Owning Rental Property Directly

Owning a rental property is the one investment in this book you can paint, repair and lose sleep over. It can build wealth through four separate channels at once, and it can also turn into an expensive part-time job when the numbers were too optimistic from the start. This chapter explains where the return on a rental comes from, the costs new landlords most often underestimate, the measures used to judge a property before buying, how rental income is taxed, and how to decide whether direct ownership suits you at all.

Where a rental's return comes from

A rental property can pay its owner in four ways, and a sound purchase does not depend on all of them.

1. Cash flow: rent left over after every cost of running the property, including the mortgage. It is the only return you can spend while you own the property.
2. Appreciation: the rise in the property's value over time. It is real but uncertain, varies widely by place and decade, and is only collected when you sell or borrow against the property.
3. Loan paydown: each mortgage payment includes some principal, which the tenant's rent is effectively paying off. Your equity grows even if the value does not.
4. Tax benefits: depreciation and deductible expenses can shelter some or all of the rental income from tax, as described below.

Leverage multiplies all of this. When most of the price is borrowed, a modest change in the property's value is a large change in your equity, in both directions.

A property bought for $300,000 that rises 3.0% a year is worth about $403,175 after 10 years, a gain of about $103,175. If the buyer put down 20% and borrowed the rest, that gain is several times the down payment. The same leverage works against you: a 10% fall in value with 20% down wipes out half the owner's equity before selling costs. Appreciation is the return most often assumed and least often guaranteed, so judge a purchase mainly on its cash flow.

The mortgage sets the margin

For most rentals the mortgage is the largest single cost, and the interest rate decides how much room is left for everything else. Investment property loans usually carry higher rates and larger down payment requirements than loans for a home you live in.

Borrowing $240,000 for 30 years at 6.5% costs about $1,517 a month in principal and interest. At 7.5% the payment rises to about $1,678, and total interest over the loan grows from about $306,107 to about $364,121. One percentage point on the rate can be the whole difference between a property that pays you each month and one you pay for. Before making an offer, run the payment at the rate you can actually get, not the rate in an advertisement. The home affordability calculator shows the full monthly cost including tax and insurance.

The costs that surprise new landlords

Rent minus the mortgage is not cash flow. A realistic budget includes:

• Property tax and insurance, which rise over time and can jump after a purchase when the property is reassessed. Landlord insurance usually costs more than a homeowner's policy.
• Vacancy: weeks or months between tenants with no rent. Many investors budget 5% to 8% of yearly rent for it.
• Repairs and maintenance: a common rule of thumb is about 1% of the property's value a year, more for older buildings.
• Capital expenses: roofs, heating and cooling systems, water heaters and appliances wear out on a schedule. Setting money aside monthly turns a surprise bill into a planned one.
• Property management, typically 8% to 12% of collected rent if you hire it, plus fees for finding new tenants.
• Turnover: cleaning, painting and advertising each time a tenant leaves.
• Legal and compliance costs: licences, inspections and, occasionally, eviction.

Investors often use the "50% rule" as a first screen: over time, operating costs excluding the mortgage tend to absorb roughly half the rent. It is a rough average, not a forecast, but a property that only works if costs come in far below it deserves suspicion.

Because the costs are lumpy, a rental needs its own cash reserve, separate from your personal emergency fund.

If the mortgage, tax and insurance on a rental come to $2,200 a month, a reserve of $6,000 covers about 2.7 months without rent. A six-month reserve would be $13,200, leaving $7,200 still to set aside. The emergency fund calculator sizes the same buffer for your own costs.

Measuring a deal before you buy

Three measures help compare properties and filter out weak ones quickly.

Capitalisation rate (cap rate): the property's net operating income (rent minus operating costs, before the mortgage) divided by its price. It describes the property's earning power as if bought with cash, so it compares buildings independently of financing. Higher cap rates usually come with more risk or less expected appreciation; lower ones with prime locations.

Cash-on-cash return: yearly cash flow after the mortgage divided by the cash you actually put in (down payment, closing costs and initial repairs). It answers the question "what am I earning on my own money each year?" and is the measure most sensitive to the interest rate.

The 1% rule: a quick filter that asks whether monthly rent is at least 1% of the purchase price. Few properties in expensive cities pass it today, and passing it does not make a deal good, but a property far below it rarely produces positive cash flow with a mortgage.

None of these captures the timing of returns over a whole holding period: the down payment now, cash flow each year, and a sale price years later. The IRR calculator turns that series of cash flows into a single yearly rate you can compare with a stock index fund or a REIT.

How rental income is taxed

Rental income is taxed as ordinary income, but you deduct the costs of earning it: mortgage interest, property tax, insurance, repairs, management, travel to the property and more. IRS Publication 527 lists what qualifies.

Depreciation is the largest deduction for most owners. The IRS treats a residential building (not the land under it) as wearing out over 27.5 years, so you deduct a slice of its cost each year even though you spend no cash. Depreciation often turns a property that produces positive cash flow into a tax loss on paper.

Using the loss. Rental losses are generally "passive", and passive losses can only offset passive income. There is an exception for owners who actively participate, such as approving tenants and setting rents: up to $25,000 of rental loss a year can offset wages and other income. That allowance shrinks once modified adjusted gross income passes $100,000 and disappears at $150,000. These amounts are set in the law and not adjusted for inflation. Losses you cannot use carry forward and are released when you sell. Real estate professionals who meet strict hours tests are treated differently.

On sale, the depreciation you claimed (or could have claimed) is taxed back at up to 25% as "unrecaptured section 1250 gain", and the rest of the gain at long-term capital gains rates. A like-kind exchange under section 1031 can defer the whole gain if the proceeds are reinvested in another investment property within strict deadlines.

House hacking and choosing your route

Many first-time investors start by living in one unit of a small multi-family building and renting out the others, or renting rooms in a house they own. This is called house hacking. It lets you buy with owner-occupant financing, which usually means a lower rate and a smaller down payment, learn to be a landlord with the property next door, and have tenants cover part of your housing cost.

Direct ownership tends to suit people who have steady income and reserves, are willing to spend time on it or pay someone who will, plan to hold for many years, and can absorb a bad tenant or a vacant year without missing their own payments. It tends not to suit people whose savings would all be in one building, who may need to sell on short notice, or who do not want a business. For them, the REITs in chapter 2 offer the same asset class with none of the work.