How I Analyze a Long Term Investment Property

I will take you through my process of analyzing a property as a long term investment. Properties that work as long term investments don't always work as short term investments, and vice versa. Properties that work as a short term investment may not work as a long term investment. It is important to know the difference.

The Property

Today, we will be analyzing 3527 W 132nd St in Hawthorne, CA for sale at a price of $719,000. It is a duplex with a shared yard. The front house has 2 bedrooms and 1 bathroom. It looks like it has been recently painted and currently rented out. The back house has 2 bedrooms and 2 bathrooms. It looks like it needs a lot of work.

Mitigating Factors

As someone who are remodeled units in similar conditions, I'd estimate between $10,000 to $15,000 in repairs, assuming you know a reliable handyman.

It's been on the market as of 8/13/2024 for 97 days or more than 3 months. You could realistically negotiate a lower rate without issues, but we're going to assume you pay the asking price.

After Repair Value

This is how much the home will be worth after you fix it up. This is important because it determine your starting equity. While there are properties where you can make a profit on the rental income, the real benefit of investing in real estate comes from the appreciation of property values over your portfolio's lifetime. With rental income, you have to pay taxes on the profits. With appreciation of home values, you do not.

And the higher the valuation of the home on your purchase date, all things being equal, the higher the valuation of a home after 30 years.

To put this in simpler terms, if you buy a house that is worth $100,000 in an area that appreciates at about 8% per year, after 30 years, that house will be worth $931,000.

But if you buy a house that is worth $900,000 in an area that appreciates at about 5% per year, after 30 years, that house will be worth $3.7 million.

And if you buy a house that is worth $900,000 in an area that appreciates at 8% per year, after 30 years, that house will be worth $8.3 million.

Notice, I did not say if you buy a house that costs $900,000. I said if you buy a house that is worth $900,000.

There is a difference between how much something costs and how much something is worth.

3527 W 132nd St in Hawthorne, California costs $719,000. But if we look at previous duplexes that sold in the area in the last 30 days, we find duplexes in good condition have sold for about $1,000,000.

It is safe to say, this property alone is worth $900,000. But we will use $875,000 to be more conservative, giving it a predicted value of $8.1m in 30 years.

Costs

Investors in residential multifamily properties generally have to put in between 20% to 25% of the house price as a down payment.

Foreign national investors would have to put in between 25% and 35% down.

I'm going to use 35% down for this analysis with an interest rate of 8.5%.

Over 30 years, assuming no tenants, just buying and holding, keeping it empty after a fix up and setting it up as a vacation property, it will have cost you a total of $1.6 million cash.

If after 30 years, you decided to sell, you would end up with a profit of $6.5 million.

That figure drops to $3.7 million after you account for property taxes and hazard insurance.

30 year exit = $3.7 million

Long Term Rental Analysis

But $1.6 million dollars is a lot to spend over 30 years, which includes principal mortgage payments and interest, but not hazard insurance or property taxes. That's a yearly spend of $53,333.33 or a monthly payment of $4,444.44.

It would be nice if that investment could pay for itself.

That's where rent comes in.

With long term tenants, after the units are fixed up, market rents place your monthly rental income at about $2000 for the 1 bathroom unit in from and $2300 for the 2 bathroom unit in back of a total of $4300 a month.

Assuming a vacancy rate of 25%, that's a predicted yearly income of $38,700 a year, or a loss of $14,633.33.

Does that mean you shouldn't buy it? NO!

It means your profits after you sell it after 30 years, will be even bigger!

Remember, after 30 years, the property will be worth $8.1 million. Without renting it, you would end up with a profit of $3.7 million dollars as a result of having you pay $53,333.33 every year out of pocket.

With rental income covering the majority of that, you'd only be spending $14,633.33 every year for 30 years. And because of rental inflation, rents will go up. Assuming a rental inflation of 3.18% per year, you're looking at rents being closer to $4900/month for the 1 bathroom unit and $5700/month for the 2 bathroom unit.

That's a total rental income of $1.9 million over the next 30 years even with a vacancy rate of 25%.

And tenants typically pay all utilities, so your only real costs are maybe legal costs on evictions and regular maintenance work, which I factor in at about 10% of the monthly rental income. You'd also have to pay a property management company unless you chose to manage it yourself. Property management services are typically 10% of the rental income. Then you'd have to subtract the costs of property taxes and hazard insurance.

After factoring all those costs, your exit after 30 years is actually closer to $5.2 million. It's literally as simple as adding $1.9 million to $3.7 million, which equals $5.6 million and then subtracting the added costs of providing the service.

30 year exit = $5.2 million

Your original cash investment was actually closer to $400,000. So over 30 years, you turned a $400,000 investment into $5.2 million dollars.

That's with a long term tenant strategy.

Short Term Rental Analysis

Now let's see how much money you would earn (or lose) by renting it on AirBNB. First, lets see what you could hope to earn on a yearly basis combined with lower occupancy rates.

According to rabbu.com, a 2 bedroom unit earns on average about $29,000 a year with an occupancy rate of 54% (or a vacancy rate of 46%).

But short term rentals on AirBNB vary from professionally managed, decorated, and photographed to...not professional at all.

However, bedroom units average about $45,000 a year with the same occupancy rate. So we're gonna split the difference and assume a yearly average of $37,000. I'm gonna use $35,000 per year per unit to be conservative.

That gives as a yearly income of $76,000 give or take. With rental inflation at the same 3.18% per year, after 30 years, you're looking at about a rental rate of $14,460/month.

In total, you will have collected $3.7 million in rent instead of the $1.9 million in normal rents.

But your costs are significantly higher too because now you have to pay for cleaning, furniture, and utilities including internet. And property management rates for AirBNB's are much higher too, usually around 20%.

Taking all those increased costs into account, you're looking at an exit of $6 million dollars after 30 years, or $800,000 more than with normal long term tenants.

30 year exit = $6 million

Which is Better?

That depends on how much tenant headaches you're willing to deal with. The more tenants you have, the more problems and headaches you will have. And with short term rentals, you have more tenants than with long term rentals.

If you chose not to rent it, you'd spend about $53,333.33 every year out of pocket just to keep it. After accounting for property taxes and insurance, if you sold it after 30 years, you'd net $3.7 million.

If you chose to do short term rentals professionally, you'd spend about $26,666.66 every year out of pocket just to keep it. If you sold it after 30 years, you'd net $6 million.

If you chose to do long term rentals, you'd spend about $14,633.33 every year out of pocket just to keep it. If you sold it after 30 years, you'd net $5.2 million.

Conclusion

Investing in rental properties is more involved than just seeing if the rents cover the mortgage payments.

You must consider how long you expect to hold the property and consider how fast property values appreciate in the area.

You must also consider what types of rentals you have the stomach for. Not renting to anyone results in the least profits, and short terms rentals result in the most profits. But they also come with higher costs than just doing regular long term rentals.

The small difference in profits may not be worth it to some investors who can utilize that difference in cash for other investments.

And in all cases, the bulk of profits came not from rental incomes but rather from tax-free appreciation.