Don has been a real estate investor for more than 15 years. He has accumulated over 65 rental properties and participated in many other real estate investing activities. In addition, Don is an accomplished software developer with a Mater's Degree in Computer Science. This background ensures that he takes an analytical approach to real estate investing, and he routinely makes data driven decisions.
Landlord, the lord of the land. This word from Middle English certainly implies wealth and power, and many billionaires made their fortune in real estate. Many more landlords found a path to financial ruin.
Landlords can get rich, but the bulk of this wealth will be on paper for many years. If managed properly, the landlord can become wealthy over a long time. However, many risks are associated with owning rental property and being a landlord. Most landlords are in the middle, and many more landlords go broke than become wealthy.
The short answer is that a landlord can get rich slowly. Over time rents increase, property values increase, and mortgages are paid off. It may take decades to realize the wealth you are accumulating, and a misstep can leave you broke. This article will discuss the most crucial steps for becoming wealthy by investing in rental houses.
Buying and managing rental houses is an investing approach that is within reach of many people. In most cases, you can use a bank loan to make it easier to purchase the property. Over time, the rents will increase, and the loan payment will stay the same. This difference gives you a monthly income, and property appreciation builds wealth.
Paying the Right Price
You make money when you buy, or so the adage goes. It’s true. The amount you pay will affect your investment result as long as you own the property. You may never profit if you spend too much, no matter how well you do with the other aspects of your rental business. On the other hand, a great deal on the purchase can offset mistakes made down the road.
How much should you pay? That is not an easy question, but there is an answer. Studies have shown that, on average, operating expenses on a rental house are about 40% of the rental income. This leaves you with 60% of the rent as your profit. But wait! If you have a mortgage, you will have to make a payment out of that 60%.
Let’s take a look at the 1% rule, which states that your rent should be 1% of the price of the house. Indeed, rents are usually about 1% of the property’s market value, but you must avoid paying market value. My years of experience have shown that the 1% rule will not work for investors. You can’t control the rent, but you can control what you pay for the property. You should never pay more than 55 times the market rent for a rental property.
It’s always nice to get extra rent, but you can only rely on getting fair market rent. You need to base all your calculations and planning on market rent which, by definition, you should be able to get. Once you have a lease at market rent, you must ensure that you collect the market rent, which is more complicated than it seems.
It is imperative that you collect the rent each month and charge appropriate late fees when it’s not paid promptly. If you let a tenant get more than one month behind, it’s usually less expensive for them to move than it is to get caught up. Paying a deposit and the first month’s rent is generally less than the two months they owe, with late fees added.
I’ve been doing this for 15 years, and I have been awarded over 100 judgments for past-due rent and have collected $0 from these judgments. It is crucial that you collect the rent when it’s due. It’s better for both the tenant and the landlord to have
The landlord’s primary responsibility is to perform maintenance and repairs, and the tenant’s primary responsibility is to pay rent. As a landlord, do your part promptly, and don’t be a slumlord. However, make sure that your tenants perform their part
Talk about making sure all this works, then time gets you rich. Maybe talk about scaling.
For many years the 50% rule has been used to predict rental property operating expenses. This rule-fo-thumb has always been a guess, but now there is empirical research that shows exactly what this number is.
Research shows that the operating expenses of a single-family rental are 42% of the gross annual rental income. Therefore a property producing a rental income of $24,000 per year should have operating expenses averaging $10,080 per year. This excludes any mortgage payments and capital expenses.
This article will detail how these operating expenses are defined and how the average operating expense ratio is calculated. I’ll refer to academic papers and my own experience to determine the most accurate operating expense forecast. I’ll also share some data from my portfolio.
Why does the Operating Expense Ratio matter?
Positive cash flow is an essential aspect of owning a rental property. Sure, you may get some appreciation, and the tax deductions are a great perk, but without positive cash flow, staying in the game long enough to realize other benefits is challenging. Cash flow is what enables you to meet current and unforeseen financial obligations. The higher your cash flow, the easier it is to adjust to other challenges you face.
As a landlord, your primary threat to positive cash flow is your operating expenses. Many of these expenses occur over and over throughout the life of your investment. It would be best if you learned to estimate the operating expense you will encounter accurately. This article intends to present an accurate way to determine your long-term operating expenses and, therefore, your cash flow. The article will explain operating expenses and offer an easy formula for quickly estimating these expenses as a percentage of the market rent.
What are Operating Expenses?
Operating Expenses (OPEX) are the expenses that a business incurs through its regular operation. Single-family rentals include expenditures such as property taxes, insurance, management costs, and routine maintenance1https://www.investopedia.com/terms/o/operating_expense.asp. Operating expenses contrast with Capital Expenses2https://www.investopedia.com/ask/answers/112814/whats-difference-between-capital-expenditures-capex-and-operational-expenditures-opex.asp#:~:text=Capital%20expenditures%20are%20a%20company’s,%2C%20utilities%2C%20and%20property%20taxes., which are major long-term expenses such as a replacing a roof. As a generalized rule, operating expenses are tax deductible, while capital expenditures depreciate over several years (this is not accounting advice).
Below are some examples of expenses you are likely to incur. It’s not an all-inclusive list; some costs may vary based on the legal environment in a different area. The overarching goal of this article is to determine a simple and quick formula to estimate these expenses. After you have experience in this field, you can tweak the estimate to account for local variations.
A Property tax is an annual tax levied on the property’s value. It’s simple to calculate as most municipalities publish the rules and values yearly. You should be able to forecast this value accurately, but it’s included in our formula as a convenience.
Insurance will provide financial protection for your real estate assets and personal and business protection if someone is injured on your property. Many insurance agencies will give you a price quote, so this expense is straightforward to forecast.
Maintenance costs are the unpredictable expenses required to keep your property in good condition. This will repair broken windows, missing shingles, plumbing problems, electrical issues, and most problems that tenants report. In addition, this includes the cost of refreshing the property between tenants.
The management cost is the cost you pay for someone else to manage your rental property. This is often a combination of a flat fee and a percentage of the rent. As a general rule, I recommend you manage the properties yourself until you have a lot of experience and more than 15 properties.
What are Not Operating Expenses?
When owning rental property, you will have significant cash outflow that is not classified as an operating expense. Many of these expenditures have the devasting effect of reducing your bank account balance while not being tax deductible. Others may be tax deductible but are still not classified as operating expenses. After including the actual operating cost, you need to adjust for these other items before estimating your cash flow.
That’s right. A monthly loan payment is not considered an operating expense. Generally, the interest portion of a loan is an operating expense for tax purposes. However, this article does not consider mortgage interest as an operating expense. The principal amount of your loan payment will never be an operating expense. Just think of it as trading cash for equity. For every dollar you pay in principle, you receive a dollar in equity.
If you intend to have a mortgage on your property, the debt service will be a significant cash outlay. It may be the largest cash outflow that you have each year. Be sure to adjust the cash flow estimate to include this payment.
Capital Expenses can be thought of as home improvements. This includes things like replacing the roof or the HVAC system. Generally, from a tax perspective, these large items are capitalized and depreciated over several years. These are not operating expenses, but when they are needed, they will be costly. If large items are near their end of life when purchasing the property, but sure to factor in this high cost. In some cases, I go ahead and do the replacement immediately.
Advertising and Marketing your vacant property is not considered an operating expense for the basis of this article. Many landlords only put out a sign to attract tenants, while others run a considerable advertising campaign. This expense varies based on your approach and is not a cost associated with operating the property. If you plan extensive marketing, remember to adjust your cash flow figure.
Legal fees, such as the cost of an eviction, are not considered operating expenses for this article. Hopefully, it’s not a cost you frequently encounter with your real estate business. If it is, you should work on your tenant selection criteria.
How much are Operating Expenses?
Operating expenses are directly related to the property condition and how efficiently management runs the business. Some expenses, such as property tax and insurance, are easy to estimate in the short term. On the other hand, routine maintenance costs are primarily based on how efficiently management resolves issues.
After scrutinizing the research paper, I analyzed my current rental portfolio of 68 single-family rentals. I performed this analysis over five years and adjusted for the properties I no longer own. I found an expense ratio of 39.97%, slightly better than the 42% in the article above. Keep in mind that my analysis was over five years, while the paper used 28 years of data. I expect my expense ratio to approach that of the research paper as the time horizon grows.
As a third method for confirming the operating expense ratio, I pulled the last year’s operating expenses from my accounting package5. In August 2021, I changed accounting packages. I don’t readily have access to 2022 and previous years combined.. The table below shows my actual operating expenses for the year 2022. This shows that I had a 45% operating expense ratio, higher than my previous five years and the number predicted from the document.
I believe the reason for this expense increase is that I had a higher-than-normal tenant turnover rate in 2022. This was a result of the expiration of the recent eviction moratorium.
Total Operating Income
Total Operating Expense
Income Statement – Year Ending 12/31/2022
Real World Reality Check!
WOW! My net income for 2022 was over $400,000. This sounds impressive, but remember, this is just a calculation of operating expenses. As mentioned earlier, this doesn’t include capital expense and debt service. My capital expenses were nearly $125,000, and I paid about $276,000 in debt service. This left me with a cash flow of about $40,000 for the year, and I will owe taxes on a much larger number.
Using my data and the 2015 study by Andrew Demers and Andrea Eisfeldt, it’s safe to say that operating expenses are about 40% of the rent. This leads to a profit of about 60% of the rent. It should be stressed that this number is a rough estimate. However, due to the dynamic nature of real estate investing, it’s unlikely that we will be able to pinpoint a more accurate number. In some years, you will have many more expenses, and the costs will be lower in other years. If you stick with 40% of rental income, you should be close to the actual number over several years.
This paper fully described operating expenses and estimated what the operational expenses should average as a percent of the rent. It should be stressed that other non-operating costs are not included in this number. As mentioned above, debt service for a mortgage is not included in our operating expense ratio. In addition, capital expenditures will likely be needed over the life of the property, and they are omitted here. I used academic research and my data to determine the expense ratio estimated in his article.
How do you set the rent amount? Setting fair market rents is one of the first challenges a new landlord has with their rental house. That is a complicated process, but the best property managers follow these steps.
Find comparable properties in the same area., that are currently for rent.
Reduce this list of comparables until it only includes properties with square footage and the number of bedrooms and bathrooms.
Calculate the average rent for the comparables.
Adjust rent from the average based on amenities that your property offers.
These steps are simple to follow, and the challenge comes from accurately identifying comparable homes. Identifying the correct comparables is an essential skill that you must cultivate to manage rental properties effectively. The article will explain the best way to find these comparables to find the rents that are charged.
What is Market Rent?
Market rent, as defined by Law Insider, is the amount of rent that can be expected for the use of a property in comparison with similar properties in the same area. This is generally considered the amount of rent qualified tenants are willing to pay and that landlords of comparable houses are willing to accept. The fair market rent will vary between cities, neighborhoods, and even by the block. The rental amounts also vary based on house size, bedroom count, and many other factors.
Why Should Landlords Know the Market Rent?
While it may be nice to get excess rent on your property, all your decisions should be based on the market rent. In exceptional cases, you may be able to get rent above the market rate, but you should never rely on this to make a deal work.
Initially, knowing the market rent will help you set the rent when advertising to new tenants. You don’t want to start with low rent and then need to raise the rent on existing tenants to cover your expenses. On the other hand, it will be challenging to find a tenant if you ask too much for rent.
Later, when you have a long-term tenant, knowing the market rent will help you decide if it’s time for a rent increase. If you arbitrarily raise the rent over market value, your tenants can find similar houses at a lower cost. This increases the chance that the tenant will leave, and you will end up with a vacancy. If you keep the rent artificially low, you may have problems paying the property taxes or making timely repairs.
In cases where you plan to charge more or less than the market rent, you must have a baseline from which to deviate. When analyzing the purchase of the rental property, you must know the market rent to forecast revenue. Market rent is one of the most critical metrics for a rental property, and accurately discovering market rent is a valuable skill for any real estate investor. In the end, if you can’t get the market rent, you’ve done something wrong. After all, by definition, market rent is the amount you can get.
How Can You Determine the Market Rent?
The goal of determining market rent is simple; determine what similar properties in your area are renting for. Determining the market rent is more complicated. You should be able to zero in on the market rent by checking other properties offered for rent. Don’t forget that it’s essential to use data from similar properties, not just any nearby homes for rent.
A good starting place for finding the market rent is Zillow, which uses an algorithmic approach to estimating rents. Put simply, this means using formulas and existing data to determine what the market rent should be. Zillow will attempt to calculate the correct rent amount but will also give you a range of rents based on its formula. Ocassianly this value is off because of external factors that the algorithm is unaware of. In rare cases, Zillow may not have a value, and you will need to use one of the other methods.
It’s simple to get the rent amount from Zillow. You type in the property address, and Zillow will show you the rent amount.
The Zillow rent estimation will give you a general idea of what similar houses rent for. It can be easily used to disqualify a property if the rents are far from what is needed for the deal to work. If the number is close to a deal, continue with the other methods to zero in on actual market rent. Keep in mind that sometimes Zillow is skewed by an outlier.
When you are new to an area, you should check the asking rent for other houses. This is simple to do online with tools like Facebook MarketPlace.
When using the Facebook marketplace, narrow the search as tight as possible. Sometimes a rental in the next neighborhood rents for many times what your target property will rent for. In addition, use the filter to ensure you look at similar square footage and the same number of bedrooms and bathrooms. Remember, comps are comparables, so you want to find the houses that most resemble your target property.
Other sites, like rent.com, apartments.com, and realtor.com, can provide a similar service. I suggest trying them all out; the more data you have, the more accurate your number will be.
Know The Area
The best way to know market rent is to understand the area already. It will take some time, but once you have done this for a while and have a few rentals in the same area, you will know what the rents are. Hopefully, you have followed my advice about getting the maximum rent and instantly understand what a house can get in the area you work.
If you come across a lead in an area where you have several rentals, you will already know the market and can make a purchasing decision faster. Soon you will get to the point where you don’t need to check the other sources. This is especially true when you already have similar houses with the exact bedroom/bathroom count and square footage. You can always use the methods above when deviating from your area, but investing in the area you know is the best way to know what you are getting into.
How I Determine Rent
When I know the area, I use that knowledge first. I still check Zillow as a sanity check on my number and to note areas where the Zillow value may be skewed. Then I’ll check out what competitors are asking to ensure I haven’t missed a market change. If I have to go outside of my area of expertise, I determine rent using the methods above.