Real Estate Investing: Rental Property Returns, Mortgages and REITs

What you'll learn

Calculate a rental property's gross yield, net operating income (NOI) and cap rate.
Understand when a mortgage multiplies your return and when it destroys it.
Spot the costs and risks most first-time landlords leave out.
Know the basic tax rules for rentals, including depreciation.
Compare owning a rental with investing in REITs and REIT index funds.

"Real estate always goes up" is close to an article of faith in America. Rental property can be a great investment: it's tangible, it produces income and it tends to keep up with inflation over long periods. But it also concentrates a lot of money in one asset, it's slow to sell, and it carries costs that never appear in the listing. In this lesson you'll analyze a single-family rental the way a professional investor would, then compare it with the easy alternative.

8.8%gross yield in our example, the number sellers like to quote

4.0%the cap rate once real operating costs are subtracted

27.5 yearsthe IRS depreciation period for residential rental buildings

The case: a rental house in Indianapolis

Marisol is considering a $300,000 single-family home she could rent for $2,200 a month. Closing costs (title, lender and inspection fees, prepaid items) add 3%: $9,000. If she paid cash, her total investment would be $309,000.

Gross yield: the number in the listing

Gross yield = Annual rent ÷ Price = $26,400 ÷ $300,000 = 8.8%

It's useful for a first comparison, but it isn't what you'll earn. Two quick screening rules investors use: the "1% rule" (monthly rent of at least 1% of the price; here $2,200 ÷ $300,000 = 0.73%, so it fails) and the "50% rule" (expect operating costs to eat about half the rent). They're rough filters, not analysis.

Net operating income: what's really left

Item	Per year
Rent (12 × $2,200)	$26,400
− Vacancy: one month empty per year	$2,200
− Property taxes (1.2% of value)	$3,600
− Landlord insurance	$1,800
− Maintenance and repairs (1% of value)	$3,000
− Capital reserve (roof, HVAC, water heater)	$1,800
− Property management (8% of rent collected)	$1,936
Net operating income (NOI), before mortgage and income taxes	$12,064

Vacancy and management (15.7%) $4,136Empty months and the property manager's cut.
Taxes and insurance (20.5%) $5,400Due whether or not the house is rented.
Maintenance and reserves (18.2%) $4,800Repairs now, and money set aside for big replacements.
Net operating income (45.7%) $12,064What's left before any mortgage and income taxes.

More than half of the rent goes to operating costs, close to the "50% rule."

Cap rate = NOI ÷ Price = $12,064 ÷ $300,000 ≈ 4.0%
Net yield on all cash invested = $12,064 ÷ $309,000 ≈ 3.9%

If the home also appreciates 3% a year ($9,000 on $300,000), the total return is about 6.8% a year before income taxes. Not bad, but not spectacular either: it's in the range a diversified stock-and-bond portfolio might earn (lesson 10), with far less liquidity and far more work.

The costs nobody writes down

Your time: finding and screening tenants, handling repairs, collecting rent, following fair housing rules and local landlord-tenant law.
Problem tenants: unpaid rent and an eviction can cost months of income plus legal fees.
Big-ticket surprises: a roof or HVAC replacement can wipe out several years of profit.
Illiquidity: selling takes weeks or months, and agent commissions and closing costs take a real slice of the price.

1. A house costs $240,000 and rents for $1,650 a month. What's its gross yield?

6.9%
9.0%
8.25%

Annual rent $1,650 × 12 = $19,800; $19,800 ÷ $240,000 = 8.25%. The net yield will be much lower once you subtract vacancy, taxes, insurance, repairs and management.

The mortgage effect (leverage)

Marisol doesn't have $309,000. Investment property loans typically require a bigger down payment and a higher rate than a home you live in. Say she puts down 25% ($75,000) and borrows $225,000 for 30 years at an illustrative 7%. With $9,000 of closing costs, her cash invested is $84,000.

Monthly payment:   =PMT(7%/12, 360, -225000)     → $1,496.93
Annual debt service: $1,496.93 × 12              → $17,963
Cash flow:          NOI $12,064 − $17,963        → −$5,899 a year (≈ −$492 a month)

She'd have to add about $492 a month from her own pocket to keep the property running. What about her total return in year one?

Cash flow −$5,899 + principal paid down $2,286 + appreciation $9,000 = $5,386
On $84,000 invested: ≈ 6.4%   (vs. ≈ 6.8% buying with all cash)

Here's the central lesson of leverage: debt magnifies the result in whatever direction it goes. If the property earns more than the loan costs, borrowing boosts your return. If the loan costs more (here, 7% vs. a property return of about 6.8%), every borrowed dollar slightly drags it down. And if the home's value falls, the whole loss lands on your down payment: a 10% price drop ($30,000) would erase more than a third of her $84,000.

Leverage helps when…Return on the property > cost of the loan

Rates: Mortgage rates are low relative to the cap rate.
Cash flow: Rent covers the mortgage and costs with room to spare.
Reserves: You can pay the mortgage through months with no tenant.

Magnifies gains

Leverage hurts when…Cost of the loan > return on the property

Rates: The loan rate is at or above the property's total return.
Cash flow: Negative: you subsidize the property every month.
Prices: A price drop hits your small down payment first.

Magnifies losses

2. When does buying a rental with a mortgage make the most sense?

Always, because you're using the bank's money
When the property's return (net income plus appreciation) beats the loan's cost and you can carry the payment through vacancies
Whenever the mortgage payment is lower than the gross rent

Leverage only adds value if the asset earns more than the debt costs. And the mortgage is due every month, tenant or not.

Taxes on rental property

Rental income is taxable, but you can deduct operating expenses, mortgage interest and depreciation: the IRS lets you deduct the cost of a residential rental building (not the land) over 27.5 years. If $240,000 of Marisol's price is the building, that's about $8,727 a year of deductions. When you sell, depreciation is generally "recaptured" and taxed. Some investors defer gains with a 1031 exchange into another property. The rules have plenty of detail, so a CPA is worth it for your first rental.

Buying to live in is a different decision

Everything above is about an investment property. Buying your own home has other benefits (stability, control) and you analyzed it with numbers in lesson 6. Don't mix the two: your home doesn't pay you rent; it saves you rent.

Investing in real estate with little money: REITs

Real estate investment trusts (REITs) own portfolios of apartments, warehouses, offices, cell towers, data centers and more. By law, a REIT must distribute at least 90% of its taxable income to shareholders each year, which is why they're known for dividends. You can buy individual REITs, or a REIT index fund or ETF holding many of them.

	Rental property	REIT index fund
Money needed	Tens of thousands for the down payment and closing costs	The price of one share, or less with fractional shares
Diversification	One property, one tenant, one neighborhood	Hundreds of properties across sectors and regions
Work	Significant, or you pay a manager	None
Liquidity	Weeks or months to sell	Sell on any trading day
Volatility	No daily price, but real risk	Price moves like stocks; sensitive to interest rates
Taxes	Depreciation and expense deductions	Most dividends taxed as ordinary income; consider holding in an IRA

Real estate crowdfunding platforms also exist, but many offerings are single projects with long lock-ups; check that the platform is registered with the SEC and FINRA and read the risks carefully. And remember: if you already own your home, your net worth is probably heavily concentrated in real estate.

3. What's the main advantage of a REIT index fund over buying a rental house?

With little money you own many properties at once and can sell any trading day
Its price never goes down
It's tax-free everywhere

Diversification and liquidity are the big advantages. The trade-offs: the price swings with the stock market and you have no control over the properties.

Judging a rental by its gross yield.

Calculate NOI and cap rate with realistic vacancy, repairs and management.

Buying with a thin down payment and no cash reserves.

Keep several months of mortgage and expenses in reserve for vacancies and repairs.

Counting on appreciation to make the numbers work.

Make sure the property works on cash flow; treat appreciation as a bonus.

4. Marisol's rental has an NOI of $12,064 and a $300,000 price. What's its cap rate?

8.8%
About 6.8%
About 4.0%

Cap rate = NOI ÷ price = $12,064 ÷ $300,000 ≈ 4.0%. The 8.8% is the gross yield and 6.8% includes assumed appreciation.

Practice exercise: duplex or REIT fund?

You're offered a $420,000 duplex in Columbus, Georgia, with closing costs of 3%. Each unit rents for $1,750 a month. You estimate 5% vacancy, property taxes of 1.2% of the price, $2,400 of insurance, maintenance of 1% of the price, a capital reserve of 0.6% of the price and management at 8% of rent collected. The alternative is a REIT index fund with an illustrative 4% dividend yield.

Calculate the gross yield and the net yield on total cash invested (all-cash purchase).
Compare it with the REIT fund. What else would you weigh?

See solution

Annual rent:     $1,750 × 2 × 12                    = $42,000
Gross yield:     $42,000 ÷ $420,000                 = 10.0%
Costs: vacancy $2,100 + taxes $5,040 + insurance $2,400
       + maintenance $4,200 + reserve $2,520 + management $3,192 = $19,452
NOI:             $42,000 − $19,452                  = $22,548
Cash invested:   $420,000 + $12,600 closing costs   = $432,600
Net yield:       $22,548 ÷ $432,600                 ≈ 5.2%

The duplex yields about 1.2 points more than the REIT fund's dividend before taxes, but it concentrates $432,600 in one building, depends on two tenants, needs management and is hard to sell. The fund yields a bit less with broad diversification and daily liquidity. For many people, that extra point isn't worth the added risk and work; for an experienced local investor with reserves, it might be. What matters is deciding with these numbers, not with the excitement of the listing.

Summary

Gross yield (rent ÷ price) is only the starting point; NOI and cap rate subtract vacancy, taxes, insurance, repairs and management.
A mortgage magnifies results: it helps when the property earns more than the loan costs and hurts when it doesn't.
Include your time, problem tenants, big repairs and selling costs in the decision.
Depreciation over 27.5 years lowers taxable rental income but is recaptured when you sell.
REITs and REIT index funds offer real estate exposure with little money, diversification and liquidity.

Next lesson: Cryptocurrency: What It Is, How Risky It Is and How to Avoid Scams. The final lesson looks at crypto with the same cool head: what it is, how much it can fall and how to protect yourself.