A little over two decades ago, Robert Kiyosaki’s book Rich Dad, Poor Dad got many people interested in a particular kind of investing: buying residential or commercial property in order to rent it out. Since publishing this bestseller, the author himself has been struck by more than a smidgen of controversy; a good reminder to take even popular financial advice with a pinch of salt. Even so, one of his basic ideas still seems to hold water:
If you buy an apartment, house, or store premises as an investment, your rental property profit can cover the mortgage payments, increasing your equity with only limited work or risk.
Stated like this, the system seems pain-free and nearly foolproof. Still, let’s remember the time-honored adage: anything that sounds too good to be true probably is. Assuming that any devil present will be found in the details, let’s dig down a little into the question of buying to rent:
Table of Contents
- 0.1 Mortgages and Your Rental Property Profit Margin
- 0.2 Down Payments, Credit Scores, and Banks’ Attitude
- 0.3 So, How Much Profit Should You Make On A Rental Property?
- 0.4 Knowing Your Local Property Market
- 0.5 Choosing the Right Rental Property
- 0.6 Avoiding Tenant Trouble
- 0.7 Crunching the Vacancy Rate
- 0.8 Tax Tricks
- 0.9 Unrelated Business Income Taxation and Non-Profit Rental Income
- 1 * * *
Mortgages and Your Rental Property Profit Margin
At the moment, and in fact for the last several years, mortgage interest rates are almost absurdly low:
On the surface, this counts in favor of anyone who wants to follow the buy-to-rent route to wealth creation. There is a flip side to this, though: this tide of cheap credit has raised demand to a point where house prices have increased more than tenfold since 1940 – this figure is adjusted for inflation!
This makes it more difficult for someone to get onto the buy-to-rent property ladder, jacks up their monthly payments, and of course increases their total risk. It also increases the pool of people who’d rather rent than take out a mortgage of their own, of course, and drives up average rent amounts. So, the simplest rental profit calculator is just this:
Monthly Rent > Mortgage Payment
The amount by which the rent you can charge exceeds what you owe the bank, minus additional expenses like maintenance, homeowner’s association fees, insurance, taxes, etc, represents your rental property profit margin. When figuring out how much profit should you make on a rental property, though, your monthly income should not be the first or the only thing on your mind.
Investing in real estate is always a long-term proposition. What you’re really doing is letting other people pay off your mortgage in exchange for the privilege of living there. Over the years, your equity – how much of the rental property you own vs how much you owe the bank for it – increases gradually. Once your debt is paid off, you can use the building as a semi-passive source of income or sell it for a lump sum. Essentially, you gain in three different ways:
- A small monthly inflow that should at least keep you breaking even,
- A mortgage that gets paid off without draining your bank account,
- With any luck, title to a property that increases in value faster than inflation.
Down Payments, Credit Scores, and Banks’ Attitude
While it’s not by any means impossible to get approved for a mortgage on a property you won’t live in, it is somewhat more difficult. Families have a vested interest in caring for and paying off their own residence, less so for investments. You’ll probably pay at least 0.5% higher interest than otherwise, and substantial down payments are preferred. At least that means you won’t have to shell out money for mortgage protection insurance.
What all of this adds up to is that you’ll probably not be offered the “typical” or “best” mortgage interest rate you saw online somewhere. A higher interest rate translates to more cash out of your pocket every month, slower equity growth, and may make your rental property project unfeasible.
One way to mitigate this problem is to start actively working on your credit score months or even years before you buy your first rental property – anything above 700 will be a great help. Alternatively, you can get one or several people to co-sign the mortgage, sharing the debt, the risk, and the profits. This poses a non-financial risk, though: money may not be the root of absolutely all evil, but it’s certainly been the cause of a lot of fights. You’ll want to define your strategy, expectations, and contingency plans clearly from the start, and ask serious investors rather than friends or family. Alternatively, you can also choose to put your money into a kind of mutual fund called a REIT (Real Estate Investment Trust). This limits your downside risk and doesn’t require nearly as high a minimum investment.
Finally, on the subject of actually getting a mortgage for a rental property, banks do prefer people who have previous experience of being a landlord or have at least owned their own home. If this applies to you, mention it to the loan officer, or offer to hire a professional manager instead.
So, How Much Profit Should You Make On A Rental Property?
This point is important enough to make once again: the best way to approach real estate investment is to look ten or more years ahead. The main benefit of owning a rental property is that your mortgage payments come out of somebody else’s pocket. Any additional cash is nice, but don’t expect your rental property profit margin, in terms of cash in your pocket, to be very high.
Of course, this doesn’t mean you shouldn’t try to maximize your income, including by charging as much as you can. This implies doing your research about what other, similar properties are going for. If you try this experiment across several locations and compare rents with real estate prices, you’ll soon notice that some cities and neighborhoods are significantly friendlier to renters as opposed to owners.
Each location’s price-to-rent ratio is calculated by dividing those numbers for typical properties; this is one of the best barometers for the local rental market. In some neighborhoods, homes may be sold for as little as 10 years of rent payments, in others, they may be worth the equivalent of over 30 years. The lower this price-to-rent ratio, the more favorable a landlord’s position: the more cash a cheaper building generates, the sooner you’ll get your money back. Let’s take a look at a few examples of how this can work, assuming a 30-year mortgage, a 30% down payment, and a 3% interest rate:
As you can see, a neighborhood’s price-to-rent ratio is of crucial importance. This is not to say that even a city with a high PTR number doesn’t offer some opportunities for making money with rental real estate; far from it. If you ignore it, however, you’re taking the risk of having to dip into your savings or other income streams to keep up with the bills. Sometimes, the rents people are able to pay just aren’t high enough, by themselves, to finance the purchase of a building. If you can cover some of the expenses, however, you will most likely see a return on investment once you factor in owning the property eventually.
Knowing Your Local Property Market
Most successful rental property owners focus on a single city, town, or even neighborhood. As the income for all their buildings depends on the same economic forces affecting the same region, you could say that this means putting all their eggs in one basket. On the other hand, another theory states that this is perfectly okay – as long as you keep a sharp eye on that basket.
Good advice for would-be property investors is to spend several months or even years getting to understand the ups and downs of their local property market. In some areas, landlords can pick and choose tenants, in others, renting out a property for what it “should” be bringing in is nearly impossible. The difference usually comes down to local business trends; the easiest way to keep your finger on this pulse is by joining your local Chamber of Commerce. Your municipality’s planning department, meanwhile, will have records of all developments that have been approved but not yet built, another reliable indication of how the property market is doing.
The greatest risk with buying to rent in the wrong location is that your property’s market value will decrease to less than the amount you owe on your mortgage, called “being under water”. Instead of gradually owning a greater percentage of the building, you may end up losing everything you’ve spent on it and more even if you sell it. Declining rents in the area may leave you no better option.
Choosing the Right Rental Property
People are notoriously driven by emotion when choosing a home. The walls being the wrong color or a dried-up lawn can easily sink a deal, even though these are relatively simple to fix. Estate agents even scent showhouses with cinnamon or vanilla to make them feel homier – we people are, in fact, that easy to manipulate.
This is one mistake you cannot afford to make if your rental property profit margin is important to you. To reiterate, the only goal is to keep your monthly mortgage payment (as well as the total amount you’ll pay over the years) as low as possible while still earning a decent rental income. A house that seems “cute” may rent more easily, but will probably be sold at a premium, may not be to other people’s taste, be located too far from the freeway, or bring in less money for any of a hundred reasons. In other words: try to be rational and look at any property for sale through prospective tenants’ eyes.
Any purchase needs to be evaluated with a rental profit calculator instead of just a gut feeling. In fact, one good strategy is to look for properties no one else seems to want to buy. These include homes that have been on the market for a long time (though not in a neighborhood where nothing sells quickly or one with many vacant houses!). Their owners will almost certainly be willing to consider an offer well under the asking price. Foreclosures are another option, so keep checking banks’ websites, online listings, and even your local courthouse or sheriff’s office. You may find great bargains and even get a good deal on your mortgage, perhaps by applying for a 203(k).
Unfortunately, you have to be prepared to make a decision quickly while also accepting a long-drawn-out closing process. Properties sold at a discount may also need major repairs or have back taxes attached to them. The last thing you need is not being able to take possession of a building because of the previous owner’s unpaid utility bill, or not finding out that it’s not up to code and therefore legally unrentable.
Buying a fixer-upper, on the other hand, can also be a good financial decision as long as you know what you’re getting into. Many enthusiastic amateurs have lost their shirts trying their hand at “flipping”. Bear in mind that most projects’ timelines and budgets are subject to Murphy’s law. You may end up having to pay both your mortgage and contractors while getting a house into habitable shape, without any offsetting rental property profit.
Avoiding Tenant Trouble
Most rental property management companies take 10% off the top of your income – not your rental property profit margin, the whole amount. This does not include maintenance expenses nor charges for finding a new tenant, which may be as high as a full month’s rent. This certainly sounds like a lot of money for collecting checks and occasionally calling a plumber! To be fair, though, these kinds of agents do perform a lot more work than that.
For one thing, they typically handle all communication with tenants. If you’re not much of a people person or simply too busy, this alone can make their fees worthwhile. A more important part of the service they provide is avoiding and handling disputes on the landlord’s behalf. It’s now standard practice to run a credit and/or criminal check on all prospective tenants – they’re even expected to pay for it.
If a tenant should cause damage to the home or fall in arrears, property managers know the law and “how things work” and will generally achieve a much more satisfactory result than an inexperienced landlord. Their rates may be high, but unless you plan to manage your properties on a nearly full-time basis, the problems they avoid can make this a good deal.
Crunching the Vacancy Rate
Good tenants are hard to find; there are numerous horror stories of people squatting rent-free or completely trashing the homes in which they live (there is an equal number of tales involving shady landlords, of course). Finding good tenants whenever you need them is much, much harder.
One factor many first-time property investors don’t pay sufficient attention to is the vacancy rate – the proportion of time a property stands empty and unproductive. If you rent out apartments in a university neighborhood, for instance, they may very well earn you nothing during summer break, or about 17% of the year. Even worse, advertising for new occupants, changing locks, deep cleaning, etc. all cost you money.
It’s impossible to predict your vacancy rate with any certainty, but it’s best to be pessimistic here. People do move out of state, in with friends, lose jobs, trade up their living arrangements, or end their leases for any of a hundred unpredictable reasons. Being on the hook for a mortgage with no rent coming in can be a major drain on your finances. Ideally, you’ll have enough savings and income from other sources to keep up with the payments when this happens. Using a rental profit calculator, carefully, beforehand is the only way to ensure you can handle this situation.
The government, at both state and federal levels, has always been keen on encouraging homeownership. Arguably, their efforts have generally done more harm than good, but this doesn’t mean that a smart investor won’t make use of such programs, including tax breaks.
Property taxes, calculated based on the value of the land and building and charged by the local authority, are generally impossible to avoid. You should consult the municipal tax office for local rates before buying, especially in states with high real estate taxes. It’s worth noting that high tax rates are often associated with prestigious neighborhoods, but may also be a sign of a struggling local government trying to make ends meet.
Single taxpayers and married couples can, at least, deduct their state and local taxes, including property tax, on their federal income form (up to $10,000 per year). Interest on mortgage debt up to $750,000 is also deductible, but only if you choose to fill out an itemized return instead of taking the standard deduction.
These write-offs are very welcome, as the IRS sees rental property profit in pretty much the same way as any other income, except that you’ll usually pay tax on only 80% of it. As for your rental-related costs, those are business expenses and count towards reducing your taxable income, so it can be worth your while to keep records of every washer you replace, carpet you clean, and letter you send. There are however certain requirements to take advantage of these clauses, including a maximum income and using certain types of business structures.
Finally, there’s also the matter of capital gains tax, based on how much an investment grows between you buying it and cashing out. This is one instance where investing in real estate has advantages. If, after a few years, you want to sell your existing rental property to finance the purchase of a more expensive (but substantially similar) building, you can use something called a 1031 exchange. This doesn’t reduce your tax burden but allows you to delay paying it, making your investment dollars go further. Similarly, you don’t immediately have to pay tax on property assets in qualified opportunity zones (QOZs), defined areas where the government wants to encourage long-term investment. A number of other entirely legal tax avoidance strategies exist – if you’re serious about buying to rent, you should consult a professional or at least read a book on the subject.
The above notes covering tax on rental property profit all apply only to normal businesses. When a registered charity, church, or other non-profit receives income from some source other than their normal business – holding a bake sale or renting a room to an employee, for example – this is called “unrelated business income”. Unlike donations, UBI is considered taxable.
Fortunately, most non-profit rental income is still considered “substantially related” to their main mission. Unfortunately, the rules are surprisingly complicated: if non-profit rental income comes from letting another charity use part of their building, it’s not taxable – but if food is served it may be. This situation is widely deplored in the non-profit community, but it is the law. If in doubt, you should consult a tax professional or the IRS itself.
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In general, there are two major mistakes people make when buying to rent: jumping in with both feet before doing their research, and letting their apprehensiveness prevent them from starting at all. There’s a fine line between boldness and hesitation.
There is a solution, though: using a rental profit calculator to manage your more optimistic expectations as well as affirm that you can indeed obtain a worthwhile rental property profit margin. As long as you purchase a nice but not-too-upscale house or apartment in a desirable neighborhood, you shouldn’t have too much trouble finding tenants. Then, assuming that you can maintain a positive cash flow, your net worth should increase without you having to do much work.
There are some risks, of course: the bottom could drop out of the real estate market, or a tornado could relocate the building to Arkansas. All investments have risks, though, unless you choose something regarded as totally safe, like a high-yield savings account at 2% return per year or government bonds producing even less than that. Returns on investment properties, including appreciation, monthly rental property profit, and whittling away at your mortgage, are more often comparable with the stock market (meaning around 10% in the long run, if all goes well).
There is one major difference, though: the level of control you have. The chances of you making better stock picks than a mutual fund manager are slim. Anyone, however, can understand the basics of buying and renting out a house. If you add skills like maintaining cordial relations with your tenants, keeping your properties in good repair, and – especially – planning ahead with a rental profit calculator or spreadsheet, you’re very much in the driver’s seat.