What to Know Before Buying a Rental Property
Evaluate the risks and returns of owning a rental property
Buying a rental property is an effective way to generate income before or during retirement. But there's a lot to consider before proceeding. Evaluating the expected income, the expenses, the return, and the rewards and risks that come with the property can help you make the most of your investment.
Rental Property Income
When searching for a rental property, it's important to determine whether the property you buy will generate a decent income. One of the primary aims of buying a rental property, after all, is to draw income from that property.
For example, let’s say that you buy a house for $100,000:
- You learn through research that the average rent for that type of property in that location is $1,000 per month.
- You can then calculate that your gross income (income before expenses) will be $12,000 per year ($1,000 x 12 = $12,000).
- The property offers a gross income of 12% on the purchase price ($12,000 / $100,000).
To assess whether the rental property has good prospects for generating income, use the 1% rule, which says that the gross monthly income on the property should be at least 1% of the price of the property to sufficiently cover potential rental property expenses.
According to the 1% rule, the property in the example above has good income-generating prospects because it generates a gross monthly income of $1,000, or exactly 1% of the property price.
The 1% rule alone shouldn't dictate your decision to buy a rental property. A property that doesn't meet the guideline may still help you meet your financial goals. Likewise, a property that meets the rule may not be a sound investment if the quality or other aspects of the property are lackluster.
Expenses of Owning a Rental Property
Of course, you don't get to pocket the gross income on your property. You must also consider the expenses you will incur as a property owner.
A simple guideline for estimating expenses is the 50% rule, which says that you should assume that your expenses will amount to 50% of your gross annual income on the property. For example, a property that generates $12,000 could incur as much as $6,000 in expenses.
To get a more accurate estimate of the expenses of owning a rental property, break down property expenses into both operating expenses and capital expenditures:
- Operating expenses: These represent recurring expenses, such as annual property taxes, property insurance, routine maintenance and repair items, property management costs, and vacancy costs (the costs if the property goes unoccupied for a period of time).
- Capital expenditures: These are generally large, irregular, unplanned expenses, such as replacing a malfunctioning water heater, air conditioner or heater, or a damaged roof, fencing, flooring, or plumbing.
Continuing the example above, assume that you calculate that operating expenses will cost about $1,000 per year. You also plan to set aside an additional $1,000 a year to pay for capital expenditures.
Returns from Buying a Rental Property
With your gross income and your expenses, you can calculate your cash-on-cash return on your rental property to determine its profitability.
First, subtract the operating expenses from the gross income to calculate the annual net operating income of $11,000 ($12,000 - $1,000). Then, divide the net operating income by the rental property purchase price to get the cash-on-cash return of 11% when expressed as a percentage.
There is no hard-and-fast rule for a "good" return; however, a range of 8%–12% is considered reasonable, which makes the 11% rate look promising.
Keep in mind that the cash-on-cash return doesn't factor in either capital expenditures or financing (mortgage payments). If you want to determine whether you would still have positive monthly cash flow after these expenditures, simply subtract the monthly capital expenditures and monthly mortgage payment from the monthly net operating income.
In this case, your monthly net operating income is around $917 ($11000 / 12). If you have $83 in monthly capital expenditures and a $500 monthly mortgage payment, subtract these expenditures from $917 to get $334. This is your cash flow after capital expenditures and financing.
For an estimate of the return you might expect from owning a rental property, try AARP's Investment Property Calculator.
Benefits vs. Risks of Buying a Rental Property
The advantages of purchasing income-generating real estate include:
- You receive passive income. You don't have to work to earn the money generated from a rental property, which makes it particularly attractive for retirees with limited income. If you buy the property outright without financing, you can enjoy an even higher monthly cash flow.
- Your property may appreciate. The value of the property will ideally grow over time, allowing you to profit yet again at the time of sale. However, you will generally have to pay capital gains taxes on the property if you sell it at a gain.
- You can take advantage of rental property tax deductions. Although rental income is taxable, rental expenses, such as operating expenses, are considered tax-deductible. This can partially offset the tax you pay on the rental income.
- You benefit from diversification. Adding real estate to your portfolio can help hedge against ups and downs in the stock market.
Owning a rental property also comes with risks:
- You may experience vacancies. This is when a rental property sits empty between renters. Since there is no tenant occupying the property during these periods, vacancies lower your return. Long-term vacancies can diminish the value of the rental property as an income-generating investment.
- You may get a bad tenant. You could incur legal expenses should you need to evict a tenant.
- Your property could be damaged. You could incur excess repair costs should a bad tenant cause damage to the property.
- You may spend more than you make in income. If you have to borrow a lot of money to buy the property, or incur substantial expenses, you may wind up with negative cash flow. In other words, you might lose money on the property.
- Your property may decrease in value. Like other investments, real estate is susceptible to losses stemming from downturns in the real estate market.
The Bottom Line
Buying a rental property can provide a stable source of income, but like any investment, you need to understand what you are getting into before you buy.
Evaluating the potential income, expenses, and return on the property can help you determine its profitability. Likewise, consider the rewards and risks. Keep in mind that hiring a property manager from a qualified property management firm can help reduce risks, as they have the experience necessary to find high-quality tenants.
Also, talk to a Certified Public Accountant (CPA) who has experience working with clients owning a rental property. An accountant will have had many clients with both good and bad experiences with rental properties, so he'll be able to provide an objective point of view on the pros and cons of buying a rental property and how to maximize the income potential of yours.