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ContinueWe take a look at the different factors that go into determining how much profit you should make on a rental property.
Rental properties can be a great way to make passive income, but it’s important to know how much profit you should be expecting from your investment. Knowing how much of a return you can expect from a rental property will help you make informed decisions about your investment.
In this article, we explore the different factors that go into determining how much profit you should make on a rental property. We’ll discuss how to calculate rental income, expenses, and net profit. We’ll also provide guidance on how to achieve a profitable return on your rental property investment.
Rental property profit refers to the tangible cash remaining after each month's expenses are accounted.
It's crucial to differentiate rental property profit from taxable net income. This is because landlords can claim additional non-cash deductions which allow them to reduce their taxable income. One main example of this is depreciation which allows investors to deduct the value of the property (not including the land) against their taxable income over a period of 27.5 years.
The strategic use of real estate tax deductions enables certain rental property investors to minimize tax liabilities significantly and ultimately increase ROI.
Calculating how much profit you should make on a rental property is one of the first things you need to do to determine if it’s going to be a good investment in the long term. This involves taking into account the expected rental income, any potential expenses, and the associated tax implications.
The property’s cash flow, however, will ultimately depend on a number of factors, including your initial investment, the type of property and its location. For instance, a single-family home in a desirable neighborhood will likely generate higher rental income than a single-family home in a less desirable area.
A few other factors to keep in mind when evaluating an investment opportunity:
Related: 2023 Rental Property Analysis Spreadsheet [Free Template]
Rental property operating expenses are those necessary costs that come with owning a rental property. These expenses include things like mortgage payments, repairs and maintenance, insurance, taxes, payroll and marketing costs.
Mortgage payments are necessary to pay off the loan used to purchase the property. Taxes and insurance are necessary to ensure the property is legally compliant and protected from any potential liabilities. Repairs and maintenance are essential to keep the property in good condition and up to code. Payroll costs are necessary to cover the wages of any employed staff, and marketing costs are necessary for advertising the rental property and finding new tenants.
In addition, rental property owners may also incur additional operating expenses such as utilities, cleaning and landscaping costs, HOA fees, and other miscellaneous expenses.
Utilities are costs associated with providing electricity, water, and other services to the rental property. Cleaning and landscaping costs may be necessary to keep the property looking nice and well-maintained. HOA fees are applicable if the rental property is located in a community with a Homeowners’ Association, and may include dues and other charges. Miscellaneous expenses may include legal fees, accounting fees, and other costs associated with owning and operating a rental property.
As you may have guessed, while rental profits may be deemed passive income by the IRS, if yo want to run a profitable business there is a lot of work that needs to be done when it comes to managing your investment property and it's finances.
Accurately tracking all of your rental property expenses throughout the year will allow you to report them on your tax return to reduce your tax liabilities and increase profit margins. The easiest way to track and report tax deductions is to use free purpose-built software like Landlord Studio.
Related: A complete breakdown of your schedule e expense categories
One of the first things landlords need to figure out is how much to charge for rent. Having a cash flow positive business is essential if you want to expand operations, and this means having little to no vacancy. To do this, you have to set a price that is attractive to tenants while still bringing in the most money.
A few tips for working out how much rent to charge include:
There are several commonly used metrics used to calculate the return on your real estate investment and help you keep your property profitable over time.
Many real estate investors determine rental property profitability from the cash flow it generates. Cash flow is the amount of positive (or negative) cash that is left over at the end of the year after all expenses (pre-tax) have been paid. There are numerous factors that influence cash flow and investors should get a thorough understanding of all of the operating expenses associated with owning and running the rental property before purchase.
A few influencing factors include:
Investors and experts alike regard return on investment (ROI) as the most important aspect of evaluating the profitability of a real estate investment. It is generally recommended to aim for an ROI of 10-15%. However, the ROI that is considered “good” or “bad” is dependent on an individual’s financial standing and the particular property they choose to invest in.
For example, you spend pay $20,000 in closing fees and maintenance/repair costs and when the property is ready to hit the market, you charge your tenants $2,500 per month. If you divide your income by your expenses, your yearly ROI would be just over 7%
The widely used real estate investment metric of cash-on-cash return (CoC) measures the yearly return on an investment based on the cash invested and net operating income. This return rate may differ greatly depending on the financing method employed, e.g. cash purchase or loan. Generally, it is advised to strive for a CoC yielding between 8% and 12%.
The capitalization rate (also known as cap rate) in real estate is the ratio of net income to the purchase price of the property. To illustrate, a property worth $200,000 that is rented out at $1,500 monthly would give an annual net operating income of $12,000, which is equivalent to a cap rate of 6%. Whether this rate is beneficial or not depends on a variety of factors. For instance, a 6% rate may not be worth it if the neighborhood is not desirable or has a high risk or potential safety concerns. On the other hand, if the area is in high demand and the tenants are trustworthy, 6% can be a great return on investment.
The 1% rule is a helpful tool for investors to evaluate the viability of a potential investment property. The rule states that the monthly rent should be at least 1% of the total purchase price. For instance, if a property is bought for $300,000, it should generate a minimum of $3,000 in monthly rent. If market prices are lower than this or seem unreasonable, the investment may not be worth it. Additionally, factors such as size and location should be taken into consideration.
Whether you invest in commercial, residential, short term rentals or other assets, understanding the financial implications of owning a rental property is crucial for running a sustainable, profitable and professional rental business. This is why leveraging tools like Landlord Studio to track your rental property finances plays such an important role when it comes to informed decision-making, accurate tax filings, and maximizing end of year deductions.
Landlord Studio is a property management and accounting software designed specifically for real estate investors. Easily track your income and expenses with powerful automation features like bank feeds and smart scan receipts. Plus, streamline every aspect of your property management. Collect rent online, manage property maintenance, screen tenants and reduce vacancies and more. When it comes to tax time you can instantly generate any of over 15 accountant-approved reports, including your P&L and a specially designed Schedule E report.
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