How Much is Your Rental Property Earning or Losing?

July 07, 2016

One of the benefits of investing in stocks, bonds, and mutual funds versus in direct real estate is that it’s a lot simpler. A good example is when it comes time to answer a key question: how much money am I actually making or losing in this investment? With stocks, bonds, and funds, this is relatively easy because it’s all spelled out for you on your statement. You can see how much you’ve collected in interest and dividends and how much the investment has gained or lost in value since you purchased it. With real estate, it’s not quite so simple.

After a couple of years of owning rental properties, including having a few big repairs, an eviction, and vacancies that lasted for months, I decided to sit down and calculate what I was really earning (or losing). The good news is that 4 out of my 5 properties have a positive cash flow of about $200/month over the last 6 months, which is about what I expected when I purchased them. The bad news is that the last property had a negative cash flow of about $500/month since it was vacant during most of that time. (Fortunately, I have a tenant there now.) This netted out to a positive cash flow of about $300 per month.

I was glad to see I wasn’t in the red even with a vacant property, but that still didn’t look very encouraging. However, when I annualized it as a percentage of what I spent on the properties, it came out to be a 5% positive cash flow. If you’ve seen interest and dividend rates lately, that’s not too bad. With the tenant in the 5^th property, it would come to about a 17% return on cash. If you have rental properties or are thinking of investing in one, here are some of the factors to consider in determining the return on your investment:

Cost Basis: This is the upfront cost of purchasing the property (the down payment and closing costs) as well as the cost of any improvements you make. (Only some of the closing costs are included in the basis for tax purposes.)

Rental Income: This is the easiest part to measure. If you’re thinking about buying a property, assume a vacancy of at least one month per year.

Rental Expenses: This is the toughest part to measure and estimate. If you have a property, be sure to keep records so you can tally them up. Don’t forget to include the costs of advertising the property to prospective tenants and any property management fees in addition to the mortgage, property taxes, and insurance. You also need to separate maintenance/repairs from capital improvements since they affect your profitability (and taxes) differently. For prospective properties, maintenance costs tend to run 1-4% of the property value, depending on it’s condition.

Tax Breaks: In addition to non-improvement expenses, you can deduct mortgage interest, property taxes, and depreciation.

Cash Flow: Take your total rental income, subtract your expenses (including taxes on the rental income), and then add in your tax breaks. This is how much income you actually pocket.

Return on Cash: Take your annual cash flow and divide it by your cost basis. This is the cash return on your investment.

Total Return on Investment: Take your cash flow and add in any appreciation in the value of your property and reductions in the mortgage balance to get your total return. Then divide it by your costs basis to get your total return. This is the most fair comparison to your total return on other investments.

When you look at all the ways you can make money (rental income, tax breaks, and building equity), real estate can have some of the highest investment returns. (You can use this calculator to make the calculations above.) But with high returns, comes high risk. Sometimes those risks are obvious, but other times they come in the form of small costs that can add up to big losses over time. Make sure you do the math on any property to see if it makes financial sense to buy, hold, or sell.