When investing in rental real estate, the amount of income you can generate off a property is key in deciding whether or not to buy it to begin with.
But knowing how much money you can realistically expect can be difficult to determine if you don't have experience in that particular rental market.
Fortunately, there are tools, strategies, and local experts you can use to figure out how to calculate rent the right way. Let’s walk through it, step by step, so you can become a savvier investor.
How to calculate rent (the right way)
When calculating rent for an investment property, many people rely on rules of thumb or rent calculators and hope for the best. However, that's not always a winning strategy and could result in disappointment and an unprofitable investment if you're not careful.
Here's how to walk through the numbers on a potential rental property to decide whether or not it is a good investment.
Step 1: Find your property’s current market value
Before you can determine if the rent you'd receive is adequate, you need to understand the value of your property. Many websites now offer property value estimates for free. These websites include Zillow, Realtor.com, and Redfin. These sites use technology to evaluate local trends, recent sales, and current listings to offer an estimated value of your home.
If you've recently bought your property, the value may not have changed much. In that case, you can use your purchase price in the calculation. Because the housing market changes over time, if you bought your home over a year ago, it would be best to get an updated evaluation of its worth.
For the truest valuation of your home, you would need to hire an appraiser. The appraiser does a thorough evaluation of your home compared to recent sales and adjusts the value of your home based on updates, features, lot size, and more. Appraisals are typically used to calculate the value of a property when buying or selling and when taking out a loan against it. According to Quicken Loans, appraisals usually cost $200 to $600, with an average of $335.
A less expensive option is to get a broker's price opinion from a local real estate agent. Broker's price opinions (BPOs) are unofficial estimates of a home's value that can be prepared relatively quickly. It is good to note that they are not equivalent to an appraisal, and the values may vary widely from what an appraiser will value your home at.
Some real estate agents will provide a BPO for free, while others may charge a small fee. BPOs are a relatively inexpensive way to determine if you should move forward with an investment or if you should pay for an appraisal.
Step 2: Use the percentage rule of thumb
Now that you have a sense of the value of your home, you can find a number to start with by using the 1% Rule. The 1% Rule states that you should expect to receive 1% of the property's value per month in rent.
Dustin Heiner, the founder of Master Passive Income and owner of numerous rental properties, uses the 1% Rule to filter potential properties when looking to purchase real estate. He says that "using the 1% Rule, I can tell in five seconds if a property is worth spending more time analyzing the numbers to see if it will be a good rental property."
While the 1% Rule is ideal, in reality, rents typically fall between 0.8% and 1.1% of a home's value. In some markets with higher-priced homes (like California or New York City), rents may be far less as a percentage of the value, while other markets might be much more.
Here are some examples of how home value and price of rent translate into a percentage:
|Rent / Value||
|Meets 1% Rule?||
Now that you have a basic percentage to start with, there are some other things to consider that could affect whether the 1% Rule is adequate enough to make your rental property a profitable business.
Step 3: Tally your expenses
While rental income brings money in, it is equally important to control the money going out. Many properties might meet the 1% Rule, yet are still unprofitable once expenses are subtracted. Remember, your rental property is an actual business, even if you haven’t incorporated or filed for a business license.
When investing money into rentals, you need to identify all the expenses you’ll need to pay. This is especially true if you need to take out a mortgage in order to buy the property versus paying for it with cash savings. In addition to normal expenses that you pay regularly, you should also budget for future potential expenses, such as vacancy, larger repairs, and capital improvements.
Here are many of the typical expenses that rental property investors budget for:
- Mortgage payment (principal and interest)
- HOA dues (if applicable)
- Property taxes
- Homeowner’s insurance
- Property management fees (typically 10% of the monthly rent)
- Small repairs and maintenance
- Utilities (usually only when a property is vacant in between tenants)
- Future larger repairs
- Future vacancy or lower occupancy rates
Even if you don’t hire a property manager now, you may want to do so in the future. That’s why it is good to budget for this expense.
Large future repairs can bust your budget if you haven’t been saving for them over time. These items can be quite expensive, like replacing a water heater, roof, or HVAC. Having savings dedicated to these projects can cover some or all of the costs and help you avoid going into debt to pay for them.
Vacancy is the industry term used when your property is without tenants. Although it isn’t really an expense, budgeting for these times can help with the loss of income during this period or the turnover expenses that happen between tenants. When one tenant leaves, and before another can move in, you often have to pay for “wear and tear” repairs that you can’t charge against a tenant’s security deposit. This may include a fresh coat of paint, small repairs, or improvements necessary to attract your ideal tenants.
When you’ve added up all your expenses, does your rental rate cover the amount? Is there a profit and does the profit provide an adequate return on your investment? Does it allow for the cash flow you need? If not, can you make any adjustments to your budget? Or if you are evaluating this rental for purchase, should you let this property go?
Step 4: Look at other rental prices in your area
When determining how much you’ll charge for your property, you also have to factor in the competition. While you may meet the 1% Rule and cover all your expenses, if you price your rent too high, you’ll price yourself out of the market.
Your property may be nicer than others, but there may be a reason that other rentals are priced lower. For example, local jobs may not pay enough for someone to choose your rent price, no matter how much they love it and want to live there.
Pricing can go the other way too. You could be missing out on extra revenue if you’re the lowest-priced rental in the neighborhood. Properties in up-and-coming or trendy neighborhoods can see dramatic rent increases from one year to the next.
Shop around virtually, over the phone, or in person to find out how much other landlords are charging. This information could help you understand what the floor and ceiling are for acceptable rents in the area.
If your property is unique or it is hard to find other rentals to compare it to, you may have to do some calculations. This involves finding the typical “rent per square foot” for the properties in the area. Selecting a handful of properties and calculating this number will help you understand the range of values and averages to price your rental properly.
To find the rent per square foot for competing properties, divide the monthly rent by the property’s square footage. For example, a property renting for $1,000 that is 1,200 square feet is $0.83 per square foot, while a $1,200 rental with 1,500 square feet is $0.80 per square foot.
Step 5: Talk to a property manager
While many real estate investors rely on property managers to operate their properties, they forget that they could also help you pick a property too. Their expertise in the local market might be able to help you decide on the appropriate rent to charge based on similar properties they are managing.
Their time is valuable, so don’t inundate them with bunches of questions. When you've narrowed down your choices and are about to make an offer on a property, that’s the time to consult with a property manager.
Rodrick Jackson, a property manager at Spoat, Jackson, & Browne in Fayetteville, North Carolina, often helps his investors with their decisions. “I help my investors understand the range of rents they may receive and how attractive that property will be in the market. Sometimes, I even advise them on what improvements to make to appeal to renters.”
If you don’t already have a property manager, consult with a few to get their feedback. During these conversations, you can also interview them to see which one you’d like to work with on your business.
In addition to these basic rules, you should also factor in some special considerations where you’ll need to adjust your expectations when it comes to rent and your real estate investing ventures:
Each state and many cities or counties have their own laws for rental properties. They may limit the amount you can charge for security deposits, late fees, pet fees, and other items. Others enforce rent control where you cannot increase rent or may not increase rents above a certain amount each year.
If your research has you thinking about raising rents on existing tenants, that might not be the right move. While additional income helps your rental become more profitable, it could cause your existing tenants to search for a cheaper option when their lease is up. Rodrick says that “reliable tenants are key to a successful rental. Vacancy and turnover expenses can turn a good rental into a bad one very quickly.”
Commercial leases are usually more complex than residential leases. Typically, commercial leases cover multiple years and often have an escalator clause that increases rents every year. The value of a commercial property is usually a combination of occupancy and monthly rents. When pricing your commercial building, remember that the value of a 100% occupied building with slightly lower monthly rents per unit is better than a half-empty building with rents above market averages.
Whether you’re evaluating your current rentals or looking to buy a new one, calculating your expected income is critical. It determines how much you should pay for a property, what expenses you can afford, and how much you’ll make.
Learning simple steps could help you estimate a property’s income and profitability when you’re learning how to invest in real estate and handle rent calculation. Then you can validate your assumptions through conversations with a real estate agent or a property manager.
Once you take advantage of all the tools at your disposal, you’ll know how to calculate rent and identify profitable rental properties.
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