“How much money can I earn?” is often the first question I get from people who are deciding whether to buy or turn their home into a rental property.
I’d argue that this is the wrong question to ask.
When you’re looking solely at how much money you’ll earn from a rental property, you’ll estimate how much you can charge for rent and how you can minimize property management expenses. These types of calculations are important, but they don’t offer a complete picture of how much value the property will create for you.
A better question to ask is, “How much wealth can I build with my rental property?” The answer to this question will give you a more comprehensive picture of your investment’s worth.
When calculating how much wealth you can build with your rental property, start by looking into how the following areas contribute to your wealth: net cash flow, mortgage debt and value appreciation. Below are a few guiding questions to help you get started.
What is your rental property’s net cash flow?
The most basic definition of cash flow is the amount of money you have coming in from a property each month, minus all of the property’s monthly costs. There are plenty of articles out there on how to calculate cash flow, so to avoid being repetitive, here are a couple of areas I’d pay close attention to:
First, make sure that you’re not underestimating your property’s expenses. Take into account every last bit of money you have to spend on the property — the mortgage payment, condo fees (if applicable), taxes, insurance and maintenance. When calculating maintenance, follow the 1% rule: Assume that 1% of each month’s rent will go toward maintenance costs, even though you likely won’t have to do maintenance every single month.
Second, it’s critical to charge market rate. Too often, I see property owners underestimate what their properties are worth on the rental market. Take time to make a list of similar homes near your property that have rented recently, and keep track of the rental rates. Make sure the properties you’re tracking are of similar size, number of bedrooms and quality to yours. That’s the only way to really know what the market is saying.
How fast are you paying down your mortgage debt?
If you decide to spend some of your rent income on paying down principal on your mortgage — instead of holding interest-only debt or no debt at all — then you’re building wealth with every monthly debt payment. To calculate how much money you’ll save in interest by paying down your rental property’s mortgage faster, MorgtageCalculator.org’s Extra Mortgage Payment Calculator is a good place to start.
For example, you can calculate that if you have an income property with a $500,000 30-year mortgage at 4.25% interest, and pay an extra $100 per month on the mortgage, you will save $33,287.22 in interest payments over the course of the loan. That’s more than $1,000 of interest savings per year on average.
What is the expected value growth of your rental?
This is one question to which I feel people don’t pay nearly enough attention. If your home is steadily growing in value each year, it not only means that you can charge more for rent. It also means you could be in a good position to leverage your property’s equity to purchase another rental property, or take out a home equity loan to spend on big life events.
When it comes to single-family and condo rentals, their value will go up in relation to similar units in the market for primary residences. Simple tools like Zillow or Redfin will give you a sense of how much your property will or has increased in value.
Often, value growth is the greatest wealth creator. Some properties are operating at break-even when you look at the cash flow, but the market they’re in is rising in value, and the net wealth created is equal to tens of thousands of dollars per year.
I’ll leave you with one final thought: The amount of wealth you build through a rental property is also dependent on the steps you take to maximize the value of your rental property.