Follow these 5 rules and owning rental property will be a rich and rewarding experience. Ignore one (or more) of these rules and your rental property dream could become a nightmare.
Real estate ownership is a paradox. From one perspective, rental property is the best investment vehicle that exists. But you may know people and you yourself may have experienced the exact opposite, the nightmare that a rental property can be. What gives? What's the difference? It's these five rules.
Rule 1: 12% Productivity
Rule number one is the most important and to my amazement, the topic of productivity is almost always neglected in relation to owning rental property. I call it the productivity metric, and I would argue that if you're not going to reach a 12% productivity level, you shouldn’t own rental property. That's how serious this rule is.
How to Determine Your Productivity Metric:
Calculate your NOI: The first step is to calculate your net operating income (NOI). To calculate your NOI, take your gross rental income and subtract expenses like property taxes, insurance, management costs, maintenance, replacement savings etc.
Calculate Productivity Metric: Once you calculate the NOI, you need to determine the productivity metric. This is done by calculating “how much you have in it”. Your "in it" number includes what you purchased the property for, plus any rehab, or furnishings if it was a vacation rental.
You own property debt-free that you've been living in but plan to move out and turn it into a rental property. You intend to rent your property for $2,000 a month. The formula to calculate the gross annual rental income looks like this: $2000 x 12 = $24,000
Subtract yearly expenses:
- Taxes: $4,000
- Insurance: $2,000
- Property Management at 10%: $2,400
- Maintenance: $2,000
$24,00 (gross rental income) – $10,400 (expenses) = $13,600 (NOI)
Your “in-it” number for this example is what you could sell the house for at that time. In other words, you have the choice either to sell it or turn into a rental. Let's say your “in-it” number is $250,000. To calculate productivity, divide the NOI by the “in it” number.
The equation would look like this: $ 13,600 (NOI) / $250,000 (in it number) = 0.544 or 5.44% productivity
As you can see, this scenario doesn’t meet the productivity metric of 12%. In fact, it’s far from it. Unfortunately, this scenario is all too common. Instead of determining productivity, investors look at metrics like cash-on-cash return when the focus should be on how well that asset performs regardless of the loan. And it performs well because it produces a lot of cash relative to expenses, and more importantly, relative to what you're “in it” for.
Focus on Productivity:
Deals with 12% productivity are hard to find if you don't know what you're looking for. And I would argue this rule alone knocks out at least 80 if not 90% of all rental properties you could purchase. Yes, hedge funds are paying $250,000 for properties that rent for $2,000 a month. But that has nothing to do with you. Remember, we're trying to ensure that you have a rich and rewarding experience with your rental property, not misery. Personally, I require 20% productivity or more. Focus on productivity and the rest will fall in place.
Rule 2: Equity of 30% or More
Equity is how much the property would sell for versus how much you have borrowed against it. I've said before that not borrowing money against rental property is financially irresponsible. However, you do need some equity in the property because it allows you to sell the property quickly if need be.
Requiring 30% equity doesn’t mean you must put 30% down. You can buy a value-add rental property and create that equity or purchase well below market and gain equity at the time of purchase. The key here is not just that you have equity, but that you've invested money in a property. No money down, super creative techniques are usually reserved for short-term investment strategies. Rentals are long-term holds in which you invest money wisely and have 30% equity, either right as you purchase or within the first six months so that you have room in the deal if you ever need to sell.
Rule 3: Six Months of Reserves
Part of how you prepare for the worst is to have solid reserves. I recommend you have enough reserve cash built up in savings to cover all your expenses for six months. Six months of reserve cash ensures that if something goes wrong, you can easily handle it. As you add more units and more rental properties, building up reserves for each one, it collects in to quite a war chest.
However, there is a cost to having significant cash reserves. Having that cash in savings means you're not earning money on it and you need to periodically add to your reserves to combat inflation. These two factors take away from your productivity number, and it's one of the reasons you need a productivity rate of 12%. The productivity level is so high because we need to account for the costs of these additional rules that create a bulletproof asset.
Rule 4: Insurance
Insurance is another way to prepare for the worst and sleep well at night. Now, I'm not a huge fan of the insurance industry because it always feels like a battle with them. However, insurance plays its key role in situations of absolute loss, like fire, flood, hurricanes and tornadoes. Having significant reserves will handle 99% of the problems you will face. The insurance takes care of the one percent when everything hits the fan and it's a real disaster.
Insurance Strategy: The strategy with insurance is to have a high deductible because the higher the deductible, the lower the cost per year. Remember, we can have a high deductible because we have high reserves. However, and this is where the offset is, you need to get more than full replacement. You want to push that as high as you can push it because of high material and labor cost.
It is extremely expensive to replace what you have as a rental property, so you don’t want to be underinsured. When it’s time to renew, push that full replacement beyond full replacement. There's a point at which the insurance company won't go any higher, and that's about where you want to be to ensure you can replace that highly productive asset. Again, we're not talking about a ton of properties because you still must hit the 12% productivity target. What we're talking about is building a collection of incredible assets, so you want to be able to rebuild if things hit the fan.
Rule 5: Highly Sustainable Long-term
The properties that you're collecting are highly sustainable long-term operations, meaning it's something you can commit to for decades or more because the longer you own a rental property, the better everything gets:
- Your equity goes up
- Reserves continue to collect
- Productivity increases
I just read a statistic that in Austin, Texas rental rates went up by 40% in one year and Orlando's went up by almost 30%. You benefit from these shifts when you own something long-term. You've probably looked at someone else’s situation and said, "Man, I wish I got in when they did." The key was not when they got in, it's that they were able to keep it long-term.
The asset itself needs to be sustainable and last the long haul. People will always need a place to live, especially affordable housing. In certain markets, vacation rentals are another sustainable asset. Highly sustainable long-term rentals means that you're a collector of trophy assets and that as you add those to your portfolio those become treasures and they feed you for a lifetime. You get the tax benefits, income, and the appreciation. This is a recipe for incredible wealth-building and a great financial life.