Unlike many investments, breaking even on a monthly basis is the immediate goal with rental properties.
As long as rental income covers outgo, most investors in these properties are happy. Rental properties are long-term investments, and current income is rarely the goal.
Instead, the goal is to find a renter – or renters, depending on the property – who will cover carrying costs while the investor takes advantage of tax breaks, write-offs and appreciation. Then, as mortgage rates stay steady and rental income increases, the investor will realize a positive cash flow.
If a property doesn’t break even from the start, you will have to cover the difference between rental income and carrying costs. The breakeven point means that the market rental rate covers the mortgage, interest and taxes, plus a 10 percent buffer for vacancies, repairs, maintenance and utility costs. Verify that this will be a sufficient buffer for your property.
To maximize the potential to break even, and to minimize vacancy rates, make certain you know market rates, vacancy rates and market demand in your area. For instance, if most of your tenants commute to work, is the property close to public transit? Is it in a good school district? Then purchase the property at a price that will allow you to rent at or just below prevailing market rates.
One way to find the breakeven price is the Duct Tape Formula, named because it patches together figures to find a workable number:
1. Take the current rent for the type of property you’re considering (e.g., $1,500).
2. Take the current interest rate (for example, 5.25 percent).
3. Add a factor of one (5.25 + 1 = 6.25), and put two zeros in front of this number (.00625).
4. Divide the number into the prevailing rental rate ($1,500/.00625 = $240,000).
So an investment property with a $240,000 sales price should provide a breakeven situation. If you put 20 percent down, you are left with $192,000 to finance. The $192,000 at 5.25 percent = $1,060 + $300 for taxes and insurance (check local rates) = $1,360 + 10 percent vacancy/repair buffer = $1,490. Therefore, there would be a slight positive cash flow ($10) for this property if rented at $1,500.
The formula relies on 20 percent down and works for owner-managed properties only. With more down, you can break even on a higher-priced property. If you don’t manage the property yourself, add 10 to 20 percent for property management fees.