Question about income from rental properties

49 Replies

I have a quick question regarding income from rental properties. I am a completely newb as of now, and am trying to learn what I need to learn before I get into anything. I am in Northern VA, and I am looking at possible buying a rental property, or two if possible, in Raleigh, NC. I have family down there, and it's not that far of a drive if I have to go down.

My question is, how much money, in amount or percentage, do you aim to make each month off the property?

I've been looking through a few properties just to get a feel for them. For example, there is a 3 bedroom, 3 bathroom, 1600sq/ft house for sale in Northern Raleigh for $140,000. Lets say I can snag it for $130,000. Mortgage ends up being around $850 a month, including property tax, depending on what I put down. House is in good condition, little or no repairs need to be made. Based on houses in the same neighborhood, with almost exact specs, they rent for around $1,250 a month. So if I rent it out for $1,250, and pay $850 in mortgage, that is $400 in income a month. Is that considered good? Bad? Average? I know there are other expenses, I read briefly about the 50% rule.

Am I close here, or am I way off? What is an average situation?

So if I rent it out for $1,250, and pay $850 in mortgage, that is $400 in income a month.

On such a rental you are not making anywhere near $400 a month.  That number, $400, is what I call "phoney cash flow".  It only accounts for debt service (the P&I part of your payment), taxes and insurance.  You will have many, many more expenses.  Maintenance, vacancy, legal fees, CPA fees, utilities, capital expenses (roofs, appliances), and many others.  Property management, too, if you use a PM. There's a sticky thread that talks about the "50% rule".  That rules of thumb says 50% of your gross scheduled income will go to expenses, capital and vacancy.  From the remaining 50% you have to cover your debt service.  So, an estimate of true cash flow is rent/2 - P&I payment.

Now, property management is a big expenses and if you do that job yourself you can earn that cut.

My goal is to earn at least 10% cash on cash return after accounting for all my up front investment and assuming I will use a PM.  That's a very tough goal to achieve here in the Denver area right now.

That is exactly what I wanted to know. So if most of that get's eaten up from other expenses, how do you make money renting? By eventually selling the house?

It will depend on how much you put down (it often does).  If you put 25% down that gives you a loan of $97,500 on a $130,000 property.  Your Princ and int would be just under $500 bucks.  Using the 50% rule (a rule of thumb) you should cash flow about $125 off of $1,250 in rent.  or about $1,500 a year.  

Since you are going to have to pay closing and rehab costs of at least $7,500 more your total invested would be over $40,000.  So your cash on cash return would be 3.75%.  I shoot for at least 15% with an additional 5% coming from principal paydown. 

I suggest you start looking for properties that rent for something approaching 2% of the cost of the house and 1% at the absolute minimum.  

@Mike Sheppard  you make money when you buy. If you purchase a property cheap enough your payments go down so you make more money. You also make money by having tenants pay down the principle and through the escalation of property values and rents. Know that most properties won't make you 10% cash on cash like @Jon Holdman  looks for. If those properties were everywhere there would be no need for BP. Also the 50% rule can't be found in a number of markets. You have to figure out what works for you.

I have to disagree with @Bill S. that "the 50% rule can't be found in a number of markets".  I would agree with the statement that "in many markets, you cannot find any profitable rentals after you account for the true expenses, aka 'the 50% rule'".  Expenses, capital and vacancy will be whatever they will be.  The 50% rule is simply a rule of thumb that allows you to estimate them.  From data sets that have been provided in the past it appears to be a pretty good rule of thumb in most markets.  For any particular property in any particular year they could be somewhat better (hard to avoid taxes and insurance) or may be a LOT worse.  But if you reject the 50% rule and assume taxes and insurance are your only expenses you will fail as a landlord.

My 10% goal is based simply on alternative investments.  I can put cash into making hard money loans to rehabbers and earn 10% or a bit better.  So, if the choice is to make a hard money loan or buy a rental that's cash flow break even, which would you choose?

I'll even go so far as to say most properties make crummy rentals.  Its hard to find areas where you can buy profitable rentals.

Now, the situation is more complex than just the cash flow you get up front.  Over time the value of the property generally increases.  Rents tend to go up, as do expenses.  Assuming you don't refi and take cash out your P&I payment stays the same and eventually goes to zero.  So, even if cash flow is break even or negative there may still be upside on a sale or over the long term.

Okay that makes sense. So the real money of buying a rental does not come from rental income, it comes from the renter paying the mortgage down. It sounds like I will need more than 5% down to have a chance of breaking even. And it seems the most important part is to find and make a good deal. The better the deal, the more the profit when the house gets sold.

Is this a good place to start for a new investor like me?

I ultimately would like to work my way up to apartment buildings and office buildings. That takes some serious cash and I don't know where to start...

I have another question for you guys if you don't mind!

If I buy a rental, and it pays for itself, even though I make little or no money off rent, would a bank allow me to buy a second one? How does that work?

For example. Based on my income let's say I can only afford ONE $200,000 house. I buy that house, rent it out, and break even every month. Technically the renter is paying for the house, I'm not having I spend any of my own money on it outside of random major repairs and what not, and possible vacancies, which I will have money set aside for anyways. Would a bank loan you more money to buy a second one even though you couldn't afford it if someone wasn't renting the house?

Sorry if that question is unclear. Having a hard time phrasing that the right way.

Originally posted by @Mike Sheppard:

I have another question for you guys if you don't mind!

If I buy a rental, and it pays for itself, even though I make little or no money off rent, would a bank allow me to buy a second one? How does that work?

For example. Based on my income let's say I can only afford ONE $200,000 house. I buy that house, rent it out, and break even every month. Technically the renter is paying for the house, I'm not having I spend any of my own money on it outside of random major repairs and what not, and possible vacancies, which I will have money set aside for anyways. Would a bank loan you more money to buy a second one even though you couldn't afford it if someone wasn't renting the house?

Sorry if that question is unclear. Having a hard time phrasing that the right way.

If your W-2 income was high enough sure, but that rental would count negatively for you. The lenders will look at you debt to income ratio (DTI). So say you make 100K/yr and you have 30K/yr in debts you have a 30% DTI (over simplified but you get the idea).

So let's use that same DTI and see what happens when you buy this rental. This rental will increase your income by 15K/yr and your debts by 15K/yr (break even). So now your income is 115K/yr and your debts are 45K/yr giving you a DTI of 39%. This would likely make you unlendable as trying to add any more rentals would put you over lender's DTI limits.

Depends on the bank, so call around - I have heard everything from 36% cap on the DTI to 38% to 42% (though that was when banks were lending to any "warm bodies" several years ago).

Thank you. I guess I am going to have to really learn and think about this. Rental properties don't sound too promising.

I have a question for you. What are your goals. What is the end goal and how long do you have to achieve it. Rentals is a "long term" game.

Originally posted by @Mike Sheppard:

Thank you. I guess I am going to have to really learn and think about this. Rental properties don't sound too promising.

 They can be extremely promising you just have to find the right area to invest in.  Believe me there are areas where you can get 15% or greater cash on cash while paying down the mortgage and having a good chance at appreciation.  Add in the tax advantages of depreciation things get even better.  

Do you know how good of a place Raleigh, NC is for investing right now? That is where I was looking at.

Sorry I don't know that market, but I'd bet there are at least a few areas where you can do well, especially if you are willing to rehab a foreclosure.  You could even do that closer to home in PG in the right areas and make some good money, whereas in Arlington or Fairfax you probably could not unless you went to a combat zone.  

Are you sure you want your first investment to be so far away? I guess unless you already planned to have a property manager.

If you want to make profit from day one, then you need to be sure you include all expenses (as discussed above). You need to know what that property can rent for in that neighborhood. Do you know the neighborhoods of Raleigh really well?

Next, it's very important to have a max number you're willing to pay for the place. Also be sure to consider property taxes...they make a big difference and if they are high, it can cut deep into cash flow.

Do you have a thorough lease prepared already? (Or if you'll have PM, guess it wouldn't matter as much).

Like mentioned, shop around different banks. I had to talk to a few banks before I found mine. I just did my 3rd deal with them and have been in business officially since 2012...not very long. We decided to form a LLC for our rentals.

Research and be prepared, but don't spend years doing it. You'll truly learn once you jump into the action!

Originally posted by @Nicole W.:

Are you sure you want your first investment to be so far away? I guess unless you already planned to have a property manager.

If you want to make profit from day one, then you need to be sure you include all expenses (as discussed above). You need to know what that property can rent for in that neighborhood. Do you know the neighborhoods of Raleigh really well?

Next, it's very important to have a max number you're willing to pay for the place. Also be sure to consider property taxes...they make a big difference and if they are high, it can cut deep into cash flow.

Do you have a thorough lease prepared already? (Or if you'll have PM, guess it wouldn't matter as much).

Like mentioned, shop around different banks. I had to talk to a few banks before I found mine. I just did my 3rd deal with them and have been in business officially since 2012...not very long. We decided to form a LLC for our rentals.

Research and be prepared, but don't spend years doing it. You'll truly learn once you jump into the action!

 The problem with where I am at now, the DC metro area, everything is so expensive. If you go into the cheaper areas around here, the crime is high. I've been to Raleigh a few times. It's a pretty nice area. It seems to be growing pretty rapidly with new construction and what not. And I have family down there. In fact my uncle is renting to live down there after he lost his house in a divorce. There's always the chance even he could rent the house from me. But that is all speculation and nothing that I am counting on. And the prices are much more do-able for me down there. If I could get a house for $150,000 down there, I could still afford to live up here. But if I got a house up here, it would be far away from my work and I would have to live in it.

I definitely want to jump in and get going. I've got some things I need to take care of first, such as pay off some debt, save up some more for a down payment/closing costs/reserve money. etc. In the mean time I want to get my head fully wrapped around what I am getting myself in to.

Mike, We love the Raleigh area and hope to invest more there in the future.  We focus on single family detached, 3 bdrm, 2+ bath in decent neighborhoods so hopefully we'll have appreciation as well as rent increases going forward, and they should remain easy to sell if needed.   We've found NW Raleigh and Cary to be way out of reach for us cash flow wise, at least the ones we've seen, but NE and SE Raleigh have nice little areas if you spend some time there scoping them out to find out which are appropriate for what you're looking for.   Ours meet the 50% rule, but definitely not the 2% rule.  Since you have family there, they can probably be a great help when looking for nicer neighborhoods in cheaper areas, and, more importantly, which areas to avoid.   While they do cash flow positive right now, our main goal is retirement income later and passing them onto our children, so if you're looking for huge returns now, Raleigh is not likely the place unless you are local and can jump on cash buys that need some rehab.  

@Lynn M.  That is great to hear. I am planning on going down there within the next month or so to scope the area out and educate myself some more. Maybe try to link up with a realtor.

@Mike Sheppard  

 have you read the newbie guide that BP provides? Information overload when I read it took me close to a week to actually get through it then a few more weeks to actually retain all the information.

https://beta.biggerpockets.com/real-estate-investing

So I'm putting an example together for myself right now. I looked through listings in SE Raleigh. I found a decent 3bd 2br house listed for $95,000. Let's say I make an offer of $90,000 and they take it. I put 20% down, which brings my loan amount down to $72,000. At 5% interest I'm looking at $387 per month. Based on other houses in the same neighborhood, with near identical specs, rent would be around $1050 per month. So using the 50% rule,$525 would be put away and used to pay property tax at the end of the year, along with repairs, management (if used), insurance, etc. The remaining $525 would go towards the mortgage, and the left over of $138 is cashflow.

Is this a pretty accurate representation of an ideal situation?

Originally posted by @Andy Robison:

@Mike Sheppard 

 have you read the newbie guide that BP provides? Information overload when I read it took me close to a week to actually get through it then a few more weeks to actually retain all the information.

https://beta.biggerpockets.com/real-estate-investing

 Andy, I have been making my way through it for the last couple of days, yes. There is some great info in there for sure! This thread is pretty newbie I will admit, but the ones who are successful are the ones who asked questions! (I hope) haha

What are the yearly taxes on that house you're using as an example? Do you know what insurance runs per year there?

Originally posted by @Nicole W.:

What are the yearly taxes on that house you're using as an example? Do you know what insurance runs per year there?

 Based on Raleigh/county tax combined I estimated about $700 per year on property tax. And about $725 in annual insurance. So that is $1,425. $525 left after mortgage payment totaled for 12 months is $6,300. Which leaves me with $4,857 a year for all other expenses. 

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