Another Financial Media Mistake (How to Really Measure the Return on Real Estate)

As long-time FMF readers know, I am not a big fan of the mainstream financial media. There are actually several reasons for my feelings, but the main one boils down to this: they don't know what they are talking about.

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.

Some Mistakes

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%

Ok, let's do the math here so we're all on the same page:

• 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, 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. :)

Comments

[Jon]

Oh heck, with the mainstream financial media, they're just lucky to spell "profit" correctly.

[getrichwithme]

The standard of writing on most blogs (yours included) far exceeds that on most commercial media outlets these days.
Bloggers tend to do research and then write - lazy journos seem to write first then try to find the research that best fits their "opinion"

[Apex]

3 of the top 10 places they list are in Texas. This is not a coincidence. Texas has no income tax. Which is nice if you have high income. However it still has a state and local government so where does it get its money from? One of the places it does this is by having one of the highest property tax rates in the country.

About.com lists them as third highest only barely behind New Jersey and New Hampshire (another no income tax state).

http://taxes.about.com/od/statetaxes/a/property-taxes-best-and-worst-states.htm

So by ignoring expenses they have self selected for areas that have higher expenses than other areas which are made up for either by cheaper purchase prices or higher rents in proportion to those expenses.

As FMF correctly points out this tells you nothing about whether or not something is profitable and worse yet because their methodology has selection bias it could potentially be selecting worse than average investments rather than better than average investments.

It's not just that the percent return is wrong. It is likely that the top 10 would radically change after accounting for expenses.

The article is worse than worthless. It has negative worth, as it could harm you if you were to take the advice seriously.

[Donny @ Personal Income]

I am anxious to invest in my first rental property hopefully next year, but I want to make sure that I find the right real estate agent that specializes in investment properties because I don't want to be upside down on my house or mortgage payments.

[Elizabeth]

This is why I follow my own advice and make up my own rules based on “real life” and all “details and facts”. I’d rather and DO get advice from real people rather than just the net or the articles who so very often do not take everything into consideration when writing and/or giving erroneous information and advice.

Hence, why I read FMF daily.

[moneystepper]

Some of the errors in mainstream financial media really get on my nerves. There is no wonder that the majority don't understand personal finance when misleading media reports highlight "facts" and "figures" to sensationalize their headlines rather than reporting the reality. Grrrrr.

[jim]

Very true. Simply dividing rent by the cost of a property doesn't tall you much. You really do have to look at expenses.

[LHR]

FMF, Can you show the same example return caculation but with a mortgage? Thanks!

[FMF]

LHR --

You would simply add the monthly mortgage payments as expenses (you would have some upfront loan costs, but they are one-time)and you would divide by the amount of equity you have in the property -- not the total value of the property.

[Apex]

LHR,

FMF, pointed to my article on running the numbers at the bottom of his article. That shows returns with a mortgage (both cash on cash return and ROI). It also shows cap rate which would be the same as your return without a mortgage. So it shows the results on a return that a mortgage will make.

If you want the very short version and don't want to read the article, the results looked like this on that property.

Cap Rate = 9.1% - this would be the profit after all expenses with no mortgage.

Cash on Cash Return = 14.7% - this was the amount of cash returned each year as a percent of original cash investment based on a 75% mortgage.

ROI = 18.4% - this was the actual net profit (including equity pay down) as a percent of original cash invested based on a 75% mortgage.

a 75% mortgage more than doubled the return on this particular property (9.1% -> 18.4%)

You can check out the complete article for real numbers on a real property at the link below:

http://www.freemoneyfinance.com/2012/10/real-estate-101-running-the-numbers.html

[MIFM]

Good post for anybody thinking about getting into rentals for the first time. I made this mistake on my first rental. Luckily after 4 years of barely breaking even it had appreciated enough to sell this year. But I didn't want to "get lucky". I wanted a long term cash flow asset.