Renting out property can be one of the best ways to make both passive and active income. And as with almost any other investment, high risk can lead to high reward, but how much profit should you make on a rental property?
Well, it is not so simple to answer the question.
The landlord should have a clear understanding of the market to undertake high-risk investments. But it is vital that they know it is likely that for a long period he or she will have to invest large chunks of money into the real estate before any real reward comes.
As such, it is important, as with any investment, to be patient and set your expectations realistically. If the landlord's investments are more down-to-earth, they may receive less reward, but likely much faster and their income may be steadier.
Therefore, it is up to you to decide what kind of investor you want to be. And if you were wondering how your profit levels will be determined, how much profit you are likely to receive, and what to look out for when considering investing in rental property, just keep on reading.
Firstly, let us introduce what we are talking about today- profit. In general, profit refers to a financial gain. In particular, it is the sum of money left over once all costs are subtracted from the income you, or a firm, have received.
In the case of rental property, rental profit, therefore, refers to the financial gain which remains after all the landlord's expenses are subtracted from the rental income they have received in a given period.
Before you can consider how much profit you make, considering what good investment even means is the first step. As already explained, higher-risk investments usually lead to higher rewards.
However, there are precise ways that are typically used to calculate your return on investment and help you keep the property profitable over time.
The two most popular methods for gauging profitability are Cash-on-Cash return and Capitalization Rate.
In this section, we will explain how these two methods work to help you to determine the profitability of your property.
Cash-on-Cash or CoC return is a metric widely used to calculate real estate investment profitability. Essentially, it determines annual return based on net cash invested and net operating income
Most experts advise for a CoC which lies anywhere between 8% and 12%. However, it is important to keep in mind that CoC will substantially differ depending on how you are financing your property. For example, whether it was bought by solely your savings or using a loan.
Definition Breakdown: Net Cash Invested: All the cash invested into the property, Net Operating Income: Rental income after operating expenses are deducted- this does not include interest rates and taxes
Another type of metric used to indicate the rate of return on investment is the capitalization rate.
It is calculated as net operating income divided by property value.
This metric type only accounts for the initial value of the property and does not account not for fluctuations of value over time as the market changes.
Or for additional expenses which will inevitably come as a result of owning property, such as repairs, and any other potential expenses resulting from the ownership of the property, i.e, mortgages.
Unlike CoC, there is no ideal capitalization rate as it largely depends upon the type of property and the market the property is within.
Therefore, use the capitalization rate rather as a helpful tool for deciding the possible potential of the property rather than a determinant of its actual profit rates.
Remember: However, keep in mind that this metric should be mostly used only as a consideration of the potential income of a rental property before purchasing it, rather than over time.
Although the two formulas mentioned are very good indicators to build an answer to the question; How Much Profit Should You Make on a Rental Property it is important to know that the potential level of profitability will still be dependent on numerous other factors.
Essentially, the profitability of the building will depend upon the expenses that come with being a landlord.
The rent you can charge will vary based on:
In this section, we will consider these additional factors in detail and add some tips on how best to indicate a profitable property.
Landlords typically tend to follow the 1% rule or the 1 rule in real estate as it is sometimes referred to.
Formula: Monthly Rent multiplied by 1% of Total Investment (including additional expenses, mortgage, etc.)
This has proven to be the general setting stone for an ideal rental rate within the real estate community, and many landlords follow it.
Of course, you should use it more as a guideline rather than a given formula, as your rental rate will also depend upon factors such as the location of the property, demand for it, rental rates of similar properties within the area, and many others.
When these are taken into consideration, the rate is likely to be anywhere between 0.8% and 1.1%.
You Should Know: Nonetheless, this metric is still vastly useful as it should help you create sufficient profit rates to have positive cash flow, cover all your expenses, and keep some of the income.
You should estimate that at least 40% of your rental income will be directed towards expenses on the property. These can include property taxes, insurance, property management, and any possible vacancies which are inevitable to crop up.
Now, do not forget that repairs or exchanges are always going to come up. Furniture, appliances, and decorations will face wear and tear and in some instances, your washing machine may break down. If you are to include this in your estimation, then the proportion of your rental income directed toward expenses will be even higher than the recommended 40%.
Keep in Mind: Repairs and changes will inevitably be needed, even if it's only a minor repair, try to account for those in your estimation of expenses.
Unfortunately, the expenses do not end here. There is likely to be another set of expenses that are not connected directly with the property itself.
You probably purchased the rental property using a loan, and thus there will be a set of monthly mortgage payments which need to come from the leftover 60% of the rental income.
However, if you have purchased the property using your savings, there is no need to worry about this part.
Now that we have established how to determine whether a property has the potential to be profitable in the first place, let's look at how much profit you will receive.
Let illustrate this with a step-by-step example:
After this is all added up, you can see that even a smaller profit per month can generate a large amount over time.
Building upon this, you might be questioning whether investing in real estate is worth it for you. However, only you can know this as it depends on the rest of your cash-flow/income situation.
It also depends upon how you want to use the investment, whether solely for profit to add to your income, use it as a source of your main income, or perhaps as a tax shelter if you are already in a high-paying job.
Lets say you would be using the given rental income as a source of additional income. Well, in that case, one can generally say that profit below $100 per month is arguably not worth it. You might think to yourself but why?
Surely any additional income is always good?
Well yes, but, when you take into consideration the unexpected expenses that come into play, then making below $100 per month may not help to cover those expenses.
The likelihood that something will break or end up needing a repair in the property, whether it be water or an appliance you need to have funds to counter for these defects.
Even if there are no major damages, fees on the property may increase, such as property taxes you have no choice but to pay- if you wish to keep your property.
However, profit above $100 per month is arguably worth investing in - $1,200 is still a sizable annual passive income.
Bear in Mind: Investing in real estate properties is solely your responsibility and is not a one-off expense.
As with any investment, being patient and setting your expectations realistically is the first step you need to take before anything else.
As there are multiple factors to bear in mind when trying to grasp- How Much Profit Should You Make on a Rental Property? , the returns you make from real estate investment may vary from one rental property to another.
Remembering to consider things like the location of properties, condition of properties, and demand for properties are some of the key aspects that can cause a variation in the amount of profit generated.
Keep in the forefront of your mind, that rental property investment is not a speedy process to generate massive profits. It's a slow process, so set yourself a clear plan and define your goals and stick to it.
Things may not go to plan the first time around, so jot down your mistakes, learn from the experience! If you are ready for your next adventure, then pick out your next real estate deal and you'll see the improvements!
Profit is the financial benefit gained from an activity like, renting out properties, that surpasses the expenses, taxes, and costs involved in the activity.
In general, there are two main metrics used to determine the financial potential of a property: cash-on-cash return and capitalization rate.
The first refers to the annual financial return of a rental property based on net cash invested and net operating income.
The second metric is capitalization rate, which refers to net operating income divided by property asset value, and is expressed in percentage terms.
Both, however, only point to the potential of a property and other factors will influence property profitability.
The general rule is that a landlord should charge around 1% of the total sum they have invested into the property per month. However, based on different circumstances, this usually varies anywhere between 0.8% and 1.1%.
You should count that at least 40% of your rental income will be directed towards expenses on the property- which does not include mortgage payments and any unexpected costs from repairs
And as profit is calculated by subtracting total costs from the rental income received, your profit levels are not likely to exceed 60% of your total rental income.
Generally, anywhere below $100 of profit per month is not worth investing in. This is because if any unexpected costs occur, you might not only have to spend all your profit on the costs but may end up enduring a loss.
When it comes to profit levels above $100 per month, whether investing in rental property will end up paying off is largely dependent upon personal circumstances and the purpose of the rental property.
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