| The National Association of Realtors points
out California has a price-to-rent ratio of 25, the highest in the country.
Hawaii is next at 23. Massachusetts is third at 19. On the other end of
the scale, states like Delaware, Missouri, Texas and Vermont, have price-to-rent
ratios are 11 or 12.
"The only reason you'd be a California landlord at today's prices is because you're expecting price appreciation," notes local investor Bruce Norris. "Monthly cash flow would be almost impossible to achieve without an enormous down payment."
If the property is income producing, such as single family homes, apartments, office buildings, warehouses or retail centers, the investor must be involved in the day-to-day management of his property, or factor in management costs. If the investor is a rehabber or flipper, real estate becomes more of a business rather than an investment.
Until the earl ‘80s, investment-grade real estate was bought and sold on the basis of a property's capitalization rate (income divided by value). As math calculation tools have become more sophisticated, the internal rate of return – a.k.a. IRR = the total return on an investment, including annual cash flow and profit upon sale. In less speculative times, the IRR was not used as an analytic tool when making investment decisions because of the perceived vast number of undeterminable variables. Because property prices have skyrocketed, investors now calculate future appreciation along with cash flow.
"The most significant factors for the determination of yield on the equity investment are usually the duration of the holding period and the net reversion to equity,” shares L.W. Ellwood, noted real estate valuation expert. “Obviously, these are imponderables at the time of appraisal. They will be the result of management decisions, which cannot be made until specific opportunities to sell occur at various specific times in the future.”
Let us calculate the IRR on that condo in Dallas that you purchased for $95,000. Say you put $30,000 down and carried a $65,000 mortgage. If the condo rents for $1,200 a month, your net profits -- after costs such as mortgage, maintenance and property taxes -- should be in the $2,000-a-year range. With good planning, that $2,000 per month will let you pay off the entire mortgage within 14 years.
The true upside is had when you think about the fact that you have turned $30,000 in equity into $95,000 – even if rents and property prices stayed the same. Factor in 3% annual rent increases and price appreciation, and the property's net value to the owner would be closer to $200,000.
A stock fund would need to return 15% a year for 14 years to better that return on investment – and don’t forget that stocks don't give you any of the tax breaks that can come with being a property owner.
“Real estate in not for the armchair investor,” notes Lipson. “Even a landlord who contracts out plumbing, painting and rent collection make a big time commitment.”