Analyzing the income and expenses of a rental property is a key part of real estate investing. While estimating rental income is pretty straightforward, predicting operating expenses can be a little bit tricky, simply because there are a number of costs to take into account.
By properly estimating operating expenses for a rental property, an investor may be able to make a better analysis and identify opportunities for increasing profitability and cash flow.
- Operating expenses are the recurring costs to maintain a rental property in good condition.
- Common rental property operating expenses include marketing and advertising, leasing and property management, repairs and maintenance, insurance, and property taxes.
- Costs excluded from operating expenses include mortgage payments, capital expenses, and depreciation expenses.
- Other costs to consider when investing in a rental property include appraisal and inspection fees, business and license fees, and closing costs.
What is included in rental property operating expenses?
Understanding what is and isn’t an operating expense can sometimes be confusing.
When an investor reviews the operating expenses on a rental property, or puts together a pro forma of estimated expenses, only items that are on-going costs to maintain and keep the property in a good condition should be included.
Operating expenses may also be different from one property to the next. With that in mind, here’s a list of some of the most common operating expenses to expect for a single family rental home or small multifamily building:
- Marketing and advertising such as print and online ads, ‘For Rent’ signs, and a website for the property or real estate business.
- Tenant screening fees paid to run a prospective tenant’s credit report, background check, and rental history and eviction report.
- Leasing fees (if you use a property manager) vary from company to company, but generally are equal to 1 month of rent for a new lease and half of one month of rent for renewing a lease with an existing tenant.
- Property management fees also vary, but typically run 8% of the monthly rent collected.
- Repairs and maintenance are expenses to keep a rental property in good, habitable condition, such as fixing a leaking pipe or mending a hole in the bedroom carpet.
- Landscaping and snow removal may be a tenant expense in a single family rental, but a landlord expense in a small multifamily building.
- Pest control to pay for seasonal treatment of pests such as termites, ants, scorpions, or spiders.
- Utilities paid by a landlord (such as water, sewer, and trash) are operating expenses sometimes found in a multifamily rental property.
- Insurance premiums for homeowners and landlord insurance are also deductible expenses, even if they are included in the monthly mortgage payment.
- Property taxes are another fully deductible expense for a rental property, even when they are part of the mortgage payment.
- HOA fees and annual dues paid to a homeowners association are a common operating expense found with single family rental homes.
- Professional service fees paid to an accountant, financial planner, or attorney are generally deductible as operating expenses.
IRS Schedule E (Form 1040) serves as a good guide for understanding how operating expenses from a rental property are reported to the IRS when tax time rolls around.
A good place to find software that makes tax season a breeze is Stessa. After signing up for a free Stessa account, head over to the Tax Center for tax resources created in partnership with The Real Estate CPA, including how-to articles and videos.
Costs that are not operating expenses
There are four costs that are excluded from operating expenses:
1. Mortgage payment
Also known as debt service, the principal and interest payments from a mortgage are not a legitimate operating expense. That’s because financing terms and conditions may vary from one investor to another, such as a different interest rate or the size of a down payment.
2. Capital expenses
Money spent or set aside to pay for major repairs and improvements, such as replacing a roof or an HVAC system, are also excluded from operating expenses. For example, while one owner may opt for having the highest quality finishings possible in order to charge a higher rent, another investor may be satisfied with a property’s existing cash flow.
3. Investor income taxes
The amount of tax an investor pays each year does not affect the direct financial performance of a rental property. For instance, being in a high or low tax bracket has no relationship to the amount of income a rental property generates.
The IRS allows an owner of residential investment property to claim an annual depreciation expense as compensation for wear and tear, and obsolescence. For instance, if a home is worth $110,000 (excluding the land value), the annual depreciation expense would be $4,000 ($110,000 property cost basis / 27.5 year depreciation schedule).
While depreciation is a major benefit of owning a rental property used to reduce an investor’s taxable net income, depreciation doesn’t affect a property’s ability to generate income.
How to estimate operating expenses for rental property
Some real estate investors use the 50% Rule to “ball park” rental property operating expenses.
Simply put, the rule states that operating expenses are equal to ½ of the gross annual rental income. So, if a property generates a rental income of $18,000 per year, operating expenses should be about $9,000 per year, excluding the mortgage payment and capital expenses.
While the 50% Rule is a good way to initially screen out underperforming properties, there are several steps an investor may take to more accurately estimate operating expenses for a rental property:
- Purchase a rental property listed for sale on Roofstock that includes due diligence documents such as a rent ledger and pro forma cash flow statement.
- Talk to other landlords and local property managers who own or manage similar properties in the same area to gain a better idea of what typical rental property operating expenses are.
- Contact utility companies to the average costs of utility services for a property, even if a tenant is paying their own utilities, because a home with historically high utility bills may be unaffordable for a tenant.
- Use Stessa Rent Estimate to determine a fair asking rent based on current listings, rent comparables, and market trends.
Other property costs to consider
While these are not technically operating expenses, there are other property costs that an investor may wish to consider:
A professional appraisal is conducted by a third party to estimate the fair market value of a property. A lender may order an appraisal to ensure that the home is worth at least the purchase price, while a cash buyer may order a property appraisal as well.
As part of the due diligence process, an investor may have a licensed home inspector or contractor perform an in-depth property inspection. Depending on the issues found, a buyer may ask a seller to lower the asking price, offer a credit for repairs, or close the deal and pay for any needed repairs out of pocket.
Closing and escrow fees
Buyer closing costs on a rental property typically range between 2%-5% of the loan amount. With the exception of interest, certain mortgage points, and property taxes, most other closing costs must be added to the property costs basis and depreciated over time.
Business license and permits
Costs to set up a limited liability company (LLC), annual state registration fees, and local and state business licensing fees vary depending on the state, county, and city a rental property is located in.
Where to find a free template for rental property operating expenses
Downloading a rental property expense worksheet template from Zillow is one option for keeping track of operating expenses. The Microsoft Excel worksheet is easy to use, and may be a good match for owners with 1-5 properties.
However, one of the big drawbacks to using a spreadsheet is that expenses have to be entered manually. Instead of using a conventional spreadsheet template, a rental property owner can sign up for a free account with Stessa to track every expense down to the last penny, and claim every possible tax deduction as well.
Stessa was designed by rental property owners for rental property owners to provide real estate tools to the investment community at the lowest possible cost. After signing up for a free account, simply enter the property address, connect bank, credit card, and mortgage accounts, and begin running financial performance reports in real time directly from the owner dashboard.