How To Evaluate The Return On Rental Property And Investment Real Estate

by Hank Coleman

Why you need renter's insuranceBeing a landlord is a great way to build your wealth and increase your net worth. In fact, Money magazine listed becoming a landlord as one of its highest rated ways for the average American citizen to become a millionaire. Even after the housing bubble and credit crisis that hit the United States in 2008, real estate is a great way to increase your wealth, save for retirement, and supplement your income with a new stream.

So, how do you go about evaluating if rental real estate is right for you. There are a few things that you need to consider when evaluating your options on the return on rental property and investment real estate. How much should you charge for rent when you pay for a rental house with cash? Does your calculations change if you only make a 10% or 20% down payment?

Have you thought about all of those extra costs that are associated with owning a rental property and more importantly how that affects your bottom line? These are all considerations that you need to have when making your investing decisions. Like most transactions, the profit that you make is determined when you buy the home.

What Is Your Required Rate Of Return?

Believe it or not, but everyone has their own internal required rate of return on all investments. You invest your money expecting to earn a certain rate of return. For example, most people invest in equities expecting to earn an average of 8% annual rate of return. Is that what you require if you were to invest in real estate? Or, would you be happy with 5% return year after year? Do you expect 8% or 10% from that investment as well? Knowing your rate that you want to earn from your investments, all investment asset classes, can help you understand your real estate investment options.

Opportunity Cost When Paying Cash For A Rental

There are primarily two ways to pay for rental real estate. You can can either take out a mortgage after putting a down payment down on the property, or you can pay for the entire home or building with cash. While this may seem like a stretch for many early real estate investors just starting out, it may not be too far of a stretch for experienced investors with several properties looking for more.

So, if you pay for cash for you investment property, then it becomes an exercise in opportunity cost. You will be tying up a significant amount of capital with your purchase. That money could be earning you a rate of return if you had been using it somewhere else, in another investment, for example. So, if you bought a home with $100,000 cash and were looking for an annual rate of return of 6%, you would want to earn a monthly profit of approximately $500.

This might be entirely doable without a mortgage payment if you control your other costs. Of course, many of these calculations will be dependent on home values and rental values in your area of the country, but the way you calculate your costs, profit, and return remain the same.

What To Consider When Making A Down Payment

Paying for a rental property using a mortgage and a down payment also comes with an opportunity cost of doing business. Even if you make a $10,000 or $20,000 down payment on the same $100,000 home used in the above example, there is a cost associated with tying up that amount of money for an indefinite period of time.

If you are looking for that same 6% rate of return and you put a down payment of $20,000 on your mortgage when you purchased the rental property, you should be charging enough rent to take home $1,200 in profit per year or $120 per month. Of course, your costs will be significantly higher if you have a mortgage on your rental property. You must take those added costs into account when you factor your return on rental property and whether or not investing in this type of investment is right for you.

You May Be Forced Into A Real Estate Investment

Of course despite your due diligence and careful calculations, you may find yourself becoming an accidental landlord. Whether it is because of a move that you had to make because of a job or thanks to the real estate market bottoming out, many people are finding that is it a better financial decision to rent out their former home instead of trying to sell it.

Many people would also even consider renting their home for a small loss every month in the hopes of a housing turn around instead facing large losses in a single swoop. For example, you could be expected to pay approximately $6,000 or more in closing costs, fees, and other expenses on that same $100,000 home in our example if you tried to sell it.

But, if you rented it out at a $100 per month loss, it would take you the equivalent of five years to reach $6,000 in cumulative losses. In that amount of time, a lot might happen like a rebound in home prices, a rise in rents in your area, or a host of other events that could help get you back into the black.

Paying For A Property Manager Is Worth The Cost

If you are do not have much free time, if you value your sleep, if you don’t know the difference between a ball peen hammer and a mallet, then hiring a property manager might be right for you. Typically, a property manager will charge you 10% of your rent in order to manage your rental property for you. You might be thinking that that is a lot, but it is actually a great value for what you get.

A property manager will help you find a tenant, screen them, collect rent, and even kick your tenants out if need be. It is a great deal for the cost. I highly recommend using a property manager if you think that you cannot handle it alone or simply do not want to.

All The Other Costs Of Owning A Rental Home

There are other costs associated with being a homeowner whether or not you have a mortgage. Of course, you will have more costs that will eat away at your profit margin when you have a mortgage payment. Here are a few costs that you may not always think about having if you are not used to being a landlord. As with all properties, you will need to set aside money for maintenance.

Rental properties seem to always break at an inopportune time, like the middle of the night. That is why you need a property manager to handle those late night plumbing phone calls for you. One good rule of thumb is that you will typically spend the equivalent of $100 or more a month on maintenance and renovations. You should add a value for maintenance to the rent that you require your properties to produce. Subtract this amount from your rent income before you can calculate your profit margin.

You also have to take into account having vacancies with your property. There will be times that your rental unit will not have a tenant. Have you factored this into the rents that you collected? Have you set aside money for your vacancy factor in a retained earnings type of account? Other costs that you need to factor into your profit calculations are the cost of your homeowner’s or fire insurance.

If you do not put 20% down payment on your real estate purchase, then you will most likely be required to pay private mortgage insurance (PMI) which can eat away $100 or more per month depending on the amount that you borrow. There are also property taxes, homeowner association fees, and other expenses that will continue to take a bite out of your profits as well.

Don’t Forget Taxes On Your Rental Property

While you will have property taxes and income tax that you will most likely have to pay on your real estate, there are also many tax benefits that you will be able to take advantage of because you are a homeowner. The mortgage interest tax deduction is a large benefit to homeowners if you still have a mortgage that you are paying on your property. Another tax benefit that you will realize is the ability to write off many of the expenses of running your business. Many of your costs such as property management fees and other expenses are tax deductible.

It is so much easier to have a profit with your rental properties when you make smart purchasing decisions. There are so many different points that you must consider in order to have a profitable investment. How much do you put down? How much do you charge your tenants for rent? How many other expenses are cutting into your profit margins? Rental real estate whether it is residential or commercial property is an excellent way to build wealth.

What about you? Have you found that a smaller down payment helps you boost your rate of return on rental properties? Or, do you prefer all cash deals? I’d love to hear your thoughts in the comment section below.

Related Posts Plugin for WordPress, Blogger...
Share the Love
Get Free Updates

About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and is currently pursuing his Certified Financial Planner credentials. Email him directly at Hank[at]MoneyQandA.com.


Hank Coleman has written 498 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


Subscribe To Money Q&A

If you want to learn more about taking back control of your money please subscribe to Money Q&A’s RSS feed or via email to receive all the latest articles! You can also subscribe to our Free Weekly Newsletter.

{ 2 comments… read them below or add one }

Deacon @ Well Kept Wallet

I couldn’t agree with you more about the property manager being worth the cost. I manage a rental property for my in-laws and I have had plumbing issues, tenant issues, appliance issues, and the list goes on. Property managers are definitely worth the cost.
Deacon @ Well Kept Wallet recently posted..Get Cash Back Using a Debit CardMy Profile

Reply

Tracey March

So many potential real estate investors give up before they start — this post lays out the numbers that really do need to be considered. I would emphasize that anyone looking to invest should consider the math before buying the investment property–not after the fact. I often see two major mistakes: (1) underestimating the cost of capital expenses (and a report has actually just been released stating that the condition of rental housing has deteriorated because rental owners generally haven’t been maintaining their properties); and (2) rental owners underestimate how much time is necessary to manage a property–which is why they often end up realizing that a property manager can make their lives easier, take the midnight maintenance calls, deal with tenant screening and rent collection, as well as deal with the more unpleasant stuff–like evictions.
Tracey March recently posted..Celebrity Nightmare Tenants and EvictionsMy Profile

Reply

Leave a Comment

CommentLuv badge

{ 7 trackbacks }

Previous post:

Next post: