The Finances Behind Being a Landlord: Is It Worth the Investment?
Like many investments, property ownership is not without its ups and downs. For many, being a landlord can be seen as both lucrative and daunting. So how do you know if it is right for you financially? Beyond your obvious commitment to your tenants, general property upkeep, and personal responsibility in the investment, the financial repercussions can be difficult to assess. Here are a few ways to shed light on your situation.
Crunching the Numbers
We previously calculated an example of return on investment for a rental property in which the house cost $300,000 and you charge $2,000 a month in rent. This time, we’ll further break down the numbers using additional hypothetical figures:
Gross monthly income (monthly rent): $2,000
Breakdown of monthly expenses:
- Property tax: $250
- Insurance: $83
- Property management: $200 (optional)
- Homeowners association fee: $42
- Vacancy: $200 (10 percent of monthly rent)
- Repairs: $100 (5 percent of monthly rent)
- Mortgage: 1,000 (if you put down 50 percent)
Total monthly expenses: $1,675 (without property management; $1,875 including property management)
To determine whether you’ll end up with a positive cash flow, subtract monthly expenses from your monthly income. Note that if you put down the minimum to purchase a house, you might have a negative cash flow until you pay off the mortgage.
Cap Rate and Cash-on-Cash Return
A couple of basic calculations will help you determine if the property investment is positive: cap rates and cash-on-cash returns.
Cap rate accounts for your real income, or the annual return you can expect to get, once you figure in expenses. To calculate it, divide your net annual income, excluding mortgage payments, by the purchase price. In the above example, your net annual income would be $15,900 (2,000-675=1,325, then 1,325×12). Dividing 15,900 by 300,000 reveals a 5.3 percent cap rate. It’s a good rule of thumb to have a cap rate of at least 5 percent, so 5.3 is a positive one.
Cash-on-cash return is the cash you invest compared with the income you generate from the property. In other words, it’s how much you’ll make on the money you invest. This calculation doesn’t factor in possible appreciation or tax benefits, and it isn’t an exact science, but it does provide a useful ballpark figure. To determine your cash-on-cash return, divide your net annual income by the total cash you invested. Mortgage payments are included here, unlike with the cap rate, so your net annual income in this example would be $3,900 (2,000-1,675=325, then 325×12).
Next, divide 3,900 by 150,000 (50 percent down payment). That equals a cash-on-cash return rate of 2.6 percent, which isn’t that good. If you put down 20 percent instead of 50 percent and your net annual income could remain the same (3,900 divided by 60,000), you’d end up with a much better cash-on-cash return rate of 6.5 percent.
Landing the Right Tenants
To minimize the chances of your rental property sitting vacant, buy in a hot area where people want to live. Some states experiencing an influx of population include Texas, Colorado, Florida, Washington, South Carolina, and Georgia. Keep your property well maintained so that it looks attractive to potential tenants. To protect against bad tenants, perform a thorough credit and background check through a tenant screening service or a credit reporting agency such as Experian.
Being a landlord is a great investment opportunity for many people. However, it can be a serious time commitment, especially if you do not have a property management team working alongside you. Depending on where you live, the taxes associated with home ownership may yield less of a return on investment than you originally thought. However, with the above methods for financial projections in hand, you have methods for determining if it’s the right choice financially for you.