To make the most out of an income property investment, it's important to understand how inflation can affect rental income. History can teach us a lot about how inflation will affect us in the future. Here are some examples of how inflation can manipulate rental income.
The RV Ratio, or Jason Hartman's “Rent to Value” ratio, provides an easy rule of thumb to calculate cash flow. Monthly rental income on properties is based on this ratio. An ideal RV Ratio is around 7%, while the smallest acceptable RV Ratio is around 5%. For an example, we can say 6% is a reasonable average RV Ratio, right in the middle.
With rental income, we also can't assume the property is going to be rented out every month, which brings in the element of vacancy rate. On average, an income property can be rented out about 11 months per year, or about 92% of the time.
Let's go back in history. If you invest a $18,000 home in 1972, the rent would be around $110 a month. If the home was valued at $31,000, the rent would
instead be $189 per month. The increase is proportional. During this time, inflation was high. Inflation affected income property investors in a few different ways.
Real Rental Income
In the example above, the annual income would be around $1,206 per year with a one month vacancy. The payments on the property might be closer to $1,211 per year. This equates to about $5 per year of negative cash flow, which isn't bad. Sound like a worthy investment? There's one more thing to consider. What effect does inflation have on the rental income? It attacks it. This makes it so, even if you raise the rent, inflation chips away at the money you receive.
The real rental income in this scenario is only keeping up with inflation. It doesn't do anything better. Now, skip to 1984. Inflation has come down to about 4.3% and, in adjusted terms, a dollar is worth about $0.40. In 1984, the payments on the property in the example are still around $1,211. However, the real value is only about $487 per year. Though you're still paying $101 per month in nominal dollars, it translates to only about $41 in real dollars.
With inflation, the property would have been worth about $33,182 in 1984. With a .6 RV ratio, rent would run about $199 per month. That puts your annual income at about $2,200. Because of inflation, this equals about $880 in real dollars. The net cash flow will be $220 per month. With the right strategies, you can make money from inflation and leverage. (Top Image: Flickr | Quinn.Anya)
The Young Wealth Team