July 30, 2012

How Much Will A Rental Make? More Complex Than Just Rent - Mortgage

Often times on the internet I see people talking about renting out their current home and saying something like "I can rent it for enough to cover the mortgage".    It is common for people to think that if they can charge rent that will cover their mortgage then they will break even.   So the common equation used is simply :

Rent - Mortgage = Expected Profit

For example : If you can buy a place for $100,000 and get a mortgage of  $600 including tax and insurance and then rent it for $700 a month you might assume that you're going to net $100 a month.  You'd be wrong.

However the actual cash flow situation for a rental can be far more complex.   There are a variety of routine and potential costs with a rental that you need to consider if you're deciding if it is or isn't a good investment.

Vacancies - One of the first mistakes is to assume that you'll get rent every month of the year.  People tend to look at $700 in rent as equal to $8,400 per year and never account for gaps due to vacancies.   However vacancies are routine part of being a landlord.   Usually you should account for a vacancy rate of something around 5-10%.   It varies depending on your market and 5% vacancy is probably a fair bet for most areas.   With a reasonable 95% occupancy rate your $700 in monthly rent or $8,400 in gross rent is actually estimated at $7,980 a year.    Of course you want to do what you can to minimize your vacancies but its not always possible to keep a place 100% occupied between renters.

Higher Mortgage costs - The interest rates paid on rentals are generally higher than what you pay on a primary residence.   Lets say you are buying a $100k house and putting 30% down.   With a primary residence you can get a 3.75% loan with $324/mo payments.    But if that same house was a rental then a mortgage would likely be 4.125% with a $339 payment.  Thats an extra $15 /month.    If the property is currently your primary residence and you turn it into a rental when you move out you can usually avoid a higher mortgage rate since you can usually keep an existing mortgage in place and convert a primary residence to a rental assuming you live there for a minimum time period. But even in that case if you ever want to refinance you'll end up paying the higher interest.


Higher Property Taxes (possible) - In many areas home owners get a discounted rate on their property tax for their primary residence or people are charged higher rates for rentals.  Its not always the case but you can often pay more for property taxes on a rental.     For one rental my wife and I own, the property tax was about $1600 when it was my wifes primary residence and is now $2400 as a rental.    We're paying about 50% more or $800 per year in taxes simply because its a rental.

Higher Insurance costs.  (possible) -Its also likely that your insurance rates could be higher with a rental.    I don't know how much it will change or in which cases it does change.   But its certainly another potentially higher cost.


Utilities (possible) - You may or may not end up paying some utilities.   For single family homes its more common for the renters to pay all the utilities.   But in some areas it may be expected and typical for the landlord to foot the bill for some utilities.    In multi-family units its more common for the landlord to pay common bills like garbage and water.  Often times these bills do not have individual meters so you can't charge tenants individually for water.   In the worst situation you may have shared electricity or heat services which essentially forces the landlord to pay for the electricity and/ or heat.   You may expect that you can just raise the rent to compensate but it often doesn't work out that way.  Renters in general tend to under appreciate and discount the value of free utilities and then often turn around and over use the free services thus raising your costs.

Lawn Care (possible) - Depending on the property either the landlord or the tenant  may be responsible for lawn care.   Usually for multi-unit properties the landlord handles lawncare and its more common for the tenant to do it in a single family home.   If you have to do the lawn care then you may pay a service and that can typically run $100 a month or more.   You can save money by doing it yourself but then you have to buy and maintain your equipment and probably spend some gas for the mower.

Snow Removal (possible)  - In the Northern states its common to have snow in the winter and the landlord is often responsible for dealing with it.  This can be another expense similar to lawn care where you either have to pay a service or spend some money to do it yourself.

Repair and Maintenance - This category is a big unknown price.    If you're handy and do a lot of work yourself you can minimize the costs.   I spent $30 on a part to fix a stove which would have cost me easily $100-$200 for a service call from a repair man.    Or I could have easily spent $300 or more to buy a new stove.     Or I could have decided that I should get a nice stove and ended up $800 out of pocket.  Now what happens when a fence breaks, the roof leaks, the furnace stops working or the toilet is running?   All of those things are typical and common repairs.   You can't know what the repair and maintenance costs will be but you should budget for something as they are inevitable and usually unavoidable.

Damages (potential risk) - Most tenants do a good job of maintaining a rental and leave it in good shape.  There are always the exceptions where tenants do damage to a property either through neglect or accidentally.   You should of course get a security deposit from the tenant but it is quite easy for a tenant to do more damage than the security deposit will cover.   And its not uncommon for a negligent tenant to leave on poor terms with unpaid rent as well.  We had one tenant who left without even telling us and there were considerable damages to fix after the fact.  Trash the carpet?   Thats $1000 or $2000.   Scratched up the hardwood floors?  Thats another $1000.   Unpaid electric bill and a fridge full of rotted food?   A cat that doesn't know how to use its litter box?   It all adds up.    Even something simple like some picture hooks in walls can cost you a couple hundred to get fixed if you don't do it yourself. 

Wear and Tear -    This is a category of cost that I consider separate from repair, maintenance or damages.   Consider carpet.   Even with careful tenants and no specific damages a carpet will wear out eventually.    Eventually some things just get too old and need to be replaced.   You don't really repair some items but just wait till they're worn out and replace them.   Carpet, blinds, painting, all only last so long and will need to be replaced after a certain number of years.    Lets say your carpet costs $1000 to replace and you expect it to last 10 years with reasonable use.   Thats an extra $100 annual cost to account for.     The roof or the fence will eventually wear out and those are hefty bills to replace.

Legal and Accounting services  (possible / optional) - Hopefully you'll never have to evict a tenant but eventually it is likely to happen.  If you've never evicted someone before then in my opinion is best to hire a legal service to do it for you.   If you aren't familiar with the eviction process then you can easily make mistakes that delay the process and ends up costing you more lost rent.    It can cost a few hundred dollars to hire a service to do an eviction.   Occasionally you might also get sued by a tenant, this too is rare but it might incur additional legal costs to you.    You may also want to hire a CPA to do your taxes or if you do it yourself you may need to spend a few extra bucks to get a more advanced tax prep software package.  


Travel costs - Do you ever plan to visit your rental?   The answer should be yes.   That will incur some travel costs.   One of our rentals is 25 miles away.  Round trip that costs me about $8 in gasoline. Ideally your rentals are not too far away from you so it won't cost you much in travel costs to get there.   But any trip will have an incremental cost. 

Supplies and misc. - There are also various little expenses that add up.   Say your renter wants to renew their lease.  That means you have to print out a new copy of the lease and mail them a copy.   Thats 45¢ for a stamp and a few cents more for the envelope and print out.  

(optional) Property Management costs - Many people run their rentals by themselves, but often times people opt to hire a property manager.   The property managers will charge fees anywhere from 6% to 15%.  It varies considerably.    That amount is taken off the gross rent.   However you also have to be aware that the property managers often charge additional amounts for filling vacancies.  I've seen managers quote numbers like 1 month of rent or $500 to fill a vacancy.     You could quite easily pay 10% of rent plus $500 per year for property management.   Of course this fee is optional and can be avoided entirely if you do all the work yourself.

PLUS Depreciation - Its not all bad.   One thing that can actually save you some money is depreciation of the property on your taxes.   You can generally depreciate the value of the building over 27.5 years and this amount gives you a tax deduction.   For example : say you bought a property for $100,000 and the land is worth just $10,000.  The building is then worth $90,000.   That means you can claim a tax deduction for depreciation worth $90,000 / 27..5 = $3,272 annually.   Thats a pretty heft tax dodge.

+/- Taxes - Depending on what your expenses and income are you may or may not owe taxes.   Depreciation in particular can help get you a good tax benefit for your rentals. 


Lets add it all up : 

Consider that initial example I gave above with a $100,000 property that has a mortgage of $600 a month. You can rent it for $750.

Overly simplistic assumption : 
rent - mortgage = net income
$750 - $600 = $150 /month profit

More realistic assumption :
95% rent - mortgage + increased tax/insurance - 1% property value for repair/maintenance - $20 misc expenses and travel costs = net
(95% x $750) - $600 + $62 increased tax - (1000/12) - 50 = $52 monthly loss

Thats a $200 monthly swing in expenses taking you from a $150 profit to a $52 loss.   You thought you were going to make $1800 a year but now you're losing over $600.

Now lets consider taxes.

Taxable income = $8,550
Deductible expenses =
property tax/insurance = $2300
repairs, maintenance = $1000
depreciation -= $3200
misc expenses = $240
mortgage interest = $4070
total == $10,810

Net = loss of $2,260.   This amount might give you a tax deduction of $2,260.     You can usually claim up to $25,000 in rental income loses to offset other income but that is phased out if your income exceeds a certain threshold.   So for high income earners this won't help you.   On the other end, if you're low income you may have no tax liability or pay a low tax bracket so it won't be of much help for low income folks either.   Most people will save 15-25% of this in their taxes for a net benefit of $339 to $565.   Many other folks may see $0 impact to their taxes.   State income taxes will vary considerably but there may or may not be some impact to the state bills too assuming your state has income tax.

Do you Really Lose money?
All of the above is about monthly cash flow.    However you will have other long term impacts to your net worth.   While you're making that monthly payment the principal of the loan is going down and hopefully the property is appreciating.   So in the long haul you will see other financial benefits.   In the example above you may be paying down $2300 in principal in the year and your $100,000 property may go up to 2% to $102,000 for a +$2000 increase in value.   Thats an increase of $4300 in your net worth.   Of course theres no telling if the value of the property will go up or down in todays market, you could also see it plummet 10% and lose you $10,000 on paper. 


Bottom Line :  Determining the cash flow on a rental property is far more complex than simply rental income versus mortgage expenses.   When considering an investment property don't forget to consider all the potential costs involved.


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4 comments:

  1. Great job on this post! Anyone who is thinking about becoming a landlord needs to read this. All these expenses are the reason why the landlord need to raise rent every year. Even a $20/month raise can go a long way toward the repairs.

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  2. Hi,
    Good post and a quick question. Lets say I buy a property for 200k (15 year loan) and my net loss per year is $2500. That's a loss of $37500. Lets assume my property cost stays the same, I still make a profit of 162500 correct? If I waiting all the way to the end, it should be a profit right? Am I missing anything here?

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  3. Sumanth, Yes. You would be paying off the mortgage. And in the long run you'd have a paid off property.

    The monthly mortgage payment pays down principal and that is a net gain. The topic here is about monthly cash flow. You could count the reduction in principal on the loan towards that cash flow if you want to look at it that way, but its not really 'money in the bank' but instead increase in equity.

    Jim

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  4. You forgot 1) opportunity cost associated with your time as a property manager which could otherwise be spent working as a property manager for a company or doing some other job or something else yourself such as cooking to save on food cost, 2) Storage cost associated with the square footage taken up by the maintenance equipment and your office for the paperwork and such, and 3) associated transportation costs as part of the situation (you mentioned gasoline, but not car repairs/maintenance, extra vehicular depreciation associated with those miles, or extra insurance for "business use" of a vehicle.

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