Content of the material
- The Benefits of Rental Properties
- How Do I Determine The Potential ROI For My Rental Property?
- Know Your Legal Obligations
- Beware of High Interest Rates
- Property taxes
- Are You A Landlord?
- Rental Property Cost Analysis Calculations
- Net Operating Income
- Net Rental Income
- Total Expenses
- Net Cash Flow
- Capitalization Rate
- Gross Rent Multiplier
- Closing costs
- Estimating Repairs Maintenance
- Work Required for Renting
- Average Annual Maintenance Costs
- Your Property Inspector
- Your Handyman
- Property Management Fees
- Related Resources
- Understanding The BRRRR Method Of Real Estate Investment
- What Is Rental Property Depreciation?
- What Is The 70% Rule In House Flipping And How Can It Help Me Decide How Much To Pay For A Distressed Property?
- How do you calculate the ROI on a rental property?
- Getting Started
- Tax Deductions For Rental Properties
- Investment property for supplemental income
- Know how mortgages differ for second homes and investment properties
- Research your investment
- Types of properties
- Investment strategies
- Search for the right property
- Bottom line
The Benefits of Rental Properties
Rental properties can round out an investment portfolio and create an ongoing income stream. Several major factors have made this a popular investment option:
- The meager returns provided by savings accounts and investments such as certificates of deposit are causing many people to take a closer look at rental property investing.
- Several years of record-low interest rates have made people wary of future inflation, which drives them away from the bond market. As an alternative, people invest in physical assets like commodities and real estate, which have the perceived benefit of inflation protection.
- Many want to diversify their investments, which means moving away from solely investing in the stock market.
If you want to get into rental property investing, you need to learn how to evaluate whether or not a potential rental property is a good investment. The following two formulas will help.
How Do I Determine The Potential ROI For My Rental Property?
When looking for a great investment property, the first question you need to ask is “Can I actually make money?” If the answer is no, it’s obviously not a great investment. To see how much money your property could potentially make, you’ll need to consider the return on investment (ROI). The ROI can be calculated by first finding the property’s net annual income. This is the rent money that’s left over after you’ve paid the taxes, insurance, property management fees, expected repairs (plan to spend 1% of the property value on this), potential vacancy periods, HOA fees (if applicable) and any utilities that aren’t going to be covered by the tenant. To find the ROI, take the annual income and divide it by the amount you spent on the property. For example, if the net annual income is $7,500 and you spent $100,000 for the property, your ROI is 7.5%.Use this calculation to see if each rental property is a good potential investment.
Know Your Legal Obligations
Rental owners need to be familiar with the landlord-tenant laws in their state and locale. It’s important to understand, for example, your tenants’ rights and your obligations regarding security deposits, lease requirements, eviction rules, fair housing, and more in order to avoid legal hassles.
Beware of High Interest Rates
The cost of borrowing money might be relatively cheap in 2021, but the interest rate on an investment property is generally higher than it is for a traditional mortgage. If you do decide to finance your purchase, you need a low mortgage payment that won't eat into your monthly profits too much.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
You should contact the county assessor to get the exact amount for the current property taxes. Make sure — especially you Californians under Proposition 13 — that you know how much you will be paying in property taxes after you close escrow. It could be significantly different from what the seller is currently paying.
Are You A Landlord?
When you start buying investment properties, you need to take some time to think seriously about your ability to manage your properties. It’s a tough job being a landlord – tougher than most people think – and I’ve seen many an investor become overwhelmed by the time it takes to be a good landlord.
Fun fact: Be on the lookout out for this kind of investor. They sometimes burn out under the weight of their landlording duties and just sell their whole portfolio at once. It’s usually a good time to swoop in and buy.
But the point is that not everyone is cut out to be a landlord. It’s an intense and time-consuming line of work, especially if you already have a day job. For this reason, I highly recommend getting a management company to do this work for you.
Sure, you’re probably spending 9% to 11% of the rent on this service, but they will take care of the tenants’ needs and collect the rent. And in the unfortunate event that a tenant needs to be evicted, they’ll help handle that process, too. Time is often more important than money, and letting go of this stress gives you the freedom to pursue additional investments.
Rental Property Cost Analysis Calculations
Four helpful calculations are Net Operating Income, Net Cash Flow, Capitalization Rate, and Gross Rent Multiplier (GRM).
Net Operating Income
Net Operating Income tells you how much money the property generates each month. The formula is
Net Rental Income minus Total Expenses = Net Operating Income
Net Rental Income
The Net Rental Income is the Gross Rental Income minus expected vacancy. In San Diego County, many investors use 3% vacancy rate. For example:
$1500 gross rental income, minus 3% vacancy, or $45, makes $1455 Net Rental Income.
Some investors estimate expenses to be 30-35% of collected rents. If you want more accuracy, here’s a list of expenses to use for your rental property cost analysis, and what percentages to estimate. Debt service is not included:
- Property management fees – 8%
- Maintenance reserve – 5%
- Any utilities not paid by tenant
- Property taxes – 1.2% annually
- Landlord’s insurance – approximately $50
- HOA fees
To use the previous example, based on $1500 gross rental income and $150,000 purchase price:
Property management fees – $120 Maintenance reserve – $75 Any utilities not paid by tenant or HOA – n/a Property taxes – $150 Landlord’s insurance – $50 HOA fees – $250 Total Expenses – $645
Net Operating Income = $1455 Net Rental Income minus $645 Expenses = $810
Net Cash Flow
In a rental property cost analysis, Net Cash Flow is the Net Operating Income minus any debt service.
A $150,000 purchase with 25% down and a 30-year fixed mortgage at 4.5% interest will have a monthly mortgage payment of $570.
Net Cash Flow = $810 Net Operating Income minus $570 Debt Service = $240
The capitalization rate is calculated by dividing the annual Net Operating Income by the property value. When you analyze a rental property as an investment, the property value is your purchase price.
Capitalization Rate = Annual Net Operating Income / Property Value
In the above example, the estimated capitalization rate is $9,720/$150,000 = 6.4%
In San Diego County, the average cap rate is approximately 3.5%.
Gross Rent Multiplier
The Gross Rent Multiplier, or GRM, is the sale price divided by the annual rental income. In general, the higher the GRM, the more expensive the property. If a GRM is 17 or higher, the property is probably so expensive that you can’t collect enough rent to pay for it. A GRM between 8 and 16 is a good range, because the property value is still high, you can expect long-term appreciation, and you either break even or enjoy good cash flow. When the GRM falls below 6-7, the property values, rents, and appreciation are all low.
Gross Rent Multiplier = Purchase Price / Annual Rental Income
Using the above example, the GRM is $150,000/$18,000 = 8.33
You may need as much as $30,000 to buy a $100,000 house, but that can increase if many repairs are required or if you have to put down more than 20 percent. You need to make sure you have enough reserves if things do not go as planned. Remember, if you are purchasing more expensive homes, that number will increase significantly and it will decrease if you are buying lower-priced homes.
Depending on house values in your area, a 20 percent down payment can be a lot of money. The houses I buy are usually right around $100,000, which is about $20,000 needed for the down payment. You will also have closing costs when purchasing an investment property, which consists of interest, insurance, recording fees, origination fees, tax certificates, appraisals, and more. It is usually safe to assume closing costs will be at least three percent of the purchase price, but you can ask the seller to pay all or part of your closing costs. I usually ask the seller to pay part of my closing costs to reduce the amount of cash I have into a property. You also may have to pay for an inspection, which can cost $250 to $500 and some sellers such as HUD do not pay for title insurance, which can add another $500 to $1,000.
Estimating Repairs Maintenance
The third item on our list to answer the question “how much money do I need to invest in real estate”: estimating repairs and maintenance.
Here is where new investors get stuck . . . You’ve bought your first rental property, but the cash requirements don’t stop there.
It’s still going to take money to maintain the house and keep it in rentable condition.
How much this will cost depends on two things:
- The initial work needed to get it rentable
- The average annual maintenance costs
Work Required for Renting
Let’s talk about the first one. Is it a fixer-upper?
If so, you’ll need to factor in a repair budget for items like:
- anything else needed to make it liveable
If not, skip these costs.
The good news is it does NOT have to look as great as a house you’re trying to sell. Forget everything you saw on HGTV.
You can get away with linoleum counters instead of granite, white appliances instead of stainless steel, and paint over the old cabinets instead of installing fancy new ones.
You will rarely get your money back from making these extra investments, and if renters want the perfect house so badly they can go buy one.
You may also need to have cash for holding costs on hand, meaning enough to cover the mortgage payment, property insurance, and taxes for 1-2 months while you’re fixing it up and finding a new tenant.
Average Annual Maintenance Costs
The second costs to be aware of are the general maintenance costs.
Some things you’ll need to pay for every year, like cleaning the gutters or putting money away towards a new roof when the time comes.
These costs aren’t as urgent, but if you don’t take care of them now then you might find yourself paying more later on, or worst case being stuck with a house you can’t get rent!
I know a lot of this can sound very scary, especially if you’re not particularly handy.
So here are your two key people to lean on before you make your purchase:
Your Property Inspector
This will be required by your lender anyway, so read their report and talk to them afterward to make sure you understand all the things that need work now or later, in order of priority.
Once you know which repairs are needed, get estimates from the people who could provide the services for you.
This will help you to know how much you’ll need now for urgent items, and every year on average for maintenance.
Property Management Fees
If you plan to have an outside manager, call around the see what the cost is for that service. Typically it’s 6 to 8 percent of the rent, and that may or may not include re-leasing costs, which could be half to a full month’s rent in addition to the monthly fee percentage.
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Understanding The BRRRR Method Of Real Estate Investment Home Buying – 6-minute read Lauren Nowacki – May 23, 2022 Interested in earning money through real estate investment? Learn how each step of the BRRRR method works, and explore pros and cons. Read More
What Is Rental Property Depreciation? Servicing – 8-minute read Hanna Kielar – June 10, 2022 Rental property depreciation is a big tax advantage that can make real estate investment profitable beyond the income it generates. Learn how it works. Read More
What Is The 70% Rule In House Flipping And How Can It Help Me Decide How Much To Pay For A Distressed Property? Home Buying – 8-minute read Dan Rafter – June 02, 2022 Real estate investors use a variety of metrics when deciding whether to buy property. Learn how the 70% rule helps house flippers calculate how much to offer. Read More
How do you calculate the ROI on a rental property?
The calculation for the return on investment (ROI) of a rental property is similar to the cap rate. One difference is that the ROI is a more accurate measurement that includes more costs, such as the borrowing costs associated with a rental property mortgage. The cap rate assumes that you bought the house with cash to give you an overall sense of the rental's profitability, while the ROI is a more personal measure of how much you will earn.
Now that you have the dollar amount all figured out, it’s time to take action!
Investing in real estate does not have to be a mystery or a dream to do “someday.”
Instead, it's just a matter of time.
If you don’t have the cash on hand right now, then create a plan to have that cash. Maybe that’s:
You can also use an app like DealMachine to find distressed properties and wholesale them to cash buyers. Wholesaling is a great strategy to make the cash you need to reinvest into your first rental property.
Your financial future isn’t going to just happen on its own. It’s going to take some sacrifices and massive action on your part. Make your plan, go for it, and stay determined!
Tax Deductions For Rental Properties
Tax deductions can heavily reduce rental property expenses and turn a profit as a result. There are several tax benefits that apply to rental property expenses to help you spend less and earn more from your investment. Here are the biggest tax deductions you should consider when investing in rental properties:
Interest: Interest used on expenses to improve a rental property is tax deductable. This includes interest paid on mortgages or loans and credit card interest used to improve your property.
Repairs & Maintenance: Repairs can be fully tax deductable within a one year, however improvements on your property may have to be fully depreciated over 27 and a half years.
Personal Property Cost Deduction: Personal property expenses on the rental property you own like appliances, furniture, and gardening equipment are tax deductible.
Pass-Through Tax Deduction: Created by the Tax Cuts and Jobs Act, the pass-through tax deduction is up to 20% of net rental income.
Travel Expenses: There are tax deductions for any travel expenses used for your rental property such as tenant showings, going to a store for supplies, or travel expenses for long-distance investors.
Home Office Expenses: Deductions apply for your own workshop used to maintain the rental property or any part of your personal residence used to conduct business.
Wages For Employees: Tax deductions apply for any wages paid to employees such as an on-site leasing manager, independent contractors, landscapers, or handymen.
Investment property for supplemental income
Think you’re ready to pull the trigger on an investment property? Here are the steps you can take.
Know how mortgages differ for second homes and investment properties
Thought you might scoop up a USDA, FHA or VA loan for the mortgage on your investment property? Unfortunately, you can’t use these government-backed loans to purchase an investment property because you can only get one of these loans if you’re purchasing a primary residence.
This leaves the following options for an investment home purchase:
- Conventional loan
- Jumbo loan
- Home equity loan
- Home equity line of credit
- Cash-out refinance
Your interest rate might also be higher for a rental property mortgage than for your primary residence because it’s an additional risk to the lender. In other words, it’s riskier for a lender because in most cases, you’ll pay your primary mortgage, but if money gets tight, you’re more likely to stop paying on your investment property first.
Kathy Fettke, CEO of Real Wealth Network, host of the Real Wealth Show podcast and author of Retire Rich with Rentals, says it’s exciting to think of the opportunities available for anyone considering a rental property. “Fannie and Freddie allow you go get up to 10 conventional loans for rental properties. For many people in high-priced markets like San Francisco or New York, it is much easier to qualify for investment property in more affordable metros than to qualify for a primary residence in your hometown,” says Fettke.
Research your investment
The most important thing you can do is find a real estate agent who knows his or her stuff. “Don’t use just a real estate agent,” says Fettke. “It’s best to look for an agent who specializes in real estate investments. Ideally, look for someone who owns them nearby. Oftentimes, property managers have brokers in-office to help.”
The best agents will know how to help you do research, understand the costs and lead you through the entire buying process. They’ll also help you narrow down the type of property that’s best for you and your needs.
Types of properties
You can generally opt for three types of investment properties: single-family homes, condo units or multi-family unit properties.
- Single-family homes offer lower cash returns than unit properties that can house multiple tenants. Consider your cash flow potential over most considerations.
- You’ll need to take care of all maintenance for a single-family home but the homeowners association (HOA), which is the association that makes decisions and regulations for the members that live there.
- There isn’t conclusive evidence that single-family homes increase your investment returns, but certain neighborhoods and properties may increase your investment return potential over time.
Watch for emerging markets, evaluate the zip code and neighborhood. Determine whether existing home sales have flourished or declined, whether rent has gone up in the type of home you’re considering and check for general growth in the area. Has a new school district been built, as well as a lot of new construction? If so, you could be on the right track toward the best possible location for your rental property.
How will appreciation fit into the mix? In other words, ask yourself whether you think the eventual return on your investment will make it worth it in the long run.
Another strategy is to avoid over-inflated real estate markets, where you’ll pay a lot for a piece of real estate but won’t have much flexibility in terms of rent pricing, since the market will drive rent pricing (good examples are California and New York City). Explore real estate that’s lower in initial cost and has more potential for an increase and return on investment.
Search for the right property
Ellingford says that as you’re trying to carve out your niche in the rental market, you’re a business owner and must think like one. “The property you purchase needs to be one that will rent easily and is likely to appreciate. It won’t necessarily be the home you would buy to raise a family,” he says.
Here are several factors to consider when evaluating rental properties, according to Ellingford:
Vacancies: An area with a lot of vacancies may not make a good rental property location.
Neighborhood: The neighborhood you choose for your rental property will attract a specific type of renter. For example, you’ll wind up with student renters if you purchase a home near a college or university.
School district: This is important if you plan to rent to families. A home in a good school system will allow you to charge more rent but home prices will generally be higher.
Crime rates: Check into the crime rates in the area.
Accessibility: The property should be near major transit and employment opportunities.
Amenities: How close is the property to city parks, fitness centers and shopping?
Above all else, Ellingford recommends not getting emotionally attached to a home that won’t bring in sufficient income.
A rental property could be a sound investment, particularly if the rental income you collect offers you some extra income. However, it’s best to weigh all aspects of purchasing a second home, including financial implications, taxes you’ll have to pay, laws involved and how much extra time you have on your hands.
Ellingford says that a second property as an income stream isn’t the only way to gain wealth. “Real estate appreciates in value over time. Of course, there are downturns in the economy, during which time a property may appear to lose value,” he says. “But maintained property will typically be worth more over a period of years.”