Calculating how much profit you should make on a rental property is straightforward, but the key word here is “should.” Repair costs, while fairly standard across the industry, will vary based on how efficiently you run your rental business. Rental revenues will fluctuate based on how well you collect market rents. However, empirical research has determined how much profit you should earn on a rental property.
Rental properties average a profit of 6.8% of the property value each year, and these same houses will appreciate an average of 3.3% annually. However, nicer properties tend to have a lower profit margin but a greater appreciation rate.
In this article, I will explain how these numbers are derived, how they differ between cities, and how you can improve the results of your rental portfolio. In addition, I’ll give you the actual numbers I am getting on my portfolio of houses.
Anticipated Rent Profit and Property Appreciation
An academic study by Andrew Demers and Andrea Eisfeldt was the first in-depth study of the total returns of single-family rentals over a long period. This paper, Rental Yields and HPA: The Returns to Single Family Rentals, looked at properties in the 30 largest metropolitan statistical areas (MSA) over 28 years. Using data from the US Census Bureau’s American Housing Survey (AHS), this study breaks down rental yields and property appreciation (capital gains) by average home values in the MSAs.
The study finds that the 5 MSAs with the lowest home values average an annual profit of 6.8%, and these homes appreciate at 3.3% each year. Over the same period, houses in the top 5 MSAs (by home value) average a profit of 3.5% with an appreciation rate of 6%. This increased appreciation in higher-priced cities is consistent with the findings of “Superstar Cities,” a 2013 paper from the Wharton School written by Gyourko, Joseph, Christopher Mayer, and Todd Sinai.
Using these numbers, a hypothetical property, in a lower-tier city, with a value of $100,000 would have a net profit of $6,800 (6.8% of the property’s value). We know that average operating expenses are about 40% of the rent; therefore, the total rent should be $11,133.33 per year. This gives a monthly rent of $944.44, which is surprisingly close to the rent predicted by the 1% rule.
How to Beat the Averages
The profit and appreciation numbers quoted above are averages based on the property’s value. The way to beat the average return on a rental property is to purchase and renovate a house for significantly less than the property’s market value. As a real estate investor, your primary skill should be finding undervalued properties.
Suppose you have a property valued at $100,000. Using the 6.8% profit predicted above, you should have an annual net profit of $6,800. If you purchased that same property for $90,000, you should get the same rent (after all, it is the same property), which produces a return of 7.67% per year. The table below shows you the returns for different purchase prices.
|Purchase Price||Rental Yield|
As an investor in rental houses, you should strive to purchase homes at no more than 50 times the monthly rent. This means you should invest no more than $50,000 in a hypothetical house that rents for about $1,000 per month, giving you an annual return of over 13%. It is challenging to find properties at this price, but this article explains why you must never pay for than 50 times the rent for a rental house.
Knowing a property’s actual value is impossible until you sell it, so I have used online sources to value my houses (mainly Zillow). My portfolio has a value of $6,578,400. In 2022, my net income, disregarding mortgage interest and depreciation, was $442,249. This net profit is 6.72% which is very close to the average of 6.8%. Sadly, I had another $84,000 in interest expense, which gave me an actual net profit of 5.45% of the property value. (Note: That net income sounds impressive, but my actual cash flow is much lower.)
I accumulated these properties over the last 15 years. Using the depreciation schedule from my 2022 tax return, I spent $2,453,677 to purchase and renovate these properties. My net profit, excluding mortgage interest and depreciation, of $442,249 gives me an annual return of 18% on the money invested (14.6% if interest expense is included). In addition, I used leverage on most of these properties, giving me a much greater cash-on-cash return.
The initial cost of my current portfolio is $2,45M, and the estimated market value of these properties is $6,58M, which is a 168% gain. It is difficult to determine the annualized housing appreciation because I did not have the same number of properties each year. Remember that this is not all property appreciation because I buy all properties well below market value.
The average profit on a portfolio of rental houses ranges from 3.5% to 6.8% of the property value, while property appreciation is from 3.5% to 6% annually. These values are primarily dependent on the geographical location of the rental properties. Rigorous academic research was used to arrive at these values, and the numbers from my actual portfolio confirm the research findings. The effective rate of return can be significantly expanded by purchasing property well below market value.