More to Rental Property Than Meets the Eye

 

Jane Young, CFP, EA

Jane Young, CFP, EA

With low interest rates and the fear of another drop in the stock market, many people are looking for alternative ways to earn investment income.  Many investors find the tangible nature of real estate appealing.  Although real estate may seem like the logical alternative to stocks and bonds, investment in real estate can be very complex, time consuming, and wrought with risk. 

Before buying, perform a realistic cash flow analysis on the income and expenses associated with the property you are considering.  Begin with start-up expenses associated with acquiring the property, including the down payment and any necessary improvements. Next tabulate the routine expenses that you will incur with a rental.  These may include mortgage payments, insurance, property taxes, home owner’s association dues, routine maintenance, and legal and accounting fees.  As a rule of thumb, maintenance and repairs run about 1-2% of the market value of your home, depending on the home’s condition.  Also consider an emergency fund to cover large unexpected repairs. 

Managing rental real estate can be very time consuming.  Seriously think about whether you want to manage the rental yourself or you want to hire a property manager.  Do you have the time and the desire to manage the property? If you do it yourself, you will need to market the property, evaluate potential renters, maintain the property, respond to tenant issues, collect rent payments and potentially evict tenants.   You also may want to learn about fair housing laws, code requirements, lease agreements, escrow requirements, and eviction procedures.  If you don’t have the time or the temperament to manage the property, consider hiring a property manager.  Property management fees usually run about 10-12% of rental income.

Some additional risks to consider when renting property include the possibility of major damage inflicted by a tenant, drawn out eviction processes, and law suits for negligence and safety issues.

After evaluating your expenses, do some income projections.  Research rents paid for similar properties in your target neighborhood.   Be sure to incorporate a reasonable vacancy rate.  According to the Colorado Division of Housing, the average vacancy rate in Colorado Springs has been about 6%, for the last 4 quarters.

Include the tax benefit of deducting depreciation into your analysis.  To calculate annual depreciation, divide the initial value of your rental home, not including land, by 27.5.  Unfortunately, you will probably have to recapture (repay to the IRS) this deduction upon sale of the property at a maximum rate of 25%.

Subtract your projected expenses from your projected income to determine your net profit.  Will the net profit you expect to gain from the property compensate you for your capital, time and risk?  In addition to the profit from rental income, be sure to factor appreciation of your property into your analysis.  Additionally, if you have a mortgage, your equity will increase every year as you pay off your mortgage.

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