Considering investing in a rental property? If so, you’re probably wondering how to figure out how risky a potential purchase is. You’re also probably wondering how much money you stand to make. One key component of analyzing an investment purchase is calculating regular operating expenses – and we’re going to show you how.
First – a definition. What is an operating expense?
An operating expense is a regular or semi-regular expense incurred by maintaining a rental property and working with renters. These expenses are basically the funds needed to keep your rental – you guessed it – operational.
Many investors are surprised to learn that this category does not include mortgage payments. It also doesn’t include renovations or appliance replacements. Reason being is, operating expenses are costs that don’t add any value to the property. Expenses that add value are categorized differently, so an investor, it’s important to keep those line items separate in your cash flow analysis.
What’s a healthy expense budget?
You ultimately want to make money off of your real estate investment by generating positive cash flow. So how much money can you sink into operating costs? Most investors agree that you can spend between 35-80% of your total profit on operating expenses and still come out on top. If you charge $2000 per month in rent and spend $600 per month in operating expenses, you’re spending 30% of your profit on operating expenses, which means you’re netting a good gain. Now let’s take a closer look at what those expenses include.
- Maintenance:
Home maintenance and repair is the hardest operating expense to estimate. It’s almost impossible to tell how often you’ll need to call a plumber or fix a leaky roof, and the cost can vary widely based on the age of the property. Most investors set aside 1 percent of the total property value per year, so if you buy a property worth $500,000, you’d need to set aside $5,000 per year for maintenance. However, it is better to be conservative and over-estimate this cost since this is where many property owners can over-spend. - Management:
Hiring an outside property manager can save you valuable time and headaches. To estimate this expense, call around to property managers in your area to see what they charge. It’s not unusual to pay a manager 5 to 10 percent of the rental income. - Taxes and fees:
Property taxes are also a major expense in addition to your mortgage. You may contact your local county assessor to get the cost of property taxes on your new property. If you’re in California, don’t forget to look at how Proposition 13 affects your property taxes.
While we’re on the topic of taxes, did you know that your can deduct some of your rental operating expenses? The IRS has outlined which expenses may be deducted and how to keep good record of those costs. “Ordinary, necessary, and current” expenses may be deducted, meaning you can include routine repairs and maintenance in these deductions but not capital improvements such as bathroom upgrades or appliance replacements, which change the overall value of the property.
- Contingency funds and other expenditures:
Don’t forget the small or irregular items–garbage collection fees, pest control, vacancy costs. Those are the things that can negatively impact your gross income if you underestimate or cut your budget too close.
Now it’s time to add these costs up, add in your mortgage, and subtract the sum from your rental income. Do you have a good profit left over after all your expenses have been accounted for? If you’ve done your research and gotten a good idea of what you’ll be spending, you can be reassured that you’re making the right decision about your investment.