Suppose you made a killing when you sold your house, or you're simply a good saver, or you received an unexpected inheritance. If you have some extra cash burning a hole in your pocket, consider investing in some rental real estate.
The advantages of owning rental property
Real estate is a good long-term investment. Historically, real estate investors have enjoyed average annual rates of return (in the range of 9 percent to 10 percent) comparable to stock market investors' returns.
Part of the reason for those healthy real estate returns comes from the fact that land is in limited supply, so the price of land — and the property on it — generally faces upward price pressure as the economy and population expands. In addition, because you can borrow upward of 80 percent of the purchase price of a property, you leverage your invested capital to work harder for you; you earn returns not only on your down payment but also on the borrowed money.
Looking ahead to your golden retirement years, rental real estate not only should appreciate in value but also should provide you with rental income for living expenses. Moreover, when you eventually decide to sell your rental real estate to tap into the equity in your property, under current tax laws, the maximum federal income tax rate that you pay on your capital gain is 28 percent, which may be less than the tax rate that you pay on your employment or investment income.
And, last but not least, if you have a great deal of your retirement nest egg stashed in the stock market, rental real estate can help you diversify your investment portfolio. Of course, when you consider how diversified your investments are (or aren't), don't forget all the money that you may have "invested" in real estate by virtue of owning your home.
Figuring the cash flow on rental property
 | Cash flow is the amount of money that a property brings in and the amount you have to pay out for expenses. Some homeowners-turned-rental-property-owners can't cover all the costs associated with rental property. In the worst cases, such property owners end up in personal bankruptcy from the drain of negative cash flow (that is, when expenses exceed income). In other cases, the negative cash flow hampers property owners' ability to accomplish important financial goals, such as saving for retirement or helping with their children's college expenses. |
Before you consider becoming a landlord, make some projections about what you expect your property's monthly income and expenses to be.
Tally up the income
On the income side, determine the amount of rent you're able to charge:
- Look at what comparable properties currently are renting for in your local market.
- Check out the classified ads in your local paper(s).
- Speak with some leasing agents at real estate rental companies.
Be sure to allow for some portion (around 5 percent per year) of the time for your property to be vacant — finding good tenants takes time.
Consider your expenses
On the expense side, you have your monthly mortgage payment. And, of course, you have property taxes. Because you probably pay them only once or twice yearly, divide the annual amount by 12 to arrive at your monthly property tax bill.
You may end up paying some or all your renter's utility bills, such as garbage, water, or gas. Estimate from your own usage what the monthly tab will be. Expect most utility bills to increase a bit because tenants will probably waste more when you're picking up the bill.
 | Be sure to ask your insurance company about how your property insurance premium will change if you convert the property into a rental. As is true with your property taxes, divide the annual total by 12 to get a monthly amount. |
Don't forget repairs and maintenance. Figure that you'll spend about 1 percent of the property's value per year on maintenance, repairs, and cleaning. Again, divide by 12 to get a monthly figure.
Finding good tenants takes time and promotion. If you choose to list through them, rental brokers normally take one month's rent as their cut. If you advertise, estimate at least $100 to $200 in advertising expenses, not to mention the cost of your time in showing the property to prospective tenants. You must also plan to run credit checks on prospective tenants.
Estimate the cash flow
Now, total all the monthly expenses and subtract that number from your estimated monthly income after allowing for some vacancy time. Voilà! You've just calculated your property's cash flow.
If you have a negative cash flow, you may actually be close to breaking even when you factor in a rental property tax write-off known as depreciation. You break down the purchase of your property between the building, which is depreciable, and land, which is not depreciable. You can make this allocation based on the assessed value for the land and the building or on a real estate appraisal. Residential property is depreciated over 27-1/2 years at a rate of 3.64 percent of the building value per year. For example, if you buy a residential rental property for $250,000, and $175,000 of that amount is allocated to the building, that allocation means that you can take $6,370 per year as a depreciation tax deduction ($175,000 x .0364).
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