When people think about real estate investing, the first thing they often think about is owning a rental property.
And this isn’t a bad thing. After all, owning rental property is considered one of the safest real estate investments.
However, many investors jump into owning a rental house without proper knowledge of all of the financial considerations. They may even know the 1% Rule, but there are several more things to consider to make sure a rental property is a wise investment.
This article describes the checks every landlord should be making when evaluating a new rental property, as well as best practices that will make your existing investments run more smoothly.
Determining How Much to Charge for Rent
Charging the right rent price is crucial when owning rental properties. Charge too much, and your house could sit vacant for months while waiting for the right tenant. Charge too little, and you’ll leave money on the table every month.
So how do you find the sweet spot when pricing your rental house? There are a few techniques you can use.
First, search for the property on Zillow and look at the Rent Zestimate. While this number isn’t perfect, it’s usually pretty close.
One tool that landlords use to determine fair market rent is Rentometer. This tool allows you to search in your area for recently rented houses and see how much they were listed for.
The most accurate data you will find is by looking on Zillow and other similar sites and finding nearby houses currently listed for rent. Your goal should be to locate homes similar to yours in size, finishes, and number of bedrooms and bathrooms.
The 1% Rule – Should You Use It?
According to the 1% Rule, when looking at a potential rental house, the market rent should be at least 1% of the purchase price. So if a house will rent for $1,500 per month, the most the 1% Rule will allow you to purchase it for is $150,000.
The question is, should you use the 1% Rule?
In reality, this formula is an excellent rule of thumb to quickly run the numbers on a potential deal, but this shouldn’t be the only thing you consider. There are great deals that don’t meet the 1% Rule and mediocre or bad deals that do.
What formula should you use instead of the 1% Rule?
Calculating Cash-on-Cash Return
Cash-on-Cash Return (COCR) is a metric that tells you how your invested capital is working for you. It is calculated by dividing your net annual rental income by the amount of money you have invested into the property.
You must use your net annual income, which is after all expenses have been paid, when calculating COCR. If your net income is $200 per month and you’ve invested $20,000 into the property, your COCR is 12%.
Cash-on-Cash Return allows you to compare a rental property to other investment options. If you can get a better return somewhere else, then it is best not to pull the trigger on the deal.
One thing that COCR does not consider is the appreciation of a rental property’s value. However, this is never guaranteed, and its value could even go down in a poor real estate market.
Importance of Maintaining a Reserve Account
One mistake that most rookie landlords make is neglecting to set aside money for maintenance and vacancies. Maintaining a reserve account will prepare you for when these expenses show up unexpectedly.
When it comes to maintenance issues, any landlord that has owned rental properties for a significant period of time will tell you that it’s not a matter of if, but when. Water heaters bust, HVAC units go out, and shingles get blown off, and it will be your responsibility to get them repaired.
These expenses can be a gut punch to your bank account if you don’t have money set aside. However, if you have a properly funded reserve account, you can pay for them and keep moving along as if nothing happened.
A good rule of thumb is to subtract 10% out of every rent check and set it aside for maintenance and vacancy expenses. This percentage can be adjusted based on the age and condition of major systems of the house, but it is a good starting point.
What Is Your Total Net Operating Income?
Just take your rent price, subtract off your mortgage payment, and that’s your net income, right?
Several more expenses must be accounted for when managing a rental property. Your total net operating income (TNOI) is calculated by taking your rental income and subtracting off every expense.
We have already discussed the importance of setting money aside for maintenance and repairs. This portion will come out of your TNOI. The good thing about putting this money aside is that your cash flow will remain the same when you must pay for repairs.
Another decision you must make is whether you will hire a property manager. A property manager will market your property, manage tenant relationships, and handle maintenance issues. Most managers charge 10% of the monthly rental rate for their services. While you can manage a single rental house yourself, you will likely want to find a reputable property manager if you plan to build a large portfolio.
When Should You Make Capital Improvements?
A capital improvement is when you update a portion of your rental house, such as upgrading flooring, repainting, or replacing the HVAC unit. Most of these improvements are made between tenants unless they arise from a maintenance issue.
How do you decide whether to make a capital improvement or not? There are two main reasons why you should.
The first reason you should make a capital improvement to your rental house is if it increases your cash-on-cash return. For example, if laying new flooring will cost $4,000, but you can easily get an extra $100 per month because of it, it likely makes financial sense to do it.
Sometimes making an improvement isn’t even based on COCR, but to save yourself trouble in the future. Just because the water heater is working right this minute, it might make sense to replace it now if it is on its last leg. It is much simpler to make updates like this when the house is empty than when tenants live there.
Financial Considerations for a Rental Property
If you take these financial considerations into account, you will be well equipped to make your next rental property a great investment. While implementing these fundamentals requires discipline, they will make your life much easier in the long run. No one wants to invest in a rental property only to realize that it is hardly profitable or that they lose money every year on it.
One key when looking for rental properties is to have patience. Some of the worst deals investors make are when they become too eager to secure their next deal. There are highly profitable deals out there if you work hard and keep your eyes open!
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.
Very good article and very informative.