# How to estimate the profitability and risk of investing in rental properties?

There was a recent question, Is it a good idea, to buy a flat with a loan, whilst using the rent to pay it off?, which was closed due to asking opinion-based advice. However, the question can be modified to eliminate the opinion-based nature and asking how to estimate the profitability and risk of investing in rental properties.

So, how to estimate the profits obtained and the risks taken when buying properties and renting them out? Of course, the answer will vary depending on the area, but some general principles are valid in all cases.

To purchase a house, you need to calculate the true cost of it. There may be flats available for less than 500 EUR per square meter, but they may have thousands of EUR per square meter renovation debt, i.e. renovations that must be done in the near future. To eliminate the component of renovation debt, the only possibility is to calculate the cost to buy a new property.

To construct a property, you need:

1. Land
2. Permit to build (bureaucracy)
3. Materials and labor

...resulting in the total purchase price. In civilized countries, materials and labor is relatively independent from the area where the house is constructed. So, you can obtain a realistic estimate of materials and labor by looking at all new houses and picking the area where new houses are the cheapest.

Then you pay running costs and save for the future renovations. Rent minus running costs and future renovation savings is the true real yield minus costs.

Let's use as an example the rental market in the Greater Helsinki region.

• The cost to construct an apartment building is about 2500 EUR per square meter. This can be verified by searching for new houses in all of Finland. There are areas where you can buy a house for 2500 EUR per square meter. This is the "materials and labor" component.
• The cost to purchase (not construct, but to purchase a newly constructed) house is 4500 EUR per square meter approximately (this varies a lot depending on the area and may be cheaper or more expensive depending on the area)
• The land and permit to build (bureaucracy) thus costs 2000 EUR per square meter in this example.

There are also running costs (all increase according to inflation):

• Property tax, heating, administration etc. are about 42 EUR / square meter / year in Finland. This assumes the building is not built on rented land. On rented land, you may pay less than 2000 EUR / square meter for the land and bureaucracy, but the land rent will need to be included in running costs.
• A house requires 2% per year of materials and labor to keep it up-to-date (major renovations). Another way to think about this is that a house becomes worth only the land price in 50 years (2% per year) if no renovations are done. In my area, it's 0.02 * 2500 EUR per square meter per year or 50 EUR per square meter per year. Note this is 2% of construction costs (2500 EUR). It's only 1.111% of the purchase price of a newly constructed house. This is a sane value according to other sources as well: 1% of purchase price or 2% of construction cost needs to be taken into account for renovations.

Then on the other end you have rent, which rises in the extremely long term 2% per year (inflation in the Eurozone is 2% per year according to ECB's decisions). You might want to ask whether you should include increasing house prices in this estimate. The answer is no, because you're already including the rising values in the rising rent, i.e. calculating rental yield from now to infinity.

• Where I live, rent is about 200 EUR / square meter per year (this varies according to the area)

Then you subtract from rent (200 EUR / square meter / year) the costs (92 EUR / square meter per year) and you're left with 108 EUR / square meter / year.

The real yield is (108 EUR / square meter / year) / (4500 EUR / square meter). Yield is 2.4% per year. The nominal yield is real yield plus inflation, i.e. 4.4% per year. Income taxes are not deducted here (property tax is included in the 42 EUR / square meter / year).

So, now we know the income: 2.4% per year really, or 4.4% per year nominally. Then we need to calculate the risk of that income.

Stocks benefit from economic growth (2.5% per year) and dividend yield (3.5% per year), yielding 6% per year really. The dividend increase in addition to economic growth according to the inflation, so real yield is 8% per year annually.

In the recent history (last 40 years or so), a well-diversified portfolio in the Finnish housing market has once diminished in value 50%. A well-diversified global stock portfolio has twice in the recent history diminished in value 50%. So, both have the same risk: possibility of 50% drop in general price level.

In the longer history, house prices in Amsterdam have an all-time high index value of 317.9 (in 1778/9) and all-time low index value of 68.1 (in 1814/5), so in 36 years prices diminished 78.6%. That's pretty significant: it's as large as the Great Depression drop in stock prices. So, the all-time highest drop in house prices is the same as the all-time highest drop in stock prices.

So, a well-diversified stock portfolio yields more, at the same risk as a well-diversified house portfolio in the given area. So, in the Greater Helsinki region, it doesn't make sense to invest in houses, even if you can diversify by buying numerous different houses. Investing in stocks is a much better idea.

A single flat of course has much higher risk than a well-diversified portfolio. My rule of thumb is to add 3% yield demand, so compared to a well-diversified stock portfolio (that yields 6% really), you should expect 9% yield really to obtain risk-free profit from a single flat. YMMV, but if you're investing in a single asset, you should take the riskiness of investing a lot of money into a single asset into account in the yield.

But but but... house prices increase in value over time, you say! No! There is a very long data set from Amsterdam that shows house prices double in 345 years really, i.e. real yield over inflation is 0.2%. That's very close to zero, and all of it has happened after the World War II.

But but but... if you're a good investor, stocks can yield more! Or, stocks yielded more in your favorite timeframe! However, in the extremely long run, stocks yield according to dividend yield (3.5% currently), economic growth (2.5% currently) and inflation (2% currently), yielding really 6% or nominally 8%. Any gain that's above this is short-term speculative gain. Even the best of investors have very large troubles of beating the index over a very long timeframe.

• `in Amsterdam have an all-time high index value of 317.9 (in 1778/9) and all-time low index value of 68.1 (in 1814/5)` Are you talking about year 1778 and year 1814? Nov 1, 2018 at 19:05
• "To eliminate the component of renovation debt, the only possibility is to calculate the cost to buy a new property." I stopped reading there, many investors successfully estimate renovation expenses, in my opinion new builds are actually harder to evaluate. Nov 1, 2018 at 19:28
• There are many newly built houses or apartments which have more issues than ones that are 10 to 20 years old. The amount of repairs sometimes is relative to the quality of materials used and the quality of original workmanship. Nov 1, 2018 at 22:17
• ( @aaaaaa - what else would it mean?? ) Nov 2, 2018 at 4:53
• @fattie didnt expect there to be that data Nov 2, 2018 at 9:15