How to Calculate the Cost of Owning a Rental Property

Numerous individuals see rental property investing as a pathway to financial independence. However, it's important to understand that property investment is not a passive endeavor where you can simply purchase a property and expect a steady stream of income indefinitely. Owning a rental property entails various expenses, and being aware of these costs is crucial for predicting future success.

Despite rental property investment being one of the few types of investments where investors can fairly accurately calculate expected returns, many inexperienced investors end up losing money due to underestimating the true costs involved.

In this article, we will delve into the expenses associated with owning a rental property and provide guidance on how much you should allocate for them. You will gain insights into effectively budgeting for these expenses, and we will illustrate the concepts with clear examples.

Assuming you have covered the down payment, let's explore the other expenses associated with owning a rental property.

Acquisition Expenses 

The initial cost you must consider is the acquisition expenses. When it comes to investment properties, the down payment required is typically higher than that for owner-occupied properties. Lenders usually demand a down payment of 20% or more if you intend to rent out the property from the beginning.

For instance, if you plan to purchase a house worth $250,000, you should secure at least $50,000 as a down payment. Additionally, once you have obtained the initial amount, you will have monthly mortgage payments to factor into your financial planning. It is crucial to be aware of these figures before making the purchase to ensure smooth financial management.

If you haven't taken out a loan for a rental property yet, there are several mortgage calculators available that can provide a reliable estimate of your monthly mortgage payments.

Expenses of Owning a Rental Property

The costs involved in maintaining a rental property vary depending on various factors, but most property owners estimate that aggregate expenses amount to approximately 50% of the monthly rent. These expenses include repairs, maintenance, taxes, insurance, and other property-related costs.


Let's break down each cost and examine how it is calculated. For instance, let's consider the previous scenario where you purchased a $250,000 rental property and rented it out for $2,500 per month.


Repair and Maintenance Costs

For new property owners, repairs and maintenance often become unforeseen expenses as they may not occur every month. However, preparing for unforeseen expenses is a vital skill for rental property owners. Experienced property owners follow certain guidelines when accounting for repairs and maintenance:


$1 per Square Foot Rule: A simple approach is to save $1 for every square foot of the property to account for repairs and maintenance costs. If you are renting out a 2,000-square-foot single-family home, you should allocate $2,000 annually for repairs and maintenance.

OR

1% Rule: Repairs and maintenance typically amount to around 1% of the property value per year. As an alternative to the first method, set aside 1% of the property value each year to cover maintenance costs.

OR

Rent Rate Reserves Rule: Allocate 10-15% of the rental income for ongoing and unexpected maintenance costs.

While these rules provide a good starting point, there are no guarantees when it comes to these costs. Several factors can influence the expenses associated with repairs and maintenance for each property.


Factors such as high turnover rates can increase costs. When a renter vacates a property, owners may need to spend money on repainting, flooring, and other repairs to attract new tenants. The shorter the tenure of renters in a rental property, the more owners need to allocate for repair and maintenance.


Another factor is the age of the property. Newer homes typically require minimal repairs, while older properties may necessitate frequent maintenance work. Regardless, it is advisable for property owners to save for unexpected costs from the outset.


Vacancy Allowance Cost

Although vacancy rates may be seen as a loss of income rather than an expense, neglecting to consider this cost can result in financial losses. To calculate the cost of vacancy, multiply your vacancy rate by your projected annual revenue. For example, if your vacancy rate is 4% and you rent out your property for $2,500 per month ($30,000 per year), the cost of vacancy would be $1,200 annually. Divide that by 12 to get $100 per month, which accounts for 4% of your monthly rent.


The average vacancy rate in the US during the first quarter of 2022 was 5.8%. However, your vacancy rate may vary depending on the location, price, and quality of tenants. Experienced property managers recommend researching the comparable vacancy rate in the area and factoring it into your calculations before purchasing a property. This will provide a clearer understanding of the potential income from a rental property.


Property Insurance Cost

Unlike the previous cost discussed, property insurance is a fixed expense that can be easily calculated.

On average, insurance for rental properties is approximately 25% more expensive than homeowner's insurance. To determine the cost of your property insurance, it is best to obtain quotes from local insurance companies.


Experienced rental property owners and managers recommend obtaining at least two quotes from different insurance providers and comparing them to find the best deal. Inquire about different policy types, pricing options, restrictions, and coverage details.


To calculate the monthly insurance cost, simply divide the annual premium amount by 12. For example, if your annual premium is $1,500, your monthly insurance cost would be $125, which is 5% of the monthly rent of a property renting for $2,500.


Property Taxes

Similar to property insurance, property taxes are relatively straightforward. The annual property tax amount depends on the assessed value of your property and the tax rate in your jurisdiction. Each jurisdiction sets its own tax rate, so it is important to research and understand the tax rates before investing in a rental property. To calculate the monthly cost of property taxes, multiply the assessed value of your property by the property tax rate in your jurisdiction.


For instance, if your property is assessed at $250,000 and the property tax rate is 0.51%, you can expect to pay $1,275 annually. Divide that by 12 months, and your monthly property tax cost would be $106.25. Using the example of a $2,500 monthly rent, approximately 4.25% of it would go towards property taxes.

Other Expenses

It is essential to account for other miscellaneous expenses that may often be overlooked. These can include travel expenses, bookkeeping fees, and various unforeseen costs.


Some homeowners allocate a budget of 2–4% for these types of expenses. While it is not guaranteed that this budget will be fully utilized, it is good practice to be prepared for any unforeseen circumstances.

Property Management Cost

Whether or not you choose to hire a property manager, it is important to consider property management costs for two reasons:

Property management companies, such as Poplar Homes, typically charge a management fee ranging from 6% to 8% of the monthly rent, along with an additional fee equivalent to half a month's rent for tenant placement (some companies may charge a full month's rent).

Considering tenant turnover every two years and a monthly rent of $2,500, tenant placement would cost $52 per month, or 2% of the monthly rent. To calculate the total property management cost, add 6-8% of the monthly rent to the 2% for tenant placement, resulting in up to 10% of the monthly rent or $250 for a rental property with a monthly rent of $2,500.

Bringing it All Together

Now that we have explored each individual cost, it's time to consolidate them and see the bigger picture. Using the consistent example mentioned earlier, the breakdown of costs as a percentage of the monthly rent is as follows:

As you can observe, the total cost of owning a rental property ranges from 37% to 46% of the rent. It aligns closely with the 50% rule we previously discussed, which is not surprising. However, it's important to note that these values are influenced by various factors, including the property's location, price, rental income, and chosen service providers. Additionally, the quality of your tenants can also play a role. 

Generally, having long-term, high-quality tenants can lead to more savings, which can be achieved by conducting comprehensive tenant screenings. By considering these factors and understanding the overall cost breakdown, you can make informed decisions and effectively budget for the expenses associated with owning a rental property.


Concluding Remarks

Although we would love to assure you that these costs won't arise at all, the truth is that owning a rental property can come with substantial expenses. However, there is a possibility that your actual monthly costs might be lower than what you initially anticipate. Nevertheless, it is always prudent to budget with caution and account for all potential expenses. By adopting this approach, you can effectively manage your rental property business, ensuring efficiency and minimizing the risk of financial loss.