Rental property can be the ultimate income investment, bestowing all sorts of nifty benefits, such as monthly income, tax advantages, and a profit over the original purchase price on well-maintained properties. Over a span of several years, this can turn into a pretty sweet deal -- all for a 30% down payment, and a certain amount of sweat equity.
Before you can get to all the hard work and rewards, however, you will need to do some serious number crunching. Not only must you determine whether the property is an affordable and profitable venture, but you'll also have to make certain that you will be able to afford future expenditures related to maintenance and upkeep. To be successful in real estate investing, making friends with math is an absolute requirement.
Without further ado, here are two simple math formulas that will tell you very quickly whether that rental property you covet is a wise or foolhardy investment.
Income must equal outgo (at minimum)
Once you decide upon a likely candidate for purchase, you'll need some important pieces of information: the market rents for the unit or units, your probable monthly mortgage payment, and everything else. The last category includes expenses such as property taxes, water and sewer, and property and other insurance. If you will be including utilities in the rent, you'll need to know those costs, too.
For example, let's say you've found a two-family property in good condition that you feel you could afford with a monthly mortgage of $1,000. With market rents of $1,000 per month each side, your annual cost calculations will look like this:
|Water and sewer||500|
With annual rents coming in at $24,000 yearly, the affordability quotient is pretty high, and that extra $5,500 yearly income probably looks really swell. Before you begin shopping for a big-screen TV, though, there's one more math formula you'll need to apply to your prospective investment.
Reserve for replacement formula
Components wear out in rental units, just like in any home. Replacing a roof or heating system can be expensive, so you'll want to make sure you have some money set aside to cover these expenses, as well as durable items like refrigerators and carpeting, if the need arises.
This formula is fairly straightforward, as well -- merely take the "Replacement Cost New" of a certain appliance and divide by the life expectancy.
1 (100%) / Life Expectancy = % of RCN = annual reserve for replacement
Fannie Mae has an excellent landlord guide that lists the lifespan of various components for easy reference. Here's the formula, using the example of a mid-priced electric range at Home Depot:
$549/17 = $32 annual reserve
As you can see, adding up all the items with a finite lifespan and figuring out the cumulative annual reserve for replacement will eat into your yearly net profit. In addition, it is very unlikely that all components will be brand-new when you purchase your property, so the lifespan of each item will have to be adjusted according to its age -- which will correspondingly increase the annual reserve.
Of course, there will be other expenses, both expected and unplanned, that the average rental property investor will encounter, and it is always a good idea to make sure you keep money aside at the time of purchase for things like renovation costs and tenant search expenses. However, these two simple math formulas -- used correctly and consistently -- will place you firmly on the path to real estate investing success.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.