Things You'll Need:
- Realtor
- Spreadsheet
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Step 1
For investment homes used as rentals, the rule of thumb is to charge around 1% of the purchase price as the monthly rent. For example, if an investment home is purchased for $150,000.00, then the monthly rent should be in the $1500.00 ballpark. Again, this a general rule. It also does not apply for more expensive homes, as larger homes tend to rent for between 0.8% to 1.0% of the overall prices due to the lower demand for large sized homes in the rental market. Enlist the help of a Realtor to pull rental prices for the area the potential investment home is located in to verify that a 1% monthly rental rate is feasible based on what homes are selling for.
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Step 2
Once the potential investment property has been identified, the next step is to analyze what repairs, upgrades and expenses would have to be put into the home in order to make it rentable. This includes bringing the home up to the state rental codes. State rental codes vary, however typically it is required to have smoke detectors in every room of the home as well as pass a certified home inspection process.
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Step 3
Next, check with several mortgage companies to understand the various options on investment home mortgages. Rates and closing fees vary drastically, so it is critical to shop around to get the best possible investment mortgage package. Also keep in mind that investment mortgages generally require more upfront funding (money down) in the range of 20% - 25%, and rates are usually 0.5% to 1.0% higher compared to primary residence mortgages due to the increase in risk for the mortgage company.
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Step 4
Gather details on the expected tax rate for the area the home resides in. Create a spreadsheet summarizing the costs (mortgage, taxes, upgrades, repairs, management company fees), and offset them by the monthly income obtained by rent. This will provide details on if the investment is cash flow positive or negative. If the cash flow is negative (expenses are greater than rental income), then it is wise to walk away.
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Step 5
If there is a positive cash flow, the next step is to understand the overall percentage the investment home would make based on money put into the home. Think of the home as a stock or bond, where money is put into the stock or bond, and return is made in terms of dividends or yields. An investment homes pays back money in several ways including rental income, principal accrual, depreciation of the asset over 27.5 years, and tax deduction benefits. Rental income and principal accrual are the basic pieces to take into account and are easiest to model. Determine the portion of your monthly mortgage payment that is principle, and the portion that is interest. Add the principle portion to your rental income. Now divide the sum of your rental income and principal amount for 1 year by the total money put into the home (down payment, closing costs, repair costs, etc). This will provide the overall yearly percentage return on money put into the investment home (ignoring appreciation of the home, tax benefits and depreciation over 27.5 years). Use this percentage as an indicator of how worthwhile the investment is or is not. For example, if a stock or bond has a dividend that pay 2.5%, and the investment property returns 6%, then it is clear the investment property is a better value.
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Step 6
Lastly, determine if the investment property should be managed by a management company or yourself. This depends on how knowledgeable you are on rental laws, and how much time you have available to spend on managing a rental property. Rental management companies charge between 6% - 9% of the monthly rental income. Factor in a rental management fee into your cash flow and percent return scenarios, and determine if it's beneficial or not.
