I’ve been wanting to write this post for a while.
Since I started reading CashFlowDiaries, that turnkey real estate bug has been biting me, hard… Which is why I cleared my newly created Motif Investing account, paid off my credit card debt, and hastily increased my credit score by more than 100 points in two months.
Yes, I really wanted to get a turnkey rental property, as soon as possible. I was not crazy. That 20+% cash on cash return is simply irresistible to me. As I rolled up my sleeves to analyze turnkey properties available in the market, I was slightly disappointed to find that those high cash on cash(COC) return properties are not what you can come across every day. I’ve been actively looking for a couple of month now – the best I’ve COC return I’ve seen is only around 10%, with most of others hovering around 4-8%, and the more recent ones seeming to be even lower, indicating market saturation.
So now the question is, is it still worth getting a turnkey property when the COC return is only 0-10%? Or what cash flow will justify a turnkey rental property to be worth investing?
How I determine cash on cash return
Compared to the calculation method used by CashFlowDiaries, I am being more conservative in determining the cash flow of a property. I set aside an additional monthly expense of 10% rent for CapEx, which is for these big-ticket items in a house that need to be replaced once they’ve reached end of life. According to this article from BiggerPockets, I’d need $182.75 per month for CapEx expenses, but I decided to make it simply 10% of monthly rent.
So below is the breakdown of monthly income and expenses:
Monthly income: rent
Monthly expenses: mortgage, property tax, insurance, vacancy (10% rent), repairs (10% rent), CapEx(10% rent). Depending on the property, there may be other optional expenses like HOA, utilities, snow removal, lawn care etc. but they seem not needed for most of the properties that I’ve looked at.
Annual return baseline
The overall US stock market has been generating 10% annual return for long term investors, so this will be a good baseline to determine the rental property investment worthiness. Anything below 10% annual return will not make sense to purse considering the higher risk associated with real estate.
How to calculate the annual return of turnkey rental properties
COC (cash on cash) return is frequently used in real estate investing, but to compare with the 10% return which is annual compound return rate, I’ll have to convert the COC return into annual return. Confused about what is annual return? Check out this article from Investopedia.
As shown in that article, annual return is calculated as:
(Ending_Value / Beginning_Value) ^ (1/#_of_years) – 1
For turnkey rental property investments, the End_Value would include the equity built (appreciation or depreciation adjusted) plus the net income from the rental. Beginning_Value would be down payment, closing costs, and rehab costs if any.
COC return increases over years
To calculate rental income over years, the COC return for any particular year would be needed. The great thing about rental properties is, COC return increases every year due to annual rent increase but fixed mortgage payments. Assuming an average 4% rent increase based on US Census Median Gross Rent, and assuming property tax and insurance growing at the same rate and other expenses keeping at the same ratio compared to rent, below is a chart showing how COC changes in a 30-year period. Thanks to the compound effect from rent increase, a property with an initial COC return of only 0% will eventually turn into an impressive 30%+ COC return in 30 years. Don’t get too excited just yet, because while a 30%+ COC return looks great, it is based on first year’s investment, in other words, it’s not compound annual return. That’s why it’s important to compare in terms of annual returns.
Annual return of turnkey rental properties
And below is the turnkey annual return with different initial COC returns. In case you are wondering, below are my assumptions:
a) There’s no appreciation or depreciation of the property. Appreciation is slow in Midwest even in desirable A neighborhoods, so I’ll assume no appreciation in B or C neighborhoods that I’m looking at;
b) Since the net rental income is liquid, I’m assuming it’s actively invested in stock markets to generate 10% annual return;
c) Same assumptions as used in COC return calculation.
Apparently, rental property investment is a long-term game. The initial years’ annual returns are low because of low COC returns and insignificant amount of equity built. For a 5% initial COC return, the annual return will not hit 10% until after 8 years. And even with a 10% initial COC return, it still takes 3 years to reach 10% annual return.
What cash flow makes turnkey rental properties investable?
So back to my original question, what’s the minimum COC return that makes a turnkey rental investment worthy? Clearly based on my annual return chart, I will not touch a 0% initial COC return property – even after 30 years, the annual return is still below 10%. If a turnkey property has 10% COC return, I’ll definitely jump in.
I’d say the minimum COC return I want to see in a turnkey property is around 7-8%. Honestly, there are not that many properties out there hitting that number. Turnkey providers will likely give you really nice looking COC returns, easily 10-20%, but don’t be fooled, their calculation works in their favor and usually higher than real.
I’ll keep looking.
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