* I am not an investment adviser or accountant. This post is for informational purposes only around the context of a hypothetical investment. Please consult a Registered Investment Adviser before making any investments.
There are a lot of variables that go into purchasing an investment property. To the uninitiated it might look like buying the house for a given price, collect the rents and calculate a return on investment. If it is above 8% it looks like a good deal and if we get any appreciation that is a bonus. Many people buy investment properties this way, at least their first one.
There are many other factors to consider both to your benefit and detriment, so it's important to know them all before choosing to invest. This article discusses investment properties that are one to four family residences. Once you get into larger projects, value and income is calculated differently which is for another day.
Rent is not as simple as looking at the market and multiplying an estimated rent by twelve. A major loss for investors in the single family space is vacancy. If you get a good tenant, they can stay there for years, but changing tenants is very expensive. When it does occur, you will usually end up with more than one month's lost rent. You will need to clean and update the unit to meet current market standards which generally comes with a significant cost. So not only will you be out the time of switching out the tenant, but you will also take on capital expense to upgrade the home.
Tenant screening is probably the most important thing you can do in order to provide stable income for a rental property. Multiple sources of income, good credit scores, and a low debt to income ratio are all good indicators to track. Plus it helps if you like the person and can get along with them.
For the purposes of this sheet, be sure to keep your vacancy rate 5-8%. You might get lucky with a 0% for a few years, but if you have two or three months missing during a transition, you just averaged out to 8% for those three years.
Each year you are likely going to have to raise rents by the amount of the tax increase if you live in a state with property taxes. So to maintain your returns, rents will always go up with taxes.
One of the fantastic benefits of investing in real estate is leverage though debt. So how much equity should you put into an investment property? Well it depends on your lender and your risk tolerance. You can make greater yield with lower equity, but your lender ends up taking on more risk since you have less skin in the game. There is also something psychologically nice about having no debt on a property. This is mostly a personal choice. The worksheet allows you to calculate the cost of a first and second lien position.
Annual expenses on a single family rental are often almost nothing or very expensive when you have to replace a mechanical system like the AC or a roof. Most of your expenses are going to be consumed when these long term repairs come along. I like to alleviate this by replacing or upgrading all of the major mechanical systems at the time of purchase. When you cook these high priced expenses into the purchase, you are more likely to be able to negotiate the price to cover them, plus you defer maintenance costs by many years which allows the property to appreciate substantially. So when they come due again, you have lots of equity t