Things You Must Know Before You Buy Rental Property
Evaluate Risks and Returns Before You Invest
Before you buy a rental property, consider three things: the expected amount of rental income, the annual expenses you will incur, and the risks that may come along.
Expected Amount of Rental Property Income
When searching for a rental property, find out how much a reasonable rent rate is accounting for the location and quality of the property.
- Let’s say you buy a house for $100,000.
- Through research you learn the average rent for that type of property in that location is $500 per month.
- You can then calculate that you will receive $6,000 a year($500 x 12 = $6,000), or a 6% gross return.
Next, you must consider the expenses you will incur as a property owner.
Annual Expenses of Owning Rental Property
You can break property expenses into both fixed and variable expenses.
- Fixed Expenses - You will have recurring expenses such as annual property taxes, insurance, routine maintenance and repair items, and the cost of any property management services.
- Variable Expenses - Don’t forget to set aside funds for major unplanned expenses such as replacing the water heater, air conditioner or heater, roof, fencing, flooring or plumbing.
Continuing the example above, assume you calculate that property taxes, insurance, and routine maintenance will cost about $1,000 per year. You also plan to set aside an additional $1,000 a year into an account that will pay for any major repairs.
Your actual return (net return) on your rental property is now $4,000 per year ($6,000 in annual rent minus $2,000 in annual expenses), or 4%.
That calculation assumes your property stays rented on a continuous basis. You must factor in risks like not being able to find a quality renter.
Risks of Buying Rental Property
Before you buy a rental property, consider the following risks:
- Your property could sit empty between renters, lowering your overall return.
- You could incur legal expenses should you need to evict a bad tenant.
- You could incur excess repair costs should a bad tenant cause damage to the property.
A qualified property management firm will help reduce risks, as they have the experience necessary to find high-quality tenants. Property management firms typically charge 10% of the rent received.
For a detailed analysis of the return, you might expect from buying a rental property, try AARP's Investment Property Calculator.
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.
Additional Resources on Buying Rental Property
If you are considering investment property, I'd highly recommend you read John T. Reed's book How To Get Started in Real Estate. Unlike many of the popular books on rental real estate investing, he doesn't promise you a get rich quick strategy. Instead, in a very practical way, he spells out exactly what it takes to have success when investing in real estate.
Also, talk to a Certified Public Accountant (CPA) who has experience working with clients that own rental real estate. Ask for their advice on what to do, and what not to do.
An accountant will have many clients that have had both good and bad experiences with rental property, and they'll be able to provide an objective point of view on the pros and cons.