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Is rental property right for you?

Would-be landlords should study the local market and run the numbers before buying

Last reviewed: September 2011

With today's low real-estate prices and mortgage rates, is this the right time to invest in rental property? It could be, though being a landlord can be a challenge even in the best of times. So before you jump on any seemingly excellent buys on rental property, it's important to understand your local real-estate market and analyze the deal to see what it would cost you under the worst-case scenario.

"Statistics are the key," says Susan Kaplan, a certified financial planner in Newton, Mass. "You must get data on vacancy days of comparable properties, length of time in tenant turnovers, rental rates in your community, and general demand. A property might be priced low because rentals are down in that area."

Crunching the numbers

To give a simplified example, suppose you see a well-maintained house that the current owner has put up for sale. By doing some online research and checking with the local landlords' association, you determine that comparable homes in that area rent for about $1,500 a month. You expect to be able to charge the market rent.

"As a convenient, easy formula, you can expect positive cash flow from an investment property if the monthly rent is at least 1 percent of the purchase price," says William Jordan, who heads a wealth-management firm in Laguna Hills, Calif. With a monthly rent of $1,500, you could pay $150,000 for a house and have more income than outflow. If the current owner is asking $140,000, the house might be worth a closer look.

If your goal is to maximize cash flow and you have ample liquid assets, you might want to do an all-cash deal. If you laid out $140,000 for the house and received $18,000 in annual rent, your investment would return nearly 13 percent. Even if property taxes, insurance, landscaping, repairs, and so on cuts your net cash flow in half, you'd still have a positive cash flow return of about 6 percent.

If you can't swing an all-cash deal and need a mortgage, your calculations become more complex. Assuming you have a solid credit history and a bank's appraiser agrees that the property is worth the asking price, in today's lending climate you'd probably have to make at least a 35 percent down payment and take a mortgage of 65 percent or less. "For investment property, your mortgage rate might be 2 percentage points higher than the average for owner-occupied homes," says Greg McBride, a senior financial analyst at Bankrate.com. So you could pay 6.7 percent on a 30-year fixed-rate loan.

In our example, you could put down $49,000 (35 percent of the $140,000 price) and borrow $91,000 (65 percent). At 6.7 percent, you'd pay about $7,050 a year in mortgage principal and interest. If all other costs were $9,000 a year, as assumed above, your total outlay would be $16,050 a year. With $18,000 of rental income, you'd net $1,950 a year—about a 4 percent return on your $49,000 down payment. Plus, every $12,250 of profit you'd net from an eventual sale would be a 25 percent return on that down payment.

If that sounds like a sweet deal, consider this: Buy that same house for $230,000, pay 6.7 percent on a mortgage of almost $150,000, and you'd have more outflow than income. You might also have negative cash flow if you paid, say, $160,000 or $170,000 for the house but saw hikes in property taxes, insurance premiums, or maintenance costs. So make a realistic projection of expected income and outlays to determine whether a rental property is worth the price.

Making it work

In today's housing market, negotiating a fair price with a seller could be just the beginning of the transaction. Many deals today are short sales, meaning that you're paying less than the outstanding mortgage balance. Assuming the seller won't make up the shortfall, short sales must be approved by the lender holding the mortgage, which can lengthen the process and might result in a rejection of your bid.

Other home sales take place after a foreclosure, when the house is REO, or real estate owned, by the lender. REO properties might be low-priced, but they also might have been unoccupied for months or even years. It's important that you have your own home inspector evaluate the property before making any commitments, so you'll have an idea of the expenses you'll incur to make the place suitable for renting to tenants. If you can't get a referral to a home inspector, you might be able to find one who works in your area by checking the website of the American Society of Home Inspectors.

Once your home is ready to be rented, you should screen potential tenants carefully. A tenant who proves to be troublesome could be difficult to dislodge. So ask for references from former landlords as well as employers, and check them thoroughly. Get Social Security numbers and run credit checks, too. "Today, you'll need to work through a landlords' association or a tenant-screening business to run a credit check," says Janet Portman, an attorney and editor at Nolo, a legal self-help publisher in Berkeley, Calif. Portman, also a co-author of "Every Landlord's Legal Guide" (Nolo, 2010), suggests getting a reference from an applicant's previous landlord. The current one might praise a bad tenant just to get rid of him or her.

If you don't want to screen tenants—or get calls about clogged toilets in the middle of the night—you can hire a property management company to handle it for you. But a manager will probably charge you 6 to 10 percent of your rental income plus an additional fee for screening a new tenant. You have a better chance of winding up with real profits if you're prepared to manage the property yourself.

How to deduct depreciation

Landlords are eligible for several tax breaks, and depreciation might be one of the best. Here's how it works:

Say you buy a rental property for $140,000 and wind up with $1,950 in positive cash flow, as illustrated in the accompanying article. Depreciation deductions will vary, property by property, but assume that you can deduct $4,900 (3.5 percent of $140,000) a year. You'll show a loss of about $2,050 once you deduct $4,900 from your net cash flow of $1,950 and add back the $900 in repaid principal from the mortgage. With a loss, you won't owe any income tax from the venture.

Can you deduct that $2,050 loss? That depends. With an adjusted gross income (AGI) of up to $100,000, you can deduct up to $25,000 of so-called passive activity losses, which include losses from rental properties. "That applies to single taxpayers and to married couples filing joint returns," says Blake Rubin, a partner at McDermott Will & Emery, a law firm in Washington, D.C. If your AGI is more than $100,000 your allowable loss phases out, $1 for every $2 of excess AGI. To deduct a $2,050 loss in full, you'd need an AGI of $145,900 or less.

Any losses you can't deduct right away because of AGI limits can be deducted when you dispose of the property. At the same time, you'll owe tax on all the depreciation deductions you've taken. The tax on those recaptured deductions is now capped at a 25 percent rate, so you might benefit from a tax rate lower than you usually pay as well as from tax deferral.

This article appeared in Consumer Reports Money Adviser.

Posted September 2011 — Consumer Reports Money Adviser issue: September 2011