I Revisit our Hypothetical Rental From 2021

A little over a year ago, I posted a blog asking the question “Do SFRs in the Sacramento Area still pencil?” I wanted to share how I run numbers on a property when I am determining whether to pursue it as an investment property. When asking the question, “Does it pencil?” I am asking whether the property will generate more rental income each month than there are expenses in holding costs.

The hypothetical rental I was considering at the time was a three-bedroom, two full bathroom home with 1,600 square feet of living space on a 0.16-acre sized lot in an average neighborhood. The median price for a detached single-family home in February of 2021 was $440,000. Rent rates were estimated at $1.25 per square foot, which put our generic home at $2,000 per month.

If you had A+ credit and were putting 25% down, this non-owner-occupied purchase would have been with a 2.99% interest rate loan. The resulting principal, interest, taxes, and insurance came out to $1,918.09. I also included $300 in additional expenses for a property manager, miscellaneous utilities, and monthly yard service. The monthly cash-flow for the hypothetical rental was a net loss of $218 each month.

With our hindsight, we now know that over the subsequent 12 months property values appreciated up by an estimated 19% in the Sacramento area. Rent also continued to go up throughout the year, increasing by an estimated 20%. So, let’s look back at this imaginary property and see what the numbers say.

By March 2022 the negative monthly cashflow of $218 means that we’ve lost $2,616 over those 12 months. During this first year, the property appreciated by 19% and the house is now worth $523,600 - that is an increase of $83,600 over that 12-month period. And last but not least, we were able to depreciate the property by around $14,500 on our taxes to help reduce our income taxes due to the IRS. Based on these measures, we should have purchased the rental even though we were going to incur that $218 monthly loss because in retrospect, we spent $2,616 in exchange for $83,600 worth of equity and $14,500 worth of tax write offs.

But our lease with our first tenant has expired and they moved to a house that they purchased. We need a new tenant and we put our rental back on the market. We learn that rent rates are higher. The average rent is now $1.50 per sf, and that means that our rental property now will rent for $2,400 monthly.

At $2,400 our rental property will now net us a monthly profit of $181.91 and that works out to a profit of $2,182.92 for next year. Home prices are expected to go up throughout 2022 and some estimates forecast that real estate values in the Sacramento area will be up another 15% or more by the end of 2022. I’m going to be very conservative and cut that number in half.

In summary, our hypothetical rental property which we paid $440,000 for and didn’t “pencil out” in 2021 will be worth $562,870 or more by the end of the second year we’ve owned it. We now pull in nearly $200 of profit each month, we’ve been paying down our loan balance with each mortgage payment and our income taxes benefit from the $14,500 of annual depreciation that we get to use as a write off for the next 27.5 years. My initial assessment focused on cash flow, but the benefits of real estate investment are multifaceted and taking the time to do deep dives on a potential purchase are key to the strategies of buy-and-hold investors like myself.

In the coming days, I’m going to do a blog post where we analyze a different rental based on today’s prices, costs, and interest rates.

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