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How do I determine the real cost of buying an investment property over time considering rent, interest, expenses and capital gain?

I know there are many factors at play but is there a generic formula to get started on figuring this out?

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3 Answers

There is no generic formula as such, but you can work it out using all known incomes and expenses and by making some educated assuption.

You should generaly know your buying costs, which include the purchase price, legal fees, taxes (in Australia we have Stamp Duty, which is a large state based tax when you purchase a property). Other things to consider include estimates for any repairs and/or renovations. Also, you should look at the long term growth in your area and use this as an estimate of your potential growth over the period you wish to hold the property, and estimate the agent fees if you were to sell, and the depreciation on the building. These things, including the agent fees when selling and building depreciation, will all be added or deducted to your cost base to determine the amount of capital gain when and if you sell the property. You then need to multiply this gain by the capital gains tax rate to determine the capital gains tax you may have to pay.

From all the items above you will be able to estimate the net capital gain (after all taxes) you could expect to make on the property over the period you are looking to hold it for.

In regards to holding and renting the property, things you will need to consider include the rent, the long term growth of rent in your area, and all the expenses including, loan fees and interest, insurance, rates, land tax, and an estimate of the annual maintenance cost per year. Also, you would need to consider any depreciation deductions you can claim. Other things you will need to consider, is the change in these values as time goes by, and provide an estimate for these in your calculations. Any increase in the value of land will increase the amount of rates and the land tax you pay, and generally your insurance and maintenance costs will increase with time. However, your interest and mortgage repayments will reduce over time. Will your rent increases cover your increases in the expenses.

From all the items above you should be able to work out an estimate of your net rental gain or loss for each year. Again do this for the number of years you are looking to hold the property for and then sum up the total to give a net profit or loss. If there is a net loss from the income, then you need to consider if the net capital gain will cover these losses and still give you a reasonable return over the period you will own the property.

Below is a sample calculation showing most of the variables I have discussed.

Estimated Return on Property Purchase

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When you invest in a property, you pay money to purchase the property. You didn't have to spend the money on the property though - you could have invested it in the stock market instead, and expected to make a 4% annualized real rate of return or thereabouts.

So if you want to know whether something's a "good investment", ask whether your annual net income will be more or less than 4% of the money you put into it, and whether it is more or less risky than the stock market, and try to judge accordingly.

Predicting the net income, though, is a can of worms, doubly so when some of your expenses aren't dollar-denominated (e.g. the time you spend dealing with the property personally) and others need to be amortized over an unpredictable period of time (how long will that furnace repair really last?). Moreover your annualized capital gain and rental income is also unpredictable; rent increases in a given area cannot be expected to conform to a predetermined mathematical formula. Ultimately it is impossible to predict in the general case - if it were possible we probably would have skipped that last housing bubble, so no single simple formula exists.

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Fennec, regarding the time spent dealing with the property personally; in anything we do we have to spend time on it. The more involved and the more control you want over what you are doing the more time you need to spend on it. If you want to invest in the stock market you need to spend time analysing the market and analysing the individual shares. Then if and when you buy the shares you may spend more time monitoring those shares. Or if you don't want to spend much of your own time you can pay someone else to do it for you. The same thing goes for property investments. –  Victor Apr 21 '12 at 0:49
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@Victor - the comparison of time doesn't scale. I can invest $25,000 or $2,500,000 in exactly the same way, say in an index, and spend very little time paying attention to anything. Rebalancing to a targeted mix may take minutes every year. Real estate is hands on. Or to avoid it, the added expense of a manager. I live 4 hours round trip from a rental I owned. I once paid a plumber $100 to light a match. No joke, that's exactly what his bill said. –  JoeTaxpayer Apr 21 '12 at 2:29
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@JoeTaxpayer, but that was your decision to buy 4 hours away. I bought some properties in 2008 and spent between 2-4 weeks each fixing them before renting. Since then, I would spend 2 days on each (averaged between them) doing any maintenance. We manage the properties ourselves and spend a total of between 10 to 60 minutes each week checking rents and making any calls. We spend approx. 20 days total each year on our properties and they bring us in over $50K in income per year before tax. To me this is time well spent. Regarding shares and derivatives I would spend approx. 6 hrs/week on them. –  Victor Apr 21 '12 at 4:03
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@JoeTaxpayer, also I could buy a property worth $100,000 or one worth $2,000,000 and spend the same amount of time on both of them. Regarding investing in an index, you could also just invest in a managed fund or invest directly into shares. It all depends on how much control you want over your investments. The more control the more time you will need to spend on them, and that was my point. –  Victor Apr 21 '12 at 4:16
    
"The more involved and the more control you want over what you are doing the more time you need to spend on it." This is indeed true. But some spending of time leads to financial benefit, and some does not. I merely wish to identify that the relative value of "doing something else" (pursuing other investments, engaging in leisure, just working a 9-to-5 job, contracting, etc) is nontrivial to determine, but a real cost. –  fennec Apr 21 '12 at 5:04
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I know of no generic formula for determining if an investment property is a good investment, besides the trivial formula. Make sure your income is greater than your expenses, and hope the value of the property doesn't drop.

Some people will tell you to expect the monthly rent to be a fixed percentage of the purchase price, but that is a goal not a certainty. It is also impossible to estimate the difficulty renting the property, or how long the roof will last. Taxes can't be predicted, as the value of the house increase, so do the property taxes, but you might not be able to increase the rent.

You can't even predict the quality of the tenant. Will they damage the property? Or skip out early?

You will need somebody who knows the local market to estimate the local conditions, and help you determine the estimated costs and income based on the actual property involved.

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