Buying a rental property is an effective way to generate income before or during retirement. There's a lot to think about before proceeding, so be sure you evaluate the expected income, expenses, returns, rewards, and risks that come with the property. That can help you make the most of your investment.
- 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 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 whether 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 reasons to buy a rental property, after all, is to make income from it.
For instance, suppose 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 property's price to cover potential rental property expenses. According to this 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.
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 satisfies the rule might 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?
One simple guideline for estimating expenses is the 50% rule. 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 estimate, 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 are the expenses you will endure if the property goes unoccupied for a while.
Capital expenses are often large, unplanned expenses. They could range from replacing a broken water heater or air conditioner to replacing a damaged roof, fencing, flooring, or plumbing.
You probably won't get to pocket the gross income on your property. You'll have to think about the expenses you'll incur as the property owner.
Continuing the example above, suppose you figure that operating expenses will cost about $1,000 per year. You also plan to set aside another $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. That 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%.
There is no hard-and-fast rule for a "good" return, but a range of 8% to 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.
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 ($11,000 / 12). If you have $83 in monthly capital expenditures and a $500 monthly mortgage payment, subtract these expenditures from $917 to get $334. That 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. That 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.
Ideally, the property's value will grow over time, which 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 and 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 those 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.
Investing in real estate adds more variety to your portfolio. That 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 from having tenants. They may damage your property, for example. Damage often happens 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 those cases, the property is taking money from you instead of generating it. That 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
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. Be sure to think about the risks and rewards as well. A property manager from a qualified firm can help reduce risks; they might be able to help you find high-quality tenants. They may also have contacts in the local area who can do repair work for less.
Consider talking to a certified public accountant (CPA) who has experience working with clients who own rental property. They will have had many clients who have had both good and bad experiences with rental properties, which 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.
Frequently Asked Questions (FAQs)
Is it possible to own a rental property with a mortgage?
You don't have to pay cash for a rental property. If you qualify for a mortgage and have at least 20% cash to put down on a home you'll be using for rental income, you can own a rental property while making payments on it.
Will I pay tax on the rental income I own?
You will pay federal tax on rental income and report it just as you report other income on your income tax return. There are currently nine states that don't have an income tax, and therefore you wouldn't pay tax on rental income there: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Can I use my primary home for a rental property?
In most cases you can turn the home you're living in now into a rental property, but you'll need to check a few things first. Check with your mortgage company to see what, if any, restrictions it has. For some home loans, you must live in the home full time for at least a year before you rent it out. Check with your homeowner's association, if you have one, to make sure it's not against the rules to turn your home into a rental.