Figuring the value of a rental home

devorahJuly 30, 2008

Currently, my husband and I keep most of our $ in CDs. We assume that inflation will eat away at that pretty rapidly so we are looking for a house to buy for a rental. Somewhere I read that dividing the cost of the house by 15 and then by 12 will give me the rent amount I would need to receive to show a profit. Does anyone know if that really is a good rule of thumb? This method doesn't seem to make a provision for taxes and insurance unless it is built into the number 15. When looking at the balance sheet can one subtract the amount paid on the principle from the debit side? How about the amount one realizes from depreciation? Does that get plugged in anywhere?

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I'll try to address part of your post. I believe that you are thinking about the buy to rent ratio. That statistic is used in general terms to determine whether it would be cheaper to buy a property or to pay rent. The historical ratio (house purchase price divided by annual rent) has been in the neighborhood of 15. When it is higher than 15, housing is thought to be over-priced (or rents could be depressed due to the local economy) and it is considered cheaper to rent than to buy, and when it is lower than 15, it is considered cheaper to buy over the long term.

Think of it as akin to a P/E ratio for stocks. When a stock's P/E ratio is below 15, it is considered "cheap" and when it is greater than 15, it is considered too expensive for its underlying value. (This is an extremely elementary explanation and is only one small part of evaluating a public company.)

But back to your question.....The buy:rent ratio of 15 should only be used in the most generic manner. If you are looking to buy an investment property, and want to ensure positive cash flow, you need to run the figures specific to that property, you can't rely on a generic formula.

    Bookmark   July 30, 2008 at 4:22PM
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oh okay, thank you

    Bookmark   July 30, 2008 at 9:38PM
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And it might be a good idea to check with RE agents in the area and see what they think.

    Bookmark   July 30, 2008 at 9:43PM
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If housing prices have been depressed in the area recently and there is a good possibility that they may recover over a few years, there might be additional value in that.

Are you able to manage the rentals yourself?

Including cleaning and fix-up when a vacancy occurs?

Tough enough to manage renters effectively?

Do you have some financial resources above current needs to enable some major expenditures, e.g. new roof, replace furnace, handle vacancy for several months while evicting non-payers, etc. (and fix-up if some semi-trash the place)?

Some things - among a number of others - to be considered.

ole joyful

    Bookmark   July 31, 2008 at 12:17AM
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You'll need to know what rent you can expect to recieve.

Will you provide landscaping services, utilities?

Will the property require up-front work before you rent it?

What will your costs be for mortgage, taxes, any association fees, maintenance, insurance, advertising?

Will you manage the property or hire a manager?

Then you take all those numbers to your accountant; decide on a schedule of depreciation; see how this will affect your tax situation.

All this gets you close to knowing if the property will cost you, carry itself, or earn a little profit -- while you wait for it to appreciate!

    Bookmark   July 31, 2008 at 12:08PM
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And remember it is wise to keep 3-6 mos. of total expenses for a rental property in savings for those times when the house is empty and you are trying to rent it to someone new.

    Bookmark   July 31, 2008 at 1:59PM
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The area where we are looking has not declined in value because it is near a university, even though the rest of the city has declined considerably.

My daughter would be the long distance manager. She already has 3 rentals in the area. She has a very good and reasonable handyman and once a year she and my husband travel to the area to paint, trim vegetation and generally fix-up the properties. Her properties have not had a day when they weren't rented

The down payment of 25% would take up 1/4 of our savings

My real question was how to figure profit. WE are currently renting out a house for slightly less than the payment which includes taxes and insurance. We are okay with that since we intend to move into the home when we retire but of course we don't want to do that with a property that is stricly for investment purposes. My question was whether people consider the reduction on the principle owed when figuring profit/loss and if they consider the allowance for depreciation of the property that the IRS requires.

    Bookmark   July 31, 2008 at 9:13PM
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In general, No, but keep in mind the depreciation is just delaying the tax bill by reducing your cost basis at time of resale.

    Bookmark   August 1, 2008 at 4:50PM
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Oh my! You rent to COLLEGE kids?

    Bookmark   August 1, 2008 at 6:10PM
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Chris - I realize that depreciation is a waiting to bite us at a later date. Does anybody know if my kids get the property at a stepped up basis when they inherit? I don't know how that works for depreciated properties.

Sue - No, we rent to the parents of college kids - the kind who don't want their credit ruined. So far it has not been a problem but of course, it may be in future.

    Bookmark   August 1, 2008 at 10:07PM
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I'm glad it's worked out well for you. My DH and I had to live in temporary housing between the time our prior home sold and the new one was ready. We had the misfortune of living in an apartment below (supposedly) four college boys, one of whose fathers signed the lease. It was awful! There were probably seven boys actually living there, in a 2 BR unit and there were drugs being sold out of the parking area.

We've owned houses rented to families, and now we own a vacation rental condo on Maui. The only time we had a problem at the condo was when it was rented to college kids. One shouldn't generalize, but it seems to me that college kids behave younger than ever. (Our own DS and his friends were clearly 'not all there' at that age!)

    Bookmark   August 2, 2008 at 9:44AM
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