 eal estate investments have soared over the past several years. According to the National Association of Realtors, about one in three homes purchased last year was for investment purposes. If you’re looking to feather your retirement nest, rental real estate not only should appreciate in value, it also provides an additional source of monthly income. If your 401(k) or other retirement plans are held in stocks and bonds, rental real estate is also a good way to diversify your investment portfolio.
If you’re thinking about taking the jump and investing in rental real estate, here are a few things to consider.
Figuring out the dollars and sense
The first step in determining whether rental property is right for you is to calculate the potential cash flow—the amount of money a property brings in and the amount you need to pay out to cover expenses. It’s not uncommon for rental properties to start out having negative cash flow—the amount you collect for rent does not cover the mortgage payment. If that is the case, you need to determine whether you feel comfortable making this additional cash outlay each month. Here’s how to estimate what your monthly cash flow will be.
1) Estimate your income
The first step is to determine the amount of rent you can charge for the property. Look at what comparable homes—same size, location, amenities— are renting for in your area. You can get a good idea by browsing the classified ads in your local paper or online. When estimating your income, allow for the amount of time that your property may be vacant. Most landlords factor in about 5 percent per year; however, figures vary depending on the current rental market in your area.
2) Tally up your expenses
Your monthly mortgage payment and property taxes are your largest expenses. You may also end up picking up the tab for utilities, such as garbage, water or gas. Again, check what comparable rental properties are offering in your market. If you do plan on paying utilities, use your own usage as a ballpark estimate.
Property insurance is another cost. Your insurance company can tell you what the premium will be if you utilize the property as a rental.
Rental properties need repairs and maintenance just like any other home. Appliances break, plumbing leaks, fixtures wear out. Figure on spending about 1 percent of the property’s value per year on maintenance, repairs and cleaning.
Finding a good tenant always pays in the long run, but it does take time and money to conduct an effective search. If you use a property management company or rental broker, include those fees. If you are conducting the tenant search yourself, add in any advertising expenses and a nominal cost, usually under $25, for running credit checks on prospective tenants.
The good news about all these operating and maintenance expenses is that they may be deducted from your rental income on your taxes. If you’re thinking about upgrading the property, keep in mind that expenses related to improvements to the property must be depreciated over time, rather than deducted in the year paid. Improvements are defined as actions that add to the value of the property or substantially prolong its life. Examples include adding a new bathroom, remodeling a kitchen, installing insulation or building a deck.
3) Calculate the cash flow
Now total all the monthly expenses and subtract that number from your estimated monthly income to determine your cash flow. To fully evaluate the investment, you also want to factor in the tax write-off benefits of depreciation. Depreciation is an accounting deduction that the IRS allows you to take for the overall wear and tear that occurs on the home over time. Only the building can be depreciated, not the land. The value of a residential structure 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 $300,000, and the building is worth $200,000, you can take $7,280 each year as a depreciation deduction ($200,000 x .0364).
In addition, if your rental property shows a loss for the year, you may be able to deduct the loss on your tax return.
Consult with your tax advisor to help determine which deductions you qualify for and other tax implications for your situation.
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