What to Know Before Buying a Rental Property

Evaluate the risks and returns of owning a rental property

For rent sign in front of gray and white home
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Buying a rental property is an effective way to generate income before or during retirement. But there's a lot to think about before proceeding. Be sure you evaluate the expected income, expenses, returns, rewards, and risks that come with the property. This can help you make the most of your investment.

Key Takeaways

  • Rental property can be a strong source of income if you've done your research.
  • Owning a rental property can cost you more than it makes for you if it's in the right (or wrong) condition.
  • There are other risks involved in owning a rental property, such as vacancies and damages.
  • If you're looking into buying property to rent, a financial professional can help you decide if it's a good investment for you.

How Much Rental Property Income Can You Expect?

When searching for a rental property, it's important to figure out whether the property you buy will generate a decent income. One of the main perks of buying a rental property, after all, is to make income from that property.

For instance, 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. The 1% rule says that the gross monthly income on the property should be at least 1% of the property's price to sufficiently cover potential rental property expenses.

According to the 1% rule, the property above has good income-generating prospects. It generates a gross monthly income of $1,000, or exactly 1% of the property price.

Important

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 lacking.

What Are the Expenses of Owning a Rental Property?

A simple guideline for estimating expenses is the 50% rule. Under the 50% rules, you should assume that your costs will amount to 50% of your gross annual income on the property. For instance, a property that makes $12,000 each year could incur as much as $6,000 in expenses.

To get a more accurate expense estimate of owning a rental property, break down property expenses into two groups: operating expenses and capital expenditures.

Operating expenses are recurring: property taxes; property insurance; routine maintenance and repair items; property management costs; and vacancy costs. Vacancy costs the costs if the property goes unoccupied for a while.

Capital expenses are often large, unplanned expenses. These could range from replacing a broken water heater or air conditioner to replacing a damaged roof, fencing, flooring, or plumbing.

Note

You probably won't get to pocket the gross income on your property. You'll have to think about the expenses you will incur as the property owner.

Continuing the example above, let's say you figure that operating expenses will cost about $1,000 per year. You also plan to set aside an extra $1,000 a year to pay for capital expenditures.

What Are the Returns When Buying a Rental Property?

With your gross income and expenses, you can calculate your cash-on-cash return from your rental property. That helps you figure out its profitability.

First, subtract the operating expenses from the gross income. This is how you find the annual net operating income of $11,000 ($12,000 - $1,000). Then, divide the net operating income by the rental property purchase price (100 x ($11,000 ÷ $100,000)) to get the cash-on-cash return of 11% as a percentage.

There is no hard-and-fast rule for a "good" return. But a range of 8%–12% is reasonable, making 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). Here's how you can find out whether you would still have positive monthly cash flow after these expenditures: Subtract the monthly capital expenditures and monthly mortgage payment from the monthly net operating income.

Tip

For an estimate of the return you might expect from owning a rental property, try AARP's Investment Property Calculator.

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.

What Are the Benefits vs. Risks?

The advantages of buying income-generating real estate include:

  • You receive passive income.
  • Your property may increase in value.
  • You can take advantage of rental property tax deductions.
  • You benefit from diversification.

You don't have to work to earn money generated from a rental property. This makes it very attractive for retirees with limited income. If you buy the property outright without a loan, you can enjoy an even higher monthly cash flow.

The property's value will ideally grow over time. This means you should be able to profit yet again at the time of sale. But you will generally have to pay capital gains taxes on the property if you sell it at a gain. Although rental income is taxable, rental expenses, such as operating expenses, are considered tax-deductible. This can offset some of the tax you pay on the rental income.

Owning a rental property also comes with risks:

  • You may experience vacancies.
  • You may get a bad tenant.
  • Your property could be damaged.
  • You may spend more than you make in income.
  • Your property may decrease in value.

Vacancies happen when a rental property sits empty between renters. Since no tenant is living in the property during these times, it lowers your return. You may also need to evict a tenant, which can cause a vacancy. Long-term vacancies can decrease the value of the rental property as an income-generating investment.

Important

Investing in real estate adds more variety to your portfolio. This can help hedge against the ups and downs in other sectors of the stock market.

There is always the chance that you might end up spending more on the property than you make if you have tenants. They may damage your property. Damages often happen because people are less likely to care about a place that they don't own.

You may need to borrow more to make repairs or cover extra costs or losses. In this case, the property is taking money from you instead of creating it. This can also happen if the property value drops due to market conditions or other downturns. If you were planning on using some of the equity in the property to make some improvements, a value drop could reduce the property's equity.

The Bottom Line

Buying a rental property can provide a stable source of income. But like any investment, you need to know what you are getting into before you buy.

Taking a look at the potential income, costs, and return on the property can help you figure out its profitability. Also, be sure to think about the risks and rewards. A property manager from a qualified firm can help reduce risks; they might be able to help find high-quality tenants. They may also have contacts in the local area that can do repair work for less.

You should consider talking to a Certified Public Accountant (CPA) who has experience working with clients owning a rental property. They will have had many clients with both good and bad experiences with rental properties; this means they'll be able to provide an objective point of view on buying a rental property. They can also show you how to maximize your income potential.