The rule of real estate investment is that any profit is a good profit. But of course, you want to earn enough profit on your real estate investment that you can live a good life on that profit! Clearly $1 is better than $0 but is it worth owning a rental property for $1 of profit? Let’s do some math!
How much profit should you make on a rental property? When you are evaluating cash flow on a property, you must assure that your rental income will cover all expenses such as taxes, insurance, property management, and any debt you take out on the property. After you subtract those expenses, what is left over for you is your profit. Generally, at least $100 in profit per rental property makes it worth doing.
But of course, in business, more profit is generally better!
If you are considering purchasing a rental property, and want to calculate potential profit, here are some steps to take to get a handle on it.
How Much Rent Does The Property Make?
If the property has an existing tenant, you already know how much that property will make in rental income. If it does not, however, how can you estimate this?
A little homework will go a long way. You can use websites such as Rentometer.com, which gives you average rents by neighborhood. This is good for ballpark estimates but you should go one step further and ask a local realtor that specializes in rentals.
You may get a range for your potential rental, such as between $800 and $1000 per month. Use the lower number for your calculation to be conservative. That way if you make more, it is a pleasant surprise!
How Do I Know What Expenses Will Be?
You should estimate that 40% of your rental income will go towards expenses. This is assuming that your property does not need rehab repairs. If that is the case, that is beyond the scope of this post.
40% of expenses include property taxes, insurance, property management, and possible vacancies. It is a conservative number but again, we are being conservative on purpose here.
So is the other 60% Profit?
Not necessarily. If you are planning to get a loan on the property, the remaining 60% can be used to pay for the monthly mortgage payment. This means you should not secure a loan with monthly payments higher than 60% the estimated monthly rent.
So NOW is the remainder profit?
Yes! Whatever is left over after your 40% expenses and your mortgage payment is your profit. But it is also the profit that the government will tax you on so make sure you do not spend it all because the taxman wants his share of that leftover pie! The taxes you pay on this income is NOT the same as the taxes you pay on the property. Two different things so make sure you plan to have to pay BOTH. There are ways to lower your taxes as a real estate investor but those things are beyond the scope of this post.
Let’s Do A Sample Problem
Sure! Let’s play this out in real numbers so that it is clear. Let’s say you find a rental property that you can buy and the tenant in that property pays $1,000 per month. This means that the amount of money that property will make is $12,000 per year. You set aside 40% for taxes, insurance, management, and vacancy. That is $4,800. The remaining $7,200 plays out to $600 per month. If that is your profit, great! But let’s pretend there is also a mortgage payment of $300 per month on the property. In which case, your profit is now $300 per month. This is pretty great for one property! One property does not a millionaire make but it is a great start towards financial freedom!
So How Do I Know If It Is Worth It?
This is a harder question. It depends on the rest of your cashflow situation. Do you need that $300 to supplement your lifestyle? Or perhaps you have a high-paying day job and you want real estate to be a tax shelter. Real estate offers all manner of solutions to all manner of goals. But let’s assume you want to use that profit to live your real life right now since that is usually the reason one starts investing in real estate. In which case, the more profit the better, right? Duh!
So is it worth it then if your estimated profit per month is only about $100 per month? Generally, yes! Is it worth it if your estimated profit per month is less than that? I am going to say proceed with caution. If your estimated profit per month is $50, that profit can easily be eaten up by the following unforeseen circumstances:
- A city tax assessment whereby the city asks you to pay for some kind of municipal repairs such as a new sidewalk or sewage line. These do happen and can be expensive and what can you do about them? Nothing. All you can do is pay the bill. These obviously eat into your profit and they are annoying.
- Something expensive breaks in the house such as a water heater or roof.
- The city raises your taxes. You can contest your property tax but if you lose and are stuck with a high tax bill, this obviously will eat into your profit too.
- Your insurance premiums go up. This could also happen. Sure, you can shop around for a better price, and you should, but increased insurance costs cut into your profits.
Any of these things happening should not cripple your investment but if your profit margin is low, it can. That is why we suggest only doing investments that will cash flow at least $100.
What About Taxes?
Great question! You must remember that you will be taxed on that profit, whether it is $1, $300, or $600 per month. The taxes you set aside in your 40% was for property taxes. You as the owner will be taxed on the profit YOU make at the end of the year at your current tax rate.
Experienced investors know how to mitigate these taxes but if you are reading a post like this, you are not an experienced investor. You are most likely just getting started so take it one step at a time. Don’t get overwhelmed. But remember that real estate is an amazing tax shelter if you know how to play the game. Make a mental note to learn that next!
Alternatively, your business entity will be taxed at the end of the year at the business tax rate on the profits of the property if you are buying in an entity such as an LLC, which of course you absolutely should be! Either you are taxed or the business is taxed but someone is going to pay tax on that rental income. The government will be sure of it. So that $300 profit is no longer $300. It is $300 PRE-TAX dollars. Keep that in mind too.
Well, let’s assume you pull the trigger and now you own an investment property and you are making a profit of $300 per month, or $3,600 per year. That’s great but that is not enough to live off of, at least not in most United States suburbs and urban centers. But if you can do this once, you can do it again! One win begets the next and eventually, you will acquire enough of these that add up to something you can live off of! Maybe $300 doesn’t seem very exciting but it is a lot more exciting than $0, where you will remain if you don’t get started.
You can only build your investments, brick-by-brick, dollar-by-dollar, profitable investment-by-profitable investment. So do your homework, run your numbers, and do that deal and collect that profit! You can!
Ready To Build Passive Income Through Rental Real Estate?
Ready to talk about your goals? We're here to show you the tools and teach you the process to begin earning legacy wealth for you and your family.