When thinking about renting their house, most homeowners tend to overestimate the profit they stand to make. Often, their estimates are well-intentioned but are misinformed on what it really costs to own and operate a rental home. That’s what this article is for: to help homeowners calculate an accurate estimate of how much money they will make so that they can decide if renting their house is worth it.
What’s in it for you
Homeowners considering renting their home often make a costly mistake in thinking that their profit is what remains after paying the monthly mortgage. This could not be further from the truth. Rental home profit is the money that’s left over after subtracting the mortgage and all other expenses from the rent received. Often, this can be a negative number which means you’re paying money out of pocket each month. Perhaps having to feed your rental a few hundred dollars each month is worth it, especially if it's in an area that is expected to rapidly appreciate. If you’re like most rental homeowners, however, the thought of losing even $1 per month is objectionable. To ensure that this doesn’t happen to you, it is helpful to understand 2 simple concepts: the 1% rule and the 50% rule.
This rental real estate rule is quick and easy math that most folks can do in their head and it gives you a fairly accurate estimate for how much cash flow your rental home will generate. In short, the 1% rule of rental homes states that the monthly rent should be no less than 1% of the home’s purchase price plus the cost to get the rental ready for tenants (total home price).
The logic behind the 1% rule in real estate is twofold. First, rental home’s that meet the rule have a greater chance of producing positive monthly cash flow. Second, rental homes that meet the 1% rule results in an annual 12% return on your money. Not too bad, right? Hold on, this is where the 50% rule can help.
The 50% rule for rental homes states that approximately half of rent will be lost to expenses not including the mortgage payment. For instance, if a home rents for $1,000 a month, approximately $6,000 of the $12,000 that you collect in rent is lost to expenses before even subtracting the mortgage payment. Therefore, rentals that meet the 1% rule result in an annual return of 6%, not 12%. Expenses could be less, but they certainly also could be more (which, for older rentals, you can count on). You can hope and pray and even plead with your deity that your rent house will be a cash-cow but with Good Vibes Homebuyers having owned dozens of rental houses throughout central Texas, understand this: no matter your situation, the 50% rule in rental real estate is unwavering. Just as important, the 50% rule of real estate rentals also means that the monthly mortgage payment must be less than 50% of the monthly rent.
The bottom line is: if your rental home expenses or mortgage payment is higher than 50% of the rent received, you’re all but guaranteed to lose money each month.
The typical costs associated with owning a rental property include vacancy, capital expenditures, repairs, taxes, insurance, and property management. An easy way to remember common rental home expenses is the acronym V.C.R.T.I.P. Who needs a TIP about VCRs, right? You do if you want to accurately project how much cash flow your rent house will produce!
Vacancy is the times where your rental is not occupied by a tenant and it can vary, however, it’s commonly projected at 5% of the monthly rent. Capital Expenditures are rental home expenses that exceed $2,500 and are often for big-ticket-items like replacing the roof, HVAC, and repairing the foundation. Anticipate CapEx costs to be around 7% of monthly rent. Repairs include ordinary fixes like unclogging a toilet, stovetop and fridge repair, and replacing fixtures. Experienced investors and savvy homeowners alike expect repair costs to be 8% of monthly rent. Property taxes vary by location, but a common tax assessment is approximately 13% of monthly rent. Insurance coverage is a must and is for catastrophic occurrences like flooding, fires, and hail damage. Insurance on rental homes is normally 7% of monthly rent. Property management finds tenants, handles their complaints and work orders, and represent rental owners in legal proceedings (e.g., evictions). Property management averages 10% of monthly rent so if you’re self-managing (not recommended), it’s fair to assume a 40% instead 50% rule.
Add together V.C.R.T.I.P and the common costs of owning a rental home total 50% of monthly rent without even subtracting the mortgage payment!
The cash flow on a rent house is calculated by subtracting all expenses (V.C.R.T.I.P.) and then subtracting the mortgage payment.
Using the earlier example of a home that rents for $2,400 a month, the formula for cash flow looks like:
$2,400 (Rent)
$1,200 (Gross profit)
-$500 (Net monthly profit)
Yikes! You’re having to feed your rental property $500 every month! That doesn’t sound great, so, let’s assume you’re going to self-manage (10% savings) plus be risky in projecting your expenses at 35%. So, you lower your CapEx and Repairs from 7% and 8% to 5% each. Here’s how you would calculate your rental house cash flow now:
$2,400 (Rent)
$1,560 (Gross profit)
-$140 (Net monthly profit)
As you can see, your rental still isn’t cash flowing. You’re instead losing between -$1,680 and -$6,000 every year! That’s not a good plan nor is it a good way to build wealth. Important to note is that 35% expenses on a rental property is extremely low and is almost impossible. Things that could make it possible, however, are a combination of the following factors: (a) new property, (b) older rentals that have been fully renovated recently, (c) low property taxes, and (d) low vacancy rates.
1. How can I figure out how much my house will rent for?
We use RentRange.com and have found it to be very accurate. It costs about $10 per report. Online sites like Zillow’s Rent Zestimate can also supply cursory insight to help you decide if you should stop or continue researching the cash flow your rental house might generate.
2. Are there reasons to keep a rental home that loses money?
Few single-family rentals cash flow during the first 5 to 7 years. People keep, however, investing in them. So, of course there are other reasons to keep a rental home that loses money. They include property appreciation and tax deductions for depreciation and the interest paid on the mortgage. Trading your cash today for the hope of the property’s value appreciating tomorrow is really the question you must answer when deciding if keeping a rental cash flow loser is worth it to you.
3. What’s another way to evaluate my return on renting a home?
Savvy investors often evaluate an investment based on its “cash-on-cash return”. Simply written, the cash-on-cash return is the ratio of your rental home’s cash flow compared to the total amount of cash you have invested. For instance, let’s say you bought a rent home for $300,000 and put down 25%. Your cost wasn’t $300,000. It was $75,000. You then calculate your cash flow and estimate that it’s (surprisingly) positive $1,200 annually ($100 per month). Your cash-on-cash return is 1.6% ($1,200 yearly cash flow / $75,000 down payment = 0.016).
Perhaps all the cards are aligning in your favor such that renting your house will result in positive monthly cash flow. Perhaps instead you’re understanding the costs and risks of owning a rental and are realizing that you have a greater chance to lose money than you do to make money. Either way, you have nothing to lose by contacting Good Vibes Homebuyers to see how much we can offer. We provide owners with multiple ways to sell a rental house and there’s no risk or obligation so reach out to us now!
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