What You Should Know Before Buying a Rental Property

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Have you ever thought about buying a rental property to earn some passive income? As I pay off my home mortgage, I am getting closer and closer to scouting out my first rental property (I have been waiting a long time for this!), which has prompted me to start looking at available properties and calculate their potential. Since I have not yet gotten rid of my debts (and I would really like to buy my first rental property with cash), I won’t be buying a rental house yet, but I need to get used to analyzing and understanding which houses will be cash flow positive and which ones are dives when it comes to investments. If you are interested in real estate, you need to be able to calculate your potential earnings before buying a rental property.

Potential Rental Property Expenses

buying a rental propertyExpenses in real estate are more than just taxes and the mortgage payment. Here is the list I consult when I calculate the yearly expense of each potential home I look at:

  • Mortgage
  • Property Tax
  • Insurance
  • Utilities
  • Trash Pick-up
  • Legal Fees (for the rental contract)
  • Cleaning and Maintenance
    • Lawn Care
    • House cleaning each year
    • Interior painting
  • Repairs
  • Depreciation Expense
  • Advertising
  • Auto and Travel (mileage costs)
  • PMI (Private Mortgage Insurance – if you do not pay for 20% of the home upfront)

The big expenses are obviously the mortgage, property tax, insurance, and repairs. Typically, you will have the renter pay for the utilities and trash pick-up. And, as for the other expenses, they are really up to your discretion. To pay fewer taxes, I would most definitely claim all of the expenses that you can (including depreciation), even though some of them may not feel like they cost you anything per year. To keep this post simple, let’s just focus on the mortgage, property tax, insurance, and repairs.

Potential Rental Property Income

Calculating your income is quite a bit simpler than estimating your expenses, but it still isn’t super easy. Before you put in a bid on a house, you really need to know how much someone will be willing to pay each month to live there! Here are a few ways to estimate your monthly income:

  1. Utilize the rental estimate from Zillow.com, but do NOT depend on this tool only
  2. Look through properties that are for rent in your desired purchase area
  3. Ask your friends what they are paying for rent and what they would be willing to pay each month
  4. Ask the seller if there is any rental history on the house (in other words, was it previously rented out, and for how much?)
  5. Use the rule of thumb for your area – in mine, it is just under 1% of the home value. So, buy a $100,000 home and expect to get $1,000/mo.

So let’s say you come up with a number, be sure not to assume an income for 12 months out of the year. There will be times when your home is not occupied and is therefore not generating an income. Out of every 12 months, your property will typically be vacant for at least 1 month. For an easy calculation, assume that your income will be 90% of the maximum possible income. So, if you expect to get $1,000 a month in rent, your maximum potential income for the year is $12,000, but don’t plan on that. Plan on 90% of that, or $10,800, which then equates to $900 a month on average.

Is Your Rental Worth The Purchase?

Have you found a house and think that it’s a good deal? It’s now time to crunch some numbers. To keep the numbers simple, let’s stick with the $100,000 home example. Through your research on this house, you estimate that you could find renters that would pay $1,000 a month to live there (but we’ll use 90% of that for our calculation, so $900).

Estimated Income = $10,800/yr. = $900/mo.

By plunking a few numbers into mortgagecalculator.org ($80,000 mortgage — assuming a $20k downpayment, 4.3% interest, 30-year loan, 1.25% property tax rate), I was quickly able to estimate my monthly mortgage payment to the bank: $500.06. We’ll just call this $500 even. Insurance will likely be around only $500 per year, but this home has a few expenses coming in the future. Specifically, it will likely need a new roof and a new heating and cooling unit. Over the course of the next five years, the projected expenses will be $10,000, so we will spread this expense over each month for the next five years (which equates to $167/mo.).

Mortgage Expense = $500/mo.

Insurance Expense = $42/mo.

Repair Expense = $167/mo.

The expected total monthly expense for this house is $709/mo. So, you would earn $191 a month, or $2,292 per year. This doesn’t sound like much, but it is actually a pretty decent investment – not great, but good.

Now, what if you were only able to get $800 a month (90% of this means an expected $720/mo.) in rent? With this small difference in the calculation, you suddenly aren’t making any money whatsoever on this property! This is a clear example of why your estimates are so important! Take your time, do your homework, and have fun earning some income with real estate!

Are you thinking about investing in real estate?

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Money

Derek

AUTHOR Derek

My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.

10 Comments

  1. Thanks for sharing this, Derek! We plan to live in our condo for 5 or so years and have considered renting it versus selling it. This article will be helpful in figuring out if it’s worth it or not.
    Jessica @ Budget for Health recently posted..Coconut Chicken Curry Stew

    • Sounds like a pretty common plan among the readers Jessica! And why not? You won’t get any surprises from your condo (you’ll get to know it pretty well in five years of living there) and can predict your expenses quite well. Thanks for the comment!

    • That’s pretty cool Lance! I have considered doing the same thing, but am actually getting pretty attached to my home. I am close to work, only a block from the pool (I swim almost every morning) and am within walking distance to my church.

  2. I turned my house into a rental when I moved into my wife’s house. I always wanted to be a landlord and since my house was underwater, it gave me the perfect opportunity to try it out.

    I’ve been looking to add another rental to my portfolio and it is so important to analyze your costs correctly. Additionally, it’s important to factor in repairs and no occupancy into your monthly number. Ideally, you won’t have many repairs or any vacancies, but we all know that life happens and it’s best to have the money ready and waiting than have to find a way to cover these expenses.
    Jon @ Penny Thots recently posted..The Real Costs of Mutual Funds

    • That’s cool that you were able to rent out your house and become a landlord (since you’ve always wanted to). I hope you are able to use the tips in my post to buy another great rental property in the future!

  3. I am excited to follow you along on your journey of finding a rental property. I have some myself and I would have to say the investment is well worth it. Not only am I getting returns from cashflow but also gaining wealth from appreciation. Good luck Derek!

    • I can’t wait. I know I will be investing in rentals soon, but it still seems like it’s so far away! I know you have expertise, so if I have questions, I will be giving you a call!

  4. Never just jump into buying a rental property. You might enter a bad situation that shows itself shortly. It is important to take into consideration many factors that will impact the return on your investment.

    • I agree with you 100% Caleb. Sure, the house might be a good deal compared to others, but it still needs to generate a positive cash flow for you to be successful. One should always make their best calculation regarding the net profits (or losses) each month.


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