Economics of Owning a Rental Property

Owning a rental property is a great way to hedge against inflation and create a steady cash flow. But it also comes with certain responsibilities, drawbacks and potential pitfalls to consider.

Initial Cost

The first step in ensuring a profitable endeavor is to buy a reasonably priced property. The recommendation for rental property is to not pay more than 12 times the annual rent you can expect to get. So how is the potential rent determined? This is where local knowledge and due diligence come into play. A mere snapshot of the here and now does not give a reliable picture, as a temporary dip in demand or a glut of newcomers to town can convey a skewed impression.

Ideally, the prospective landlord will have been following the rental market for some time and know the typical price range for the size of the unit he is renting out. Add in stand-out factors such as a great view, proximity to the local university and nearby public transit. It is also important to not be carried away with overly optimistic assumptions; setting the rent too high and ending up with an empty unit for several months chips away at the overall profit in a hurry.

Making the Purchase

Banks have considerably tougher demands for giving loans for investment property than homes bought for a person's primary residence. The simple reason for this is that people are less inclined to give up and walk away from their home if times get tough. Be prepared to pay at least 20 to 30% for a down payment plus the usual closing costs. It is also important to have the property thoroughly inspected by a professional and to have a lawyer review everything before signing.

Maintenance

The cost of ongoing maintenance depends on the age of the property, the tenants and how much you plan to do yourself. A newer building does not require much more than landscaping and fixing the occasional broken electrical outlet, while an older property will have more small stuff breaking along with big items such as roof replacements and major plumbing updates.

The type of tenant also impacts the amount of repairs needed. An apartment complex for 55-plus seniors is unlikely to be subjected to the same amount of damage as a residential house turned frat house for five college boys.

Doing your own repairs cuts down the cost considerably, but it also means being on call 24/7 for emergencies. Another option is to hire a property management firm. The management firm handles everything from broken toilets to collecting rent each month but it comes at a price; expect to pay about 10% of the gross rental income for this service.

Insurance, Taxes and Local Expenses

Tenant insurance only covers a tenant's belongings; the building itself is the landlord's responsibility, and that insurance may be more expensive than a similar owner-occupied home. The rental mortgage, insurance and a certain amount of depreciation are all tax deductible.

Research the local rules and ordinances. Some municipalities attempt to discourage turning homes into rentals by imposing exorbitant permit fees and various bureaucratic red tape. It is also wise to consider the likelihood of property tax hikes in coming years. A town in financial distress may hike taxes far beyond what a landlord can realistically charge in rent.