Real Estate Rate of Return
I read an interesting statement by real estate guru John T. Reed today:
The average operating-expense ratio of a residential rental property is 45% plus or minus 2%. That is, the operating expenses – taxes, management, utilities, insurance, etc… – will consume about 45% of the gross income. That percentage applies all over the U.S. for all types of residential property.
Note however that the mortgage isn’t counted as part of the operating expenses.
After reading that, I decided to do a little homework to calculate the operating expenses, P/E (price to earnings) ratio, and earnings yield for House #2 and House #3 – assuming they are rented out at market prices. I can’t do it for House #1 because we live in that house and have never rented it out before, so I don’t know what kind of rental income I would be able to generate from it.
House #2
- Gross Income = 2,100/month or 25,200/year
- Expenses = 500 Property Tax + 100 Insurance + 100 Repair/Maint = 700/month or 8,400/year
- Net Income = 1,400/month or 16,800/year
- P/E Ratio = 480,000 price / 16,800 net income = 28.6
- Earnings Yield = 16,800 net income / 480,ooo price = 3.5%
Based on the above calculations we can determine that House #2 has a current price that is worth 28.6 times the annual profits it generates. And the earnings yield is 3.5% per annum.
House #3
- Gross Income = 1,200/month or 14,400/year
- Expenses = 150 Property Tax + 276 HOA + 50 Repair/Maint = 476/month or 5,712/year
- Net Income = 724/month or 8,688/year
- P/E Ratio = 147,000 price / 8,688 net income = 16.9
- Earnings Yield = 8,688 net income / 147,000 price = 5.9%
From the calculations we find that House #3 has a current price that is worth 16.9 times the annual profit it generates. And the earnings yield is 5.9% per annum.
Based on our findings we can financially conclude that House #3 gives a better rate of return than House #2. This is probably why it is easier to generate profits on N-plexes than single family homes. The cost for one single family home is much greater whereas it’s rent is not that much higher than a similarly sized condo or townhouse. The difference in rent does not justify the large margin in property price disparity. As a result, in order to make money in real estate, it is better to focus on smaller or more compact housing such as apartments, N-plexes, condos, and townhouses rather than buying single family homes.
Related posts: