Analyze the benefits and drawbacks of owning rental property
An efficient way to make money before or during retirement is to purchase a rental property. Before moving further, there are many things to consider, so make sure you assess the property's estimated revenue, expenses, returns, rewards, and hazards.
That may enable you to maximize your investment.
Main points
If you do your homework, investing in rental property can be a reliable source of income.
If your rental property is in poor shape, owning it may end up costing you more money than it earns.
Owning a rental property entails additional risks, such as vacancies and damage.
A financial expert can help you figure out if buying a house to rent out is a good investment for you.
How much rental income can you anticipate?
It's critical to consider whether the home you buy will produce a respectable income when looking for a rental property. After all, earning money from a rental property is one of the key reasons for purchasing one.
For instance, let's say you spend $100,000 on a home:
Research reveals that $1,000 per month is the typical rent for that kind of property in that area.
Then, you may determine that your annual gross income, which is your income before expenses, will be $12,000 ($1,000 x 12 = $12,000).
At the acquisition price ($12,000/$100,000), the property offers a gross income of 12%.
Use the 1 percent rule, which states that the gross monthly income on the property should be at least 1 percent of the property's price to cover prospective rental property expenses, to determine whether the rental property has a high chance of producing money.
This one percent guideline indicates that the property mentioned above has promising potential for generating income. It brings in gross revenue of $1,000 every month, or precisely 1% of the cost of the property.
The 1 percent rule shouldn't be the only thing that makes you decide whether or not to buy a rental property.
Even if a property doesn't fit the criteria, it could nevertheless help you achieve your financial objectives. Even if a property meets the criteria, it might not be a good investment if it isn't very good or has other problems.
What Costs Are Associated With Owning a Rental Property?
The 50 percent rule is a straightforward formula for evaluating costs. You should count on your expenses to be equal to 50% of your projected annual gross property income. For instance, expenses could total up to $6,000 for a property with annual revenue of $12,000.
To get a more accurate estimate, divide property costs into two groups: operating costs and capital expenditures.
Property taxes, property insurance, common maintenance and repair expenditures, property management fees, and vacancy costs are examples of ongoing operating expenses. If the property is empty for a long time, you will have to pay vacancy costs.
Unexpected capital expenses are common. For example, replacing a damaged roof, fence, flooring, or plumbing, example, replacing a broken water heater or air conditioner.
The gross income from your property is generally not yours to keep. You must consider the costs you, as the property owner, will incur.
Using the previous example, let's say you estimate that annual operating costs will be around $1,000. You also intend to set aside an additional $1,000 a year to cover capital expenses.
What Kind of Returns Can I Expect When I Buy a Rental Property?
You can determine your cash-on-cash return from your rental property by using your gross income and costs. You can calculate its profitability using that.
First, take the gross income and remove the operational costs. This is how you calculate the $11,000 in annual net operating income ($12,000-$1,000). The cash-on-cash return is calculated by multiplying the net operating income by the cost of the rental property (100 x ($11,000,000,000)).
The range of 8 percent to 12 percent is respectable, making the 11 percent rate seem encouraging, while there is no hard-and-fast standard for what constitutes a "good" return.
Remember that neither capital expenditures nor financing is taken into account in the cash-on-cash return (mortgage payments). Here's how to determine whether your monthly cash flow would be positive even after these expenses: Monthly net operating income is calculated by deducting monthly mortgage payments and capital expenses.
Try the AARP Investment Property Calculator to get an idea of the potential return from owning a rental property.
In this instance, your net operating income per month is around $917 ($11000/12). If your monthly mortgage payment is $500 and you have $83 in capital expenses, you can earn $334 by deducting those costs from $917. That is your cash flow after financing and capital investments.
What Are the Risks vs. the Benefits?
The benefits of purchasing real estate with an income stream include:
- You get paid in a passive manner.
- The value of your property might rise.
- Tax deductions for a rental property are available.
- Diversification is advantageous to you.
You don't need to put in any work to make money from a rental property. For retirees on a tight budget, this makes it quite alluring. An even bigger monthly cash flow is possible if you pay for the property in full without taking out a loan.
Ideally, the property's value will increase over time, allowing you to benefit once more when you sell it. However, in most cases, if you sell the property for a profit, you will be required to pay capital gains taxes on the gain.
Even while rental revenue is subject to taxation, some of the tax you pay on the rental income may be offset by rental expenses such as operational costs, which are deductible.
The dangers of owning a rental property include:
- There might be openings.
- You might find a poor tenant.
- Your possessions can sustain damage.
- You might spend more than you earn.
- The value of your property can drop.
A rental property experiences vacancies when there are no tenants occupying it. It reduces your return because there isn't a tenant residing in the home during such times.
Additionally, you might have to remove a renter, which will leave a vacancy. Long-term vacancies may lower the rental property's value as a source of passive income.
Your portfolio will be more diverse if you invest in real estate. That can act as a buffer against the fluctuations in other stock market sectors.
There is always the potential that you will spend more money maintaining the property than you will bring in from renting it out. For instance, they might harm your property. People are less likely to care for a place they don't own, so damage frequently occurs.
For repairs or to pay for additional expenses or losses, you might need to borrow more money. In some circumstances, the property is deducting money from you rather than producing it.
That might also occur if a slump in the market or other factors lower the property's value. A decline in value could cause the equity in the property to decrease if you intended to use some of it to make improvements.
The conclusion
A rental property can be a reliable source of income, but like any investment, you must do your research before making a purchase.
You may determine the property's profitability by looking at the possible earnings, expenses, and returns. Make sure to consider both the advantages and the hazards.
Risks can be minimized by hiring a property manager from a reputable company; they may also be able to assist you in finding excellent tenants. Additionally, they could know people in the neighborhood who can perform repairs at a lower cost.
Consult a certified public accountant (CPA) who has handled clients who own rental property in the past. They will be able to offer an unbiased opinion on purchasing a rental property because they will have worked with numerous clients who had both positive and negative experiences with rental properties.
They can also demonstrate to you how to increase your earning potential.
