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Financial Figuring for Landlords: What’s the Most Important Thing In Rental Real Estate?

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People usually say there are three important things: “Location, location, location!”  But in rental real estate, it’s mostly just price.

The Economics of Real Estate

In any decision to purchase — any decision to invest — you always look at “what you get and when you get it” vs. “what you pay.”  But there are a few things you should keep in mind about real estate as an investment class, regardless of the rents you get.

The majority of costs for a rental property are related to the property as an asset.  They’re things that even brilliant management can do very little about once the property has been purchased.  They all scale with purchase price:

  • interest
  • real estate taxes
  • insurance premiums
  • base depreciation

Let’s take a typical property as an example.  The purchase price was $250,000.  Twenty percent was put down at time of sale, so the interest payment at 4% is about $8,000/year, or $667/mo.  Real estate taxes might be, say, as high as 2% of asset value per year, or $417/mo.  Insurance for replacement value might run you, say, $170/mo.  Base depreciation as a residential property, per the 2012 IRS tables, might be $5,000/yr, or another $417/mo.

Now here you might object, saying that depreciation is not cash out the door, so it shouldn’t count.  But it does represent a real long-term expense, namely, what you’ll need to keep putting into the place to keep it from falling apart.  Pricier properties generally need bigger budgets.

Add up all those expenses and you find that $1,671/mo of expenses have nothing to do with how well you manage the building as a rental property.  They’re just tied to the purchase price.

So you can see that if you buy the wrong property, a management strategy to reduce utility costs, avoid lawsuits, and get the best tenants will matter comparatively little at the beginning.  It can take long time for this cost avoidance to show itself on an income statement.

The moral is “shop around before you buy.”


4 Comments

  1. Brian says:

    Great article. I’m a firm believer that you make money in real estate by buying properties below fair market value.

    Here are some thoughts regarding how maintenance costs scale vs purchase price. I think it is useful to separate out average annual maintenance costs from the upfront costs (roughly the first 18 months of ownership) due to deferred maintenance from the prior owner.

    Take the following hypothetical properties, assume similar rental income from each

    A) $200,000 purchase price, estimated maintenance of $5,000/yr, property well maintained
    B) $190,000 purchase price, estimated maintenance of $4,750/yr, property has approximately 6 yrs worth of deferred maintenance.

    Without taking into account the lack of proper maintenance from the prior owner, B) looks clearly like a better buy. When accounting for the lack of upkeep, A) is likely a better buy.

    This deferred maitenance expense is often inversely proportional to the purchase price. Something that looks like a cash cow on paper can quickly turn south when you find that the roof replacement cost has doubled due to damage from extensive leaking, or that your basement is now a mold farm because the foundation has deteriorated.

  2. dougjq says:

    Brian, thank you for the comment! I agree completely. Those six years of deferred maintenance, taken care of in the first eighteen months, make your effective purchase price maybe 15% higher on the so-called “cheaper” property, depending on the time value of your repair funds.

    One of the risks here is not being able to spot the deferred maintenance. Sometimes it’s buried in the walls. More on that to come.

  3. […] about it another way, as a function of purchase price.  I wrote about this before, where I gave a similar example.  If your depreciation is continually outstripping your income, it […]

  4. […] previous article talked about how potentially $1,700/mo can be spent just on maintaining a $250,000 property.  As […]

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