Formula For Calculating the Profitability of a Rental Property

July 20th, 2007.

Someone asked me what my formula is when calculating the profitability of a rental property, so I thought I’d post it. But before I do that, I just want to take a minute to disclaim that there are multiple formulas you can use effectively. And honestly? It’s probably best if you figure out your own. Different areas require different expenses and all that jazz.

The very first thing you should do before buying a rental property is visit other rental properties in your area to determine what the competition typically charges for rent. To do this, I’ll usually pose as a tenant looking for a new place to live and take a few tours of different apartments. Then, I’ll check back periodically to see how long it took for the apartment to be rented. For example, if I find an apartment for rent for $700 a month and it took 2 months for the landlord to get it rented, I will assume the rent is slightly higher than it should be. After all, a 2 month vacancy can kill your profits for the year. I prefer to keep my rent low enough that I can re-rent it in 2 weeks. One month, tops.

OK, so you’ve done the footwork and found that you can rent a 3 bedroom house with air conditioning and a dishwasher (Remember to keep your amenities comparable to other properties in your area!) for around $900 a month.

You will need $900 a month to cover:

1. The mortgage
2. Your taxes
3. Your insurance
4. Maintenance costs (How much I put aside for maintenance every month depends on the age of the property. For example, if the property is fairly new and won’t need any serious repairs for a few years, I’ll only put aside $30 per month. If it’s an old property, maybe I’ll decide on $70. But no matter what, put aside something every month. After all, eventually you’ll need to replace the roof, the furnace, etc, someday and you don’t want the cost of that coming out of your profits. Also, it’s good to have some extra money put aside in case you end up with a problem tenant who trashes the place. On average, I put aside $50 per month per unit.)
5. Utilities, if you elect to pay them. (I usually don’t elect to pay the utilities)
6. Vacancy (I generally plan on a 1 month vacancy per apartment, per year. If I luck out and no one moves out that year or if the empty apartment gets rented quicker, I consider it gravy.)
7. Your profit

As far as profit goes, I minimally need to make $50 per unit in straight profit. So if it’s a single family property, I would have to be able to pay all my bills and still pocket $50 a month. With a duplex, I’ve got to make $100 a month right off the bat. A four unit apartment building would have to generate $200 a month for me. And so on and so forth.

This might not seem like a lot of money at first…especially when you consider the time and effort it will take you to get new tenants. You’ll rack up minor expenses simply by placing ads in the newspaper or using gas to head to the apartment periodically to show it to potential tenants. Also, you’ll have to answer service calls (sometimes in the middle of the night) should something break. A lot of people consider these things and ultimately decide owning rental property isn’t for them.

Nevertheless, there are a couple of things they’re not considering:

1. Tax write offs. I do not factor in how much I get back in taxes into my monthly profit. I consider it all gravy. Still, it’s nothing to sneeze at. Also keep mind that any repairs you make to the property can be written off as well.
2. As the years go buy, you will eventually be able to charge more and more for rent. However, your monthly expenses will generally remain the same. The longer you own a property, the more your profit will increase.
3. At the end of the day, you will end up owning a property that someone else paid for. Not only that, but by the time it’s paid off, it will have likely increased in value substantially. Hello, easy retirement fund!
4. $50 per unit is what I want to make minimally. Generally, I end up making much more. For example, the apartment building I’m looking at now will generate closer to $90 per month per unit.

So back to our single family property that will generate a rent of $900 a month….

For the sake of easy math, let’s just decide to leave the utilities up to our tenant. In my area, taxes and insurance on a single family property will run around $150 per month. We’ll say the property is in average condition, so we’ll only be putting aside $50 per month for maintenance costs. A one month vacancy per year will cost us about $75 a month. That gives us a total of $275 for expenses. Add on the $50 a month profit and we’re looking at $325.

Ok, so say we’ve talked to our finance guy and he says he can get us an interest rate of 7% and we are planning to ask the sellers to pay our closing costs. How much should we pay for the property?

$900 rent (-) $ 325 expenses (=) $575 mortgage

At this point, I’ll use an online calculator to figure out how much a house with a $575 per month mortgage costs. I played with the numbers a bit and determined that we would have to buy the house for $86,000 to meet all of our financial obligations and still make a monthly profit.

This is more than feasible in my area. Your numbers may have to adjust if you live somewhere where the property value is much higher. Also consider that single family homes usually generate the least amount of profit. Duplexes and apartment buildings will get you more cash for your buck. However, single family homes are easier to get rid of should you decide the money you’re making isn’t worth it. It’s much harder to dump an apartment building.

Although your profit won’t be all that amazing, I recommend beginners start off buying a single family home for their first investment property. If, for no other reason, than to ‘try out’ being a landlord. To be a successful landlord you’ve got to be a good judge of character and have a low tolerance for bullshit. For example, if you’re the type to always give people a break, you may just end up with tenants who don’t pay rent for months at a time. You’ve got to be willing to be the bad guy. You’ll have tenants who will call you up with all sorts of sob stories about sick children and lost jobs and you’ve got to be able to say, “Too bad. I still need the rent.” If your personality is such that you’re unable to be a real prick when the situation requires, then you’ll find this out when you’ve only got a small, easy to sell building that can be dumped fairly quickly.

Of course, if you find that you have no problems whatsoever being an asshole from time to time, you can always start looking at duplexes and apartment buildings then. Once you’ve perfected your personal system, you can start making some really decent cash.

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