Rental real estate is all about generating profits from cash flowing investment rental properties. In order to successfully generate a profit, every investor needs to understand the topic of rental real estate finance which covers many subjects ranging from mortgages, taxes, budgeting, and more.
Table of contents
Purchasing a rental property requires a lot of capital. With investment property prices in the hundreds of thousands or even millions of dollars, it is very common for investors to use financing (i.e. a mortgage loan) to acquire an asset. By utilizing a mortgage, investors are also able to capitalize on the benefit of “leverage” but using borrowed money at a reasonable interest rate, to generate more money. Many different types of mortgage products exist, serving different rental property types and purposes.
Rental property taxes are a major component of the United States tax system for both the Internal Revenue Service and individual taxpayers. Taxes are applied to rental properties in the form of a State Property Tax and Income Tax on profits from income. While rental property income must be claimed on your taxes, there are many deductions provided to rental real estate investors that can greatly reduce the income tax obligations on your profits. Another important property tax topic is the Internal Revenue Code Section 1031 (commonly referred to as “1031 Exchange”). A 1031 exchange allows the deferral of capital gains upon selling an investment property, if the proceeds are used to purchase another investment property.
Rental Property Calculators
Rental real estate finance can get complicated quickly with so many different components of financial analysis to calculate and keep track of. We have created helpful calculators to help understand and calculate some of the most common rental property financial metrics.
Deal Analysis & Underwriting
Since rental real estate investments are expensive long term endeavors, thorough analysis should always be performed by investors. Underwriting encompasses vetting the financial viability of a borrower and financial profitability of a potential deal. The activities involved in underwriting can range from an investor performing calculations on the profit potential of a deal, to a lender assessing the investor (i.e. borrower) creditworthiness for a loan. Advanced analysis should also be performed such as determining cash flows, rate of return, capitalization rate (cap rate), cash-on-cash return (COC), Tax Consequences, and more.
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Appraisal & Valuation
Appraisal and valuation are extremely important steps in any rental real estate buying and/or selling transaction. Appraisals are performed by licensed professionals who determine an accurate value based on both a physical inspection and also comparable market data. Appraisals are often a key component to obtaining a mortgage, and different appraisal methods exist for different types of rental properties.
Investing in rental real estate now stretches far beyond the common thought of purchasing an apartment or renting out your old single family house. While that method still works very good, not everyone wants to nor can afford to invest the large amounts of time and capital needed to successfully undertake a rental property project. Thanks to the rise of the internet and stock market, new and creative ways to invest in rental real estate have risen in popularity and accessibility. Nowadays, almost anyone can start investing with publicly traded real estate stocks on their phone, or even participate in syndication deal to get in on a large rental property investment previously out of reach.
Buy and Hold
Construction finance refers to the broad category of all finance related activities in the construction process. Construction loans (also called Construction Financing) are commonly used by developers to provide the capital needed to build a new project. The capital is to be used to pay for materials, labor, and all development related costs. Construction loans are different from traditional mortgages. Construction loans are “speculative”, which means that loan collateral is non-existent or limited to the land until the project is fully built. This is compared to a traditional mortgage where the loan collateral is already existing, since the property and structure already exist and have a definitive value.
Construction Cost Management is another important component of Construction Finance. Construction Cost Management is the active management of finances for a construction project. Proper spending of capital on a construction project is extremely important. Overspending or running out of capital can bankrupt a project and leave lenders with an unfinished structure to try and recoup their funds from. Property construction cost management involves first obtaining most accurate as possible underwriting, building material and labor budgeting, and then firmly sticking to the original plan throughout the buildout process.
Operations & Budgeting
Operating a rental property is the same as operating a regular business. It requires setting budgets and ongoing monitoring of operational costs in order to ensure there is profitability for the owners taking the risk. As is especially true in commercial real estate, implementing stringent financial management often equates to higher property valuations and easier financing approvals. This is because businesses (i.e. properties) that demonstrate they can efficiently operate, are more desirable to both lenders and potential buyers as they are seen as “safer investments”. Other operational factors include occupancy, tenant creditworthiness, maintenance expenses, and more.