come at a greater cost to you in other frustrating areas, like having to market the rental yourself, deal with bad tenants, evictions, etc. Blech!

The real value I hope that you take away from this article is how important it is to do your research before pulling the trigger on that real estate investment, or any other investment. It’s never a good idea to get into something until you know exactly what it is that you’re getting yourself into, and as you can see, there are many factors to consider.

I’m not discouraging you from investing in rental properties, as it is a fantastic long term solution to building long term wealth. In fact, after 18 years, you may have a house that’s worth $100,000 generating $3,320 in passive income every year, but if you really think about it, $100,000 in value returning only 3.32% annually isn’t such a great investment. You’d want to keep hunting for something better.

For instance, if the original cost of the home was only $30,000 (and they exist), you recoup your cash in 9 years and your rate of return is now 11%. Much better. Or if your $60,000 home had a rental rate of $900.00/month, then your NOI would increase from $3,320 to $7,420 yielding an 8 year return at 12.3%.

Over all, the original scenario isn’t that great. You’d probably be better of putting $60,000 in a growth stock mutual fund for 18 years at an average of 8-10% per year. At the end of 18 years of compounding growth you’d have about $650,000 – $1,200,000 socked away. There aren’t many, if any $600.00 rentals that will appreciate from $60,000 to $650,000 in 18 years.

Guess what! Interest rates are REALLY low. They have been REALLY low for a while, and based on historical data, a) they can’t go much lower, if they go lower at all, and b) that means there is a relative guarantee that they will go up in the future.

So, if you’re renting, and you’re on a month to month, or your lease term is up soon, or the savings would simply justify making the change, you may be surprised to know that at today’s rates, you can buy an $80,000 property and your monthly payments will at about $700.00 / month.

Still renting?

Did you know that as a result of the economic climate over the past few years, millions moved back into their parents homes and are now considering moving out again? That means (considering there are lots of people who are still skiddish about buying) that rental supplies are going to go down and rents are going to go up, as those people move out and rent. That’s basic supply and demand.

Still renting?

How much are you paying? Think your rental rate will stay there? Not likely. CNN Money predicts that rental prices could increase up to 10% annually in some areas.

In some areas of the valley, home prices have fallen to levels that we haven’t seen since the late 90′s. That’s a setback of more than 10 years of growth. What that also means is that you got lucky enough to be growing up in a time when all real estate appreciation essentially was put on hold while you grew up. And as a young professional with a burgeoning career and a bright future ahead of you, thousands of opportunities to build wealth are sitting right in front of you.