Hearing some people talk about it, there is no downside to rental real estate: monthly passive income, asset appreciation, tax deductions, and you own a real tangible asset. While these are all potential benefits, just like any other type of investing it isn’t all roses. You need to do your homework.
When you first start screening potential investment properties, you may come across some that promise double-digit returns. Have you bumped into a jackpot? A 20%+ return?! Maybe. Maybe not. Before you start writing up an offer on any property, make sure to consider all the angles.
Know the Numbers
First of all, don’t blindly trust someone else’s spec sheet. Crunch the numbers yourself and be realistic! It is very easy (and tempting) to underestimate expenses to see the return you are hoping to achieve. It is much harder to deal with the reality of subpar, or even negative, returns once you own a property. Below are some expenses you must consider.
Down payment, closing costs, loan fees, points, home inspections, and any repairs, improvements or cleaning you want to perform prior to initially renting the property.
Mortgage principal and interest. Can you get a loan? If so, what is your monthly payment? Have you confirmed your rate and/or payment with a lender you trust?
Property taxes. If you are financing the property, these are most likely escrowed and included in your mortgage payment. Still, make sure to consider the impact. Often, high property taxes can make or break a deal’s profitability. What is the likelihood that property taxes will go up if you buy the property for a higher amount than it was previously sold? Some counties automatically adjust taxes after a sale. Check to see if the city and school district also charge property taxes. It can add up fast!
Insurance. Call around to a few insurance agents to get quotes on home insurance. Are you in a flood zone? Will you need flood insurance? As with property taxes, these are oftentimes escrowed and included in your monthly mortgage payment if you are financing, but you should know how much your annual premium will be.
Maintenance and repair costs. Generally, budget about one month’s rent per year for maintenance and repairs. This may seem high, but even small items add up. One year you may come in way under budget, but the next year you could have an expensive plumbing leak that takes up the entire budget! If the house is newer and/or had many systems recently replaced you can probably lower this amount; if the house is old and has many old systems, you may need to increase it. In my experience with single-family homes built in the 1970s with septic systems, it is about 8.5% of annual gross rent.
Vacancy. It isn’t realistic to think that you will have a tenant 100% of the time, no matter how strong the rental market is. You need to make sure that paying the mortgage, utilities, taxes, etc. while you are waiting for another tenant won’t ruin your return. Talk to local real estate agents and property managers to estimate a vacancy rate.
When estimating a vacancy rate, it is also important to know what type of tenants you are targeting. If you have a single-family home in a good school district, you will likely be renting to more families and couples who tend to rent much longer than younger single individuals. Also consider how attractive your property is to potential tenants. For instance, if you have a 2-bedroom house in a good school district, you may have to wait awhile between tenants as most families strongly prefer 3-bedroom homes.
If you expect that on average your property will be vacant one month per year, that is an 8.3% vacancy rate (1 month/12 months). This may seem high, but what if a tenant vacates during a slow time of year? What if they didn’t treat the property well and it takes a few weeks to turn it? Be conservative with your vacancy rate estimate; it’s always better to make a good deal look bad with overestimating vacancy than a bad deal look good.
Improvements. Are there any major improvements coming due? Make sure to have an inspector or trusted contractor evaluate the house, looking at the roof, foundation, siding, brick, electrical, plumbing, HVAC, and any other major system to find any concerns that should be added to your budget. Also consider when you may need to update flooring, appliances, windows, etc. Budgeting about 5-10% of annual rent per year is typical.
Property management fees. Even if you are planning to manage the property yourself, you should still figure this into your budget. Circumstances are always changing and at some point you may not be able to, or want to, manage the property. If this happens, you don’t want to be forced to sell your investment. Budget about 10% of gross monthly rent.
Other expenses. If you are looking at a multi-family unit or apartment building, you will likely be expected to pay for lawn care, snow removal (if applicable), and potentially utilities like water and sewer (especially if units are not metered separately). Check into any potential HOA fees as well if you are buying an individual condo or apartment.
Rental Income. What can you reasonably expect to charge for rent? Ask several real estate agents, local property management firms and search on Craig’s list, Zillow and the MLS (if you are a working with an agent they can often set you up on a search and you can filter for rental properties). All of these sources can help you estimate a market rent for your property.
How stable are rents? Make sure you understand the trends. Rents will fluctuate over time and are not always guaranteed to rise. What happens if rents drop by $100 a month? Is your investment still profitable?
Putting it All Together
I developed an Excel spreadsheet to evaluate potential rental properties. You can create one yourself or try out this rental calculator at BiggerPockets. Once you crunch the numbers, you can see if the return is satisfactory to you. Remember, while it is disappointing when a deal you really want just doesn’t cut it, don’t be tempted to compromise, another one will come along.
In my next post I will talk about some specific numbers you can calculate to more easily compare properties such as the capitalization rate, the rate of return, and gross rent multiplier.