In general, most people don’t even bother with Rental Properties – the Stock Market is king when it comes to investing.
It’s simple, liquid, and has high returns – what more could you want?
Well, in this article I’m going to go over an alternative to the stock market: Rental Properties.
I buy all my Rental Properties from a website called Roofstock. This website is simple, cheap, and has all the information you need about the house already on the website.
They also connect you with certified property managers, insurance agents, and recommend banks to use – making the house buying process MUCH easier.
If you’re interested, I wrote an in-depth review of Roofstock which shows how they turn the process of buying a Rental Property into Real Estate for Dummies – if you’d like, you can check that article out once you’ve seen how profitable Rental Properties can be and are ready to buy.
As you’ll soon see, there are many benefits that Rental Properties have over the stock market.
This review will discuss the returns you get with Rental Properties Vs the returns you get with the stock market and show how in many cases buying Rental Properties is vastly superior to buying stocks.
In order to do this, we will be using a property I bought as a case study. We will also assume the stock market provides 8% yearly returns, which is right around what it has averaged historically.
Let’s get started!
Do Rental Properties have higher returns than the Stock Market?
Compounding returns are a real thing, and the stock market is one of the best ways to take advantage of them.
However, Rental properties actually offer MUCH higher returns, if you do the research and find the right house.
My first house on Roofstock was an $85,000 single-family house in Alabama. For this house, I put 20% down ($17,000) and paid just under $4,000 in closing/loan costs, for a total of just under $21,000 invested upfront.
If I had put that $21,000 into the stock market, at 8% growth per year I would have earned $190,316 after 30 years, according to this calculator. Adding in your initial investment, your stocks would be worth $211,316 in total.
Now let’s see how much I’m going to make with my Rental property.
The simple math behind Rental Property Cash Flow
The house I bought had a renter already living there who was paying $825 in rent.
So, to calculate my return, I subtract all my monthly costs from that $825 in rent, and whatever I’m left with would be my monthly return.
The biggest monthly cost is a mortgage: for this house, I was able to lock in a 30 year fixed rate mortgage at 4% interest. This led to a monthly payment of $324.64 (let’s round up to $325 to keep things simple).
In addition, Roofstock estimated that I would have to pay $50/month for property taxes, and $50/month for insurance – this proved to be an accurate prediction within a few dollars (in general you can trust Roofstock’s predictions – they’re often pulled directly from official state sources).
Also, Property Managers that Roofstock recommends usually charge 8% of the collected rent, which meant another $63 per month.
So: $825 – $325 – $50 – $50 -$63 = $337/month.
However, there are 2 other aspects you have to consider when predicting cash flow:
1) How often will the house be vacant?
2) How much will general repairs cost for the house?
These costs will happen, but when and how much they’ll cost are a bit more unpredictable.
So, the standard advice is to set aside a certain amount of money per month in either a bank account or in safe, liquid investments, and use that money to cover vacancies, repairs, and the like whenever they happen.
Based on the area you bought in, the age of the house, and other factors, Roofstock calculates how much you should save per month to cover vacancies, general maintenance, and larger expenses (such as a roof collapsing).
For my house, Roofstock estimated a 5% vacancy rate, meaning they expect my house to be vacant for 1 out of every 20 months.
So, they recommended that I save 5% of rent every month in a safe place, and use these cash reserves to cover the vacant months when they happen. This came out to about $41/month.
In addition, while your property manager largely handles the process of finding and placing tenants for you, that does come with an extra cost. Roofstock calls this cost “leasing fees”, and suggested I save another $20/month to cover them.
Roofstock also recommended I save 5.6% of collected rent ($44) for general maintenance and 6% of collected rent ($47) for larger expenditures that would come up.
If you disagree with their estimates and want to be more/less conservative, you can adjust these numbers on their site (more on this soon).
However, assuming you’re ok with trusting their estimates, that meant I was taking $152 from my return and putting it in a bank account to cover future costs – for all intents and purposes, reducing my monthly return by that amount.
With these adjustments, my monthly return went down to $185/month.
Final Rental Properties Cash Flow Calculation
At a return of $185 per month, I am making $2,220 per year (a bit over 10% of my initial investment), and $66,600 in 30 years.
Now, you might be thinking, “Isn’t that much less than the $211,316 I would have by investing in the market”?
And you’d be right – If that was the only way you’re making money by buying Rental Properties! Let’s go through the other ways to make profit by buying a rental property.
Building up equity
One thing that’s easy to forget is that the $211,316 you’d have if you invested in the stock market includes the $21,000 you initially invested.
This applies to Rental Properties as well – in addition to all the money you made from rental income, you also own the actual house you bought.
After 30 years, your house will be completely paid for. The house in this example was worth $85,000 when I bought it, which means that even if the house value stayed the same, I would own an $85,000 asset once the 30 years are up – adding in $85,000 to the $66,600 I made from rent payments gets me to $151,600.
However, it’s extremely unlikely that the value of the house will be the same in 30 years. This brings us to our next topic:
House prices typically rise along with inflation, which is typically around 3%.
This number can vary based on location and other circumstances, but in general, 3% is a good baseline number to shoot for.
So, assuming your $85,000 house rose an average of 3% per year, it would be worth $206,317 at the end of 30 years – an increase of $121,317 from its original value.
Adding this to our total return brings us to $272,917 – over $60,000 more than if we invested in the market!
But wait – that’s not all. There are even MORE ways you can make money when buying rental properties.
As house prices rise, rent prices rise as well – but your mortgage payment stays the same.
So, in general, a reasonable expectation is that you can increase rent by 3% each year since rent prices typically rise along with the house price.
If your expenses all rose at the same rate as your rent, that would mean that profits would increase by 3% each year. However, your monthly mortgage amount will never change – meaning your revenue is rising faster than your expenses, and profits will increase by MORE than 3% each year.
This can be difficult to understand, so let’s go through a simple example.
Assume every month you collected $100 in rent, and paid out $50 for Mortgage and other expenses, for a $50 profit.
If Revenue and expenses both increased by 3%, you would collect $103 in rent, and payout $51.50 in expenses, for a $51.50 profit.
$51.50 in profit is 3% more profit than $50.
However, if expenses DON’T increase, then you would be making $53 in profit, which is a 6% increase.
If rent prices and all non-mortgage payments rise by an average of 3% per year, my total cash flow will grow exponentially each year, and after 30 years will have totaled $174,846.90 – comparing this to the original amount of $66,600 gives me an increase of $108,246.90 in cash flow compared to my original projection.
Adding this to our total, our initial investment is now worth $380,983.90.
Let’s take a break from discussing returns and talk about everyone’s favorite topic: Taxes.
In the stock market, you pay taxes on dividends earned every year, and you pay capital gains tax when you sell.
The tax you’ll pay on dividends is small, and can usually be made up for by utilizing tax loss harvesting.
However, Capital gains tax is a much bigger deal. How much you’ll pay depends on your income levels (see here for a breakdown).
Most people will fall into the 15% bracket, so let’s use that as an example. If you sell all your stocks after 30 years, you will have to pay 15% on the $190,316 that you earned in the market, minus whatever amount of that was due to dividends earned instead of capital gains.
This will likely end up totaling around $25,000 owed in taxes. Subtracting that from our total means that your stocks will actually be worth around $186,000 if you cash out after 30 years.
Now let’s look at taxes for Rental Properties, starting with taxes on your cash flow.
For starters, all expenses you pay per month relating to your rental property are tax-deductible, so you will only be paying taxes on your monthly profit.
Next, there is a big tax incentive for you to take advantage of called depreciation.
When you buy a house, the purchase price covers 2 things: the value of the house, and the value of the land.
According to law, you’re allowed to depreciate the value of the house over 27.5 years and claim this amount as a loss.
This means you can lower your yearly tax bill significantly. However, once you sell the house, you’ll have to pay income taxes on the amount that you depreciated.
So really, this is a tax deferment – similar to a traditional IRA.
In my situation, the land was 20% of the value, which meant the house was worth $68,000. $68,000 divided by 27.5 equals $2,472.73 per year.
For the first few years, $2,472.73 will likely be close to your total return, if not more. However, as you start to increase rent, profits will increase, meaning your yearly taxes will as well.
Over 30 years, expect to pay about $22,000 in taxes, lowering our total to $358,983.90
In addition, if you ever sell the house, you will have to pay Capital Gains tax on the amount that the house went up in value, PLUS you’ll have to pay Income tax on the amount that you depreciated.
Above, we estimated that the house would be worth $206,317 after 30 years.
If we depreciated $2,472.73 each year for all 30 years, that means we would owe Income Tax on $74,181.90, and Capital Gains tax on the remaining $132,135.10 ($206,317 – $74,181.90)
Let’s assume Income taxes are 32%, and Capital Gains taxes are 15%. That would mean you owe $43,558.47 in taxes once you sell the house.
Remember, you don’t have to sell the house. And, even if you DO sell the house, you can take advantage of the 1031 exchange tax rule. However, let’s assume for now that you sell the house after 30 years.
Subtracting all taxes from our total, we’re left with $315,425.16.
Compounding Your Rental Properties’ Returns
Let’s put equity, rising house prices, and tax benefits aside for a second and focus on yearly cash flow.
As stated before, just the income you’ll get from rent-paying tenants is about 10.5% per year, which is higher than you’ll get in the market.
However, by year 30, you’ll be earning more per year in dollars from the stock market than you will from your Rental Property (again, ignoring the equity you’re building up and the house price going up in value).
This is because, in the stock market, your returns are automatically reinvested, while that is not true when you invest in Rental Properties.
So, in the stock market, you’ll earn 8% of the combined total of your initial investment and profits, while with Rental Properties you’ll only earn 10.5% on your INITIAL investment, plus whatever you get from rent increases.
This is why the total stock market return of $190,316 is greater than the total rental income return of $174,846.90 – even after factoring in rent increases.
However, you can easily change that by investing your rental returns into the stock market.
This makes your rental income increase exponentially, similar to how stocks do – although the return on the rental income you put into the stock market will only be 8% instead of 10.5%.
Still, this launches your returns into another stratosphere. By investing your returns each year, you will earn an ADDITIONAL $274,716.37 in total after 30 years.
Adding this to our total brings us all the way up to $590,141.53.
Optional: Invest your reserve accounts in the market as well
Earlier, we discussed the importance of setting aside money in a reserve account to pay for vacancies, repairs, and big expenses that come up through the lifetime of the house.
If you’re comfortable with some risk, you can invest those reserves in the market as well to increase your returns even more.
Obviously, you can’t invest all of it for the full 30 years – after all, over the lifetime of the house, you’d expect to spend all that money on repairs/vacancies.
Let’s assume that on average you’re able to invest these reserves for a year before you need them for repairs. Let’s also assume that any returns you make can be kept in the market until the end of the 30 years.
At 8%, this would net you another $24,813.63.
Stock Total: $211,316
Wrap up: Rental Properties Returns Vs Stock Market
A lot of the above numbers are just examples, and many assumptions are made. If you’d like, you can recalculate the expected return using different assumptions (for example, maybe you think you will only be able to increase rent by 2% each year on average).
However, no matter what assumptions you use, you’ll likely come to the same conclusion: That you’ll make much more money investing in Rental Properties than the stock market.
Diversification: Another reason not to go all-in on stocks
No matter how confident you are in a single asset class, diversification is never a bad thing.
The stock market tends to perform very well over long periods of time, so as long as you’re planning on holding until retirement, you should be fine.
However, past performance isn’t a guarantee of future performance, so it’s always POSSIBLE the stock market is about to have a really bad 20-30 year stretch. Having your money spread between different asset classes helps mitigate the stress of that happening.
This is another reason to invest in Rental Properties. Having a portfolio that includes Stocks, Rental Properties, and other assets is MUCH safer than a portfolio that only includes a single asset class.
Rental Properties Vs Stocks: Wrap Up
If you decide to sell your house, you’ll likely have to wait for months before you see the money. This makes Rental Properties much less liquid than stocks.
So, despite all the advantages of rental properties, you shouldn’t go all-in on them.
A good Rental Property allocation target is about 30-50% of your portfolio. If you stick within that range, you should be in a good position for the long term.
However, it’s clear why Rental Properties should have a prominent place in your portfolio.
When done correctly, the return is MUCH higher than what you’ll get in the stock market – in fact, you can easily earn more than 3x what you would with stocks over 30 years.
And if you use Roofstock as I recommend, you can get started quickly and easily.
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