How to Evaluate Debt Service on a Rental Property
If you have to take out a loan, you should figure out if it makes sense financially. If you have to accrue debt, is it a good investment?
So I thought I would take this opportunity to thoroughly discuss how to evaluate debt service on a property.
The first thing you need to examine is your loan. Comprehensively examine the following points:
- How much money are you borrowing?
- How long will you be borrowing?
- What happens at then end of the term?
- What interest rate are you agreeing to?
- Is there a pre-payment penalty?
Next, you’ll want to calculate how much rent the property can bring in every month. There are a couple ways to find out the amount of profit. If you’re working with a turnkey provider, they should be able to give you an exact amount.
But if you’re doing it yourself, you might have to settle with an estimate. I like websites like Rentometer. All you have to do is put in an address or zip code, and it will give you a range. This range is based on the rent in other properties in the neighborhood. This might not be 100% accurate, but it’s a good place to start. When calculating your debt service, I would choose the lowest number in the range, just to be conservative.
Then, you’ll need to account for all of the expenses of your property, things like insurance, taxes, and a property management fee. For our properties, we like to take out 40%. Again, this is a conservative figure, but I’d rather come out pleasantly surprised than empty handed. You can learn more about our ROI formula here.
Now you’ll put all of these factors together to determine if the property will be profitable with your debt in place. You can use the website Bankrate or any amortized loan calculator. We like to use an excel spreadsheet that we’ve put together. You can download the free spreadsheet here.
In Gary Keller's book, The Millionaire Real Estate Investor, he posits if you can make $1 above your loan amount, it's a sound investment. However, I like to aim toward a profit of at least $100. Keep in mind that over time, you'll be able to pay off your debt service, and then you'll have a larger profit.