Military Financial Advice - Military Times

Simple rules for buying rental property

In general, buying rental real estate is simply an investment decision. You need to ask yourself if buying this single-family home, town house or condo makes sense as an investment. To determine the investment potential, you need to ask yourself three questions:

1. Is this real estate in a growing area?

2. Can I make money on this investment each month, or do I have to pay money each month to have this property?

3. Do I ever want to live in this house?

Question 1 involves long-term issues. If the area is not growing, the probability of having the house go up in value over time is small. Finding renters will be difficult.

It also means the number of available jobs is not expanding. In that case, people tend to leave the area, so your pool of possible renters keeps declining. Also, older people will tend to retire and move elsewhere, providing more houses to sell to an ever-declining number of possible buyers. This means prices will either decline or not increase, even at the rate of inflation. The amount of rent you can charge for your property probably will not increase and may decline while your costs are increasing.

In a growing area, especially one with low real estate prices, price appreciation tends to occur each year and you have a constant influx of new buyers and new renters. If there is a large number of transient employees, this gives you a new pool of possible renters every year. Many will go on to buy houses in the area, but many will not -- especially if they do not plan to be in the area for more than a few years.

So, location is crucial to buying real estate as an investment.

In question 2, we begin to look at the real numbers involved in deciding to buy investment real estate. The key here is "positive cash flow." If you take the rent you get each month for this rental property, subtract all the expenses (mortgage payment, property taxes, insurance, management fees, repairs and maintenance), do you have something left over at the end of the month? If there is leftover money in the account, this is positive cash flow. If the figure is negative, this means that you have to take money out of your pocket to finance the deficit (negative cash flow).

Never buy a property with negative cash flow. It is simply not worth it unless you have certain knowledge that the property's value will appreciate so greatly in a short period of time that you can sell it in a year or two at a substantial profit.

In my experience, by the time all of us realize there is a huge appreciation in real estate going on in an area, it is near the end of the price appreciation spiral. In spite of what you hear, real estate prices can -- and do -- go down as well as up.

So let's look at a real-life financial analysis of an investment in 2005:

Investment: Single-family home, 5 years old, three bedrooms, 2.5 baths, 2,550 square feet.

Cost: $220,000.

Down payment: 20 percent ($44,000; 10 percent down is a minimum).

Total cost at closing: $48,500 (down payment, points and closing costs -- seller paid $4,000 toward buyer's closing costs).

Rent per month: $1,750.

Now, your expenses:

Principal, interest, property taxes and insurance: $1,200 -- 5.5 percent fixed-rate 30-year mortgage.

Management fee: 7 percent, $123.

Association fee: $35.

Home warranty: $35.

Your positive monthly cash flow is $357 per month. Multiplied by 12, it comes to $4,284 per year of income.

Your rate of return on the cost of the investment is determined as follows: Annual positive cash flow divided by the total out-of-pocket cost to purchase -- in this case, $4,284 -- divided by $48,500 = .0883 or 8.8 percent.

This is an excellent investment.

This simple analysis will work with any price home with any amount of down payment.

You simply need to substitute the numbers for your projected purchase to see if it makes sense as an investment. Any property that gives you a positive cash flow over 5 percent in a growing area is attractive.

Question 3 is not strictly an investment question. Buying a home in an area where you want to move and renting it to pay for the costs of owning the home, making repairs, and paying down the mortgage (if the rental period is long enough) can work out very well.

If you want to live in this home in the future and really like it, then the positive cash flow percentage can be lower -- but it should still be positive. None of us wants to have to pay extra money each month just to have a rental property.

NOTE: If you are stationed at a large military base in a small- to medium-size town, remember that large-scale, yearlong deployments can cause havoc in the local rental market. The better option is a larger metropolitan area with a substantial nonmilitary population or a military base specializing in longer-term training with a constant influx of new renters who will live in the area for more than six months.

Barbara Pietrowski is a licensed certified public accountant, certified financial planner and personal financial specialist. Her practice includes tax preparation, fee-only financial planning and investment management. Her office is in Kensington, Md. E-mail her at barbarapietrowski@yahoo.com.