PROPERTYSPARK ARTICLE

What Are the Financial Considerations for a Rental

“Rental properties are great because the tenants pay down the mortgage for you!”

How many people have become landlords because of that statement – only to realize owning a rental house isn’t everything it’s cracked up to be? Not only is it more work than most people anticipate, but it usually isn’t as financially lucrative as it seems on the surface.

Don’t get us wrong – owning rental properties can be a great business. But most people don’t run the numbers properly on the front end to ensure each house will be a good investment.

Without thoroughly weighing out the financial considerations of a rental property, you could end up making a poor investment and getting a smaller return than you would have by sticking your funds in a retirement account. And you’ll have way more headaches along the way too!

In this article, we discuss how to properly evaluate a rental property to ensure it will be a solid investment that provides strong returns year after year. That way, you can view your properties as assets that are growing your wealth instead of money pits.

Let’s dig in!

How Much Should You Charge for Rent?

The first step in determining if a rental property will be a good investment is figuring out how much it will rent for. If you’re in a well-populated city, you should be able to get very close with online tools.

The fastest way to determine the fair market rent for a home is to use Zillow. First, pull up the property address and look at the Rent Zestimate. This number is typically very accurate in an area with a high number of rentals. After that, you can look for other houses in the area currently listed for rent to see what similar properties are going for.

Another way to find the appropriate monthly rent for a house is to use Rentometer. Instead of finding homes currently on the market, this tool finds houses that have recently been rented out. This is more helpful than current listings because anyone can list a house for rent for whatever price they want, but that doesn’t mean they’ll get that amount.

Zillow and Rentometer work great for metropolitan areas with plenty of housing data, but figuring out the rent price in a rural area can be much more challenging. Your best option if you can’t trust online sources is to talk to a property manager who keeps their finger on the pulse of the market.

Rookie Landlord’s Biggest Mistake – Not Accounting for Maintenance

Just subtract the mortgage payment from the monthly rent price, and that’s your cash flow, right? Not quite.

One of the biggest mistakes landlords make is not setting aside money for when maintenance issues arise. And trust us – they will.

Instead of claiming all the money that comes in from rent each month, experienced landlords set aside a portion of each rent check and put it in a separate reserve account. This account is used to fund repairs and the mortgage during vacancies.

There is no perfect number to put in your reserve account each month, but a decent rule of thumb is to set aside 15% of the monthly rent. Keep in mind that this is just a guideline, and the proper amount can go up or down depending on the condition and price point of the house.

The benefit of setting aside a portion of each rent check and earmarking it for maintenance and vacancies is that it keeps your cash flow consistent. Otherwise, when a maintenance issue comes up and you have to spend hundreds of dollars to fix it, your cash flow for that month drops significantly or even goes negative. Major problems like an HVAC unit going out could wipe out your cash flow for the entire year or more.

However, by creating a reserve account and using those funds to pay for repairs, your cash flow will remain the same every month. It will be lower each month because of the portion you set aside, but it will at least be predictable.

What is the 1% Rule and Should You Use It?

If you’ve ever read an article about purchasing rental properties, you’ve likely heard of the 1% Rule. The 1% Rule says that a rental property must rent for at least 1% of the total amount of money you have in it (including purchase price and repair expenses) to be considered a good investment.

Here is an example: Let’s assume a house will rent for $1,200 per month and needs $20,000 worth of repairs to be rent-ready. The 1% Rule says the most you could pay for the house would be $100,000. The monthly rent divided by your all-in cost of $120,000 would be exactly 1%.

Is the 1% Rule the best way to analyze a potential rental house? Not really.

The 1% Rule shouldn’t be used exclusively when underwriting deals because it is an extreme oversimplification. It doesn’t consider the current interest rates, which method you will use to fund the deal, how prone the property is to maintenance issues, if you will hire a property manager, or expenses that fluctuate based on area, such as insurance and taxes.

So if the 1% Rule doesn’t work, what should you use instead to evaluate rental properties?

A Better Metric – Cash-on-Cash Return

Instead of using the 1% Rule, you should look at the cash-on-cash return of every rental house you evaluate. Admittedly, calculating the cash-on-cash return takes significantly longer than checking the 1% Rule, but it is a much more valuable piece of information when analyzing a deal.

To calculate the cash-on-cash return of a rental property, you must determine your net annual income after all expenses have been paid. Here are the most common expenses you must subtract from the annual rent:

• Property management fees
• Mortgage payments
• Property taxes
• Insurance
• Money set aside for maintenance/vacancy reserve account
• Pest control
• HOA dues

The cash-on-cash return is your net annual income divided by how much money you invested in the deal. If you bought the house with all cash, it would be the purchase price, renovation costs, closing costs, and holding expenses. If you have a loan on the property, you would swap the entire purchase price with your down payment amount. However, the trade-off is that your monthly income will be lower because you have a mortgage to pay.

Your cash-on-cash return is expressed as a percentage and tells you how quickly your outlaid money returns to you. This number can then be compared to other investment opportunities to see if the subject property makes sense to add to your portfolio.

Investors are always working diligently to maximize their cash-on-cash returns. This is done by either maximizing income or minimizing how much money they have in the deal. Maximizing income can be difficult on a long-term rental property because you can only charge fair market rent, and there are always expenses that you must pay. There are several ways to minimize your cash in the deal, such as using the BRRRR method or buying properties with seller financing.

Buy a Rental Property That Is a Good Investment

As you can see, there are more financial considerations when evaluating a rental property than most people think about. That’s why most rookie landlords end up regretting their decision shortly after buying their first rental house.

However, now that you have the information we’ve presented, you’re much further ahead than most real estate investors. If you apply these principles when searching for investment properties, you are sure to make wise decisions and accumulate a portfolio of homes that generate healthy cash flow.

Author Bio: Jordan Fulmer is the owner of Momentum Property Solutions, a house buying company in Huntsville, AL. They specialize in buying houses in tough situations and renovating them to either sell or rent. Jordan also runs the SEO side of their business and regularly writes content about real estate investing, home improvement, SEO, and general real estate topics.