And since they don't know what they are talking about, they often make mistakes that are misleading at best and dangerous (at least financially) at worst.
I highlighted one of these mistakes in my post titled How to Measure and Track Wealth. In it I noted how the mainstream media often incorrectly uses "income" when they mean "net worth." To someone who doesn't know any better (like most of the people writing these sorts of articles), there's really no difference between the two. But as most FMF readers realize, there's a big difference between them.
Recently I ran into a piece from CNN Money titled Top 10 Markets to Buy a Rental Property. As you know, I have rental properties, so I was interested to read the piece when I saw the title.
On the first page of the article they list Wichita Falls, Texas as the top place to buy rental properties, giving this data:
- Median home price: $84,000
- Median rent: $938
- Return on investment*: 13.4%
- The price of the average home is $84,000.
- The gross annual rent from this average home is $11,256 ($938 per month * 12 months).
- This gets them a 13.4% "return on investment" by taking $11,256 / $84,000.
Does anyone see the problem yet?
Before I go into detail, you'll notice there's an asterisk after their "return on investment". It leads to the following on the bottom of the page:
*Return on investment is also known as gross rental yield, which is the percentage of profit or loss from an investment that is calculated by dividing the annual gross rental income by the purchase price or market value of the property. Ratings were calculated by comparing gross median rents (the return on investment before accounting for taxes, maintenance fees and other costs) for three-bedroom homes to median home price. All of the markets were relatively strong economically, with unemployment rates below the national average.
No, no, no.
This is so wrong in so many ways.
How They Got It Wrong
How are they wrong? Let us count the ways:
1. Gross annual rents divided by the price of a property (by the way, this includes the purchase price plus any improvements, remodeling, etc. done that are long-term in nature) tells you nothing, really. At best it gives you a very general sense of whether or not a property is a good investment. It is in no way close to the actual return you'd get on a rental property investment.
Actually, the reverse of this calculation is used by most real estate investors. Property value divided by gross annual rents is called the gross rent multiplier (GRM) and is used to get a general feel for the investment potential of one property versus another as well as a property's overall potential return.
The actual numbers vary from market to market, but I can tell you that if a property in Grand Rapids, Michigan has a GRM around 5, it's worth considering as an investment. Why? Because I know that it will be making enough gross income relative to the operating costs to hit my targeted NET return (more on that in a minute.) For the record, the GRMs of my three properties are 4.51, 4.83, and 4.26.
2. The article claims that this false calculation is "the percentage of profit or loss from an investment." Nope. There's absolutely no profit or loss contained in the calculations for one simple reason: it doesn't consider EXPENSES. And how do you know anything about the profit or loss of an investment without looking at expenses? Answer: You don't!!
The piece admits this saying that the numbers are calculated "before accounting for taxes, maintenance fees and other costs". But it simply glosses right over this fact, as if it's not important. Believe me, it's important!
3. So the result using the calculation above is a "return" of 13.4%, which sounds very impressive. The truth is, however, once you deduct all the expenses associated with owning this property, you probably have something like $4,000 left. This gives you a REAL return of 4.8%. This, coupled with an assumed appreciation in the property (not to mention other tax and cash flow benefits) might make this an attractive option for an investor. But let's be very clear. The true, overall return is probably more in the 7% range, not anywhere near 13.4%. It's very deceptive.
Just Plain Wrong
One exception to the above COULD be if they used financing. In many cases you can increase your return percentage by mortgaging properties. Yes, you'll have more expenses (you have to pay the mortgage), but you'll also have less of your own money invested. And if the numbers work correctly, your percentage return will actually increase over paying cash for a place. But since they don't mention or even hint at a mortgage, I don't think they are using one in any way.
Now some may think that I'm nitpicking a bit or am totally wrong about the calculations they've used. But I don't think so. They basically ignore any costs in their equation, suggest gross returns are the same as net returns, and calculate their "return on investment" accordingly. They imply that an investor would be getting a 13.4% return on an average place in Wichita Falls and this is nowhere near the truth.
I'm not sure if this piece is wrong because the person didn't know what in the Sam Perkins they were talking about or if they wanted the "return on investment" to be impressive, so they took a few liberties to make the numbers look good. Either way, they're wrong. And it's yet another financial mistake by media who are supposed to be "experts" on the topic. For goodness' sake, this is CNN Money we're talking about!
How to Really Measure the Return on Real Estate
So, what's the true way to measure your return on a rental property investment? That's a long and complicated answer, or at least can be if you want to get into the details of depreciation, cash flow, tax implications, and so forth, but here are the highlights that matter the most:
- Find the gross annual rents for a property. In the example above, these were $11,256.
- Find the annual expenses for the property. Things like real estate taxes, insurance, maintenance, and so forth. Let's say they are $7,256 just as an example.
- Subtract the expenses from the rents. This leaves you $4,000.
- Take $4,000 and divide it by the amount you have invested in the property. In this case you have $84,000 into it so your return is $4,000 / $84,000 = 4.76%
- If you like, you can add a "plug" number to estimate the value of appreciation. For example, if you think your property will appreciate 3% a year, you could say your investment is returning 7.76% a year. Of course you won't realize this until you sell and the number is highly subjective. For this reason, I don't add in appreciation when I look at my return rates.
For more specifics, see the post Apex did on running the numbers on an investment property.
Ok, I've rambled on for far too long already. Yes, the mistakes of so-called experts tends to get my blood boiling but I'll spare you any more ranting and call it a day on this post. :)