Cash Flow From Rentals
Cash flow is the amount of money that a property brings in and the amount you have to pay out for expenses. Some homeowners-turned-rental-property-owners can't cover all the costs associated with rental property. In the worst cases, such property owners end up in personal bankruptcy from the drain of negative cash flow (that is, expenses exceed income). In other cases, the negative cash flow hampers people's ability to accomplish important financial goals such as saving for retirement or helping with their children's college costs. Before you consider becoming a landlord, make some projections about what you expect your property's monthly income and expenses to be.
On the income side, determine the amount of rent you are able to charge by taking a look at what comparable properties are currently renting for in your local market, checking out the classified ads in your local paper(s), and speaking with some leasing agents at real estate rental companies. Be sure to allow for some portion (around 5 percent per year) of the time for your property to be vacant -- finding good tenants takes time.
On the expense side, you have your monthly mortgage payment (of which we're sure that you're already painfully aware). And, of course, you have property taxes. Because you probably pay these expenses just once or twice yearly, divide the annual amount by 12 to arrive at your monthly property tax bill.
- You may end up paying some or all of your renter's utility bills, such as garbage, water, or gas. Estimate from your own usage what the monthly tab will be. Expect most utility bills to increase a bit because tenants will probably waste more if you're picking up the bill.
- Be sure to call your insurance company to inquire about how your property insurance premium would change if you convert the property into a rental. As with your property taxes, divide the annual total by 12 to get a monthly amount.
- Don't forget repairs and maintenance. Figure that you'll spend about 1 percent of the property's value per year on maintenance, repairs, and cleaning. Again, divide by 12 to get a monthly figure.
- Finding good tenants takes time and promotion. Rental brokers, if you choose to list through them, normally take one month's rent as their cut. If you advertise, estimate at least $100 to $200 in advertising expenses, not to mention the cost of your time in showing the property to prospective tenants. You must also plan on running credit checks on prospective tenants.
Estimated cash flow
Now, total all the monthly expenses and subtract that number from your estimated monthly income after allowing for some vacancy time. You've just calculated your property's cash flow.
If you have a negative cash flow, you may actually be close to breaking even when you factor in a rental property tax write-off known as depreciation. You break down the purchase of your property between the building, which is depreciable, and land, which is not depreciable. You can make this allocation based on the assessed value for the land and the building or on a real estate appraisal. Residential property is depreciated over 27 1/2 years (3.64 percent of the building value per year). For example, if you buy a residential rental property for $250,000, and $175,000 of that amount is allocated to the building, that allocation means that you can take $6,370 per year as a depreciation tax deduction ($175,000 X .0364).
If you've crunched all these numbers and are still interested in renting your property, be sure to read the section dealing with the tax consequences of converting your home into a rental property.