What to Spend on an Investment Property VS. Potential Rental Income
Rental property can generate monthly income while building equity and appreciated value over time. Get-rich-quick success is rare in real estate investing, but rental property can be a sound investment when buyers act prudently based on thorough research and planning. Investing in real estate carries risks, and stakes are high. So it’s vital to understand — among other things — the relationships between a property’s purchase price and the revenue it’s likely to generate in the short and long term.
1 Percent Rule
Talk to anyone who knows about rental property investing, and you’ll likely hear about “the 1 percent rule.” It’s a simple exercise and a good place to start to figure out how much to pay for a property versus the rental income. Conservatively estimate monthly rental proceeds minus monthly expenses. Divide that number by the purchase price. The idea is to find a result near 0.01 or higher. For example, if you can rent the property for $1,500 a month, less expenses of $300, net revenue is $1,200 a month. Divide that by the purchase price, say $120,000, and you have 0.01 — 1 percent. The higher that number, the better.
Estimating the rental income can be tricky. Your rental has to be competitive with other rental properties in its market. Find out how much similar nearby properties are renting for and adjust for things that make your property more or less appealing to a prospective renter. For example, if your property has a hot tub for the renters’ use, that might add to your rental income. Take into account neighborhood desirability, proximity to schools, parking — anything that sets your property apart from others.
When estimating rental income and expenses, be sure to consider how many months each year your property will be vacant. Occupancy rates are highly variable by market area and demographics. The rental vacancy rate in a beach town might be much different from the rate in a ski resort. Retirement communities have different rates from college towns. Requiring renters to sign a lease can help stabilize the occupancy rate, but a lease is of little help if your renters lose their jobs.
Consider whether you’re up to the task of managing a rental property. It goes beyond collecting the rent once a month. If you’d prefer not to deal with a leaky roof, a faulty water heater or a broken window, consider hiring a property manager. Some real estate firms offer property management services, usually for a percentage of the monthly rent. If you go with a property manager, include that expense in your calculations. It will impact your quest for 1 percent.