The Expert Podcast

So how does a landlord come up with the amount that they want you to pay for rent? What's the formula? How is it calculated? Well, here's how you can get an insight into how landlords come up with the amount. It might give you some negotiating leverage if you know how rent is calculated, so you can tell what money the actual landlord is charging you compared to their cost. So today, we're going to look at an example house. This house happens to be in Georgia; it's a simple 3-bedroom, 2-bath house costing $275,000. This is the type of house that is popular for rentals. It's a house that, um, is a single-family, single-story, around 300 grand in price. A landlord or property owner who is renting this house is going to calculate that rent partially based on the market but also based on their expenses. We're going to go through those so you can make sure that the landlord is only charging you expenses that are appropriate. They're not artificially inflating it.

One of the first expenses that a landlord is going to have to pay is their mortgage. So how much does a mortgage kind of cost? Well, we put in a mortgage amount of $240,000, 30-year fixed at 8.5%. Let's change that to 7.5% because right now you can probably get 7.5%. That's going to give you $1,688—that's their mortgage payment that they have to pay. In addition to their mortgage, they're going to have to pay a couple of other things. One of them is taxes. Well, this house right here has a tax amount of about $2,000 a year, so they're going to have to pay those taxes as well. So how much does that come out to per month? Well, if you take $2,000 and divide it by 12 months in a year, that gives you about $166 for your taxes. You're also going to have to pay insurance. Insurance on a house like that will probably be about $1,200. Divide that by 12, that's $100 a month. So if you take that $266 and add it to the mortgage payment, which is $1,688, their base payment for the house is about $2,000 a month. Now, that's not all.

In addition, they're going to have to have some reserves for repairs and maintenance on the house. A good rule of thumb for a house, single-family, is about 1 to 1.5% of the value of the house. So, if you take a house that's $275,000, you multiply it by 0.015, that's about $4,000 a month. It's probably a little high, so let's call it $3,500 on average. Now, some years there may not be any repairs on the house, but some years you might have to put on a new roof, you might have to paint, and those things come up every 10 years or so, and you have to save up the money. If you just wait for the roof to go bad and need $30,000, and you didn't put money away, now that $30,000 is going to be an expense. So, the general rule of thumb is to put away about 1 to 2% of the house in a reserve fund. So, if the toilet breaks, or it needs paint, or needs a roof, you have it. So $3,500 would roughly be another $300 a month. So now you're up to about $2,300 a month total for the expense.

In addition, the property owner (landlord) is going to have some what's called "vacancy deficiency." What that means is every couple of years, there'll be a month or so that they'll collect no rent because it'll be in between tenants. So, that's maybe one month's worth of rent. Call that $1,500. So, maybe that's another $100 a month. So, if you add $100 onto $2,300, it gives you $2,400. And last but not least, some landlords will have a property management company, and they charge a fee. They charge usually one month's fee for the tenant. So let's just make that, on the low side, at another $100. So this house, in theory, at $2,500 a month, would be about a break-even for that landlord. Many landlords are willing to break even on a house because they're going to get some depreciation on taxes and they're hoping that the house is going to go up in value, and that might be their profit. Most of them are willing to break even on the house. So, if you see a landlord renting a house such as this for about $2,500 a month, that's probably in line with what their expenses are. If they charge less than that, they're probably going to lose money. If they charge more, that might be making a windfall profit. So, you can use your own best judgment and do the same math.

If you look at a different house, let's look at a house that's maybe a little bit more expensive. Here's one that's $389,000. That's a new house, so it won't have taxes. A house like this, if it's $389,000, and—well, let's back up one thing we forgot to do on this one. Remember, we put a loan amount of $240,000. The price was $275,000, that's $35,000 short. That's the down payment of that landlord. That down payment, you also have to figure a cost because instead of putting it into CDs, which get a 5% return, you're losing on the down payment. So, if you take $35,000 times 0.05%, that's going to cost you $1,750 a year in lost interest, divided by 12, so that's another $145. So now you're already up to $2,600–$2,700 for rent for the house.

On a newer home, let's take this $389,000 and plug that into the mortgage calculator. Let's do $350,000 for the mortgage amount. So now their monthly payment is going to be $2,400. Their taxes are probably going to be at the same ratio, maybe $3,800. So, you have $2,462 plus $300 a month for taxes, plus probably $200 a month for insurance, plus your reserve—remember, we got to do 1.5%-2%. That's going to be probably $500 a month reserve for repairs and maintenance. Now you're at about $3,500 plus your down payment. So, this house, if it was renting for maybe $3,600–$3,700, would be what the expenses of that landlord are. If you see a landlord charging you $4,500 for a house like this, they're making a lot more profit, which again, that's their right to try to do it, but it may not be as reasonable as somebody who's trying to get closer to their expenses.

I know you have an opinion about this. Let us know what your opinion is of what the rents are versus the cost of that landlord, and you could do the math yourself. Just take the price of the house, and you can look it up on Zillow for a Zestimate. Put it in a mortgage calculator, add the taxes, add insurance, and you can see what your landlord's expenses might be. Now, you might say, "Well, my landlord bought the house 5 years ago. He didn't pay $389,000 for the house." You're right, but if he only paid $200,000 for the house and now it's worth $389,000, that $189,000 difference, if he wasn't living in the house as equity, he could put it in CDs and make money there. So, he has to figure in that loss as well, because if you're going to rent it out for what he paid for it, that loss of interest on that cash that's sitting there—you might as well just sell the house, take the $189,000, put it in the bank, and you don't have to worry about renting a house and having tenants and all the administrative costs that go along with it.

So, you can't just go by what they paid for. You have to go by the current market value because that equity could be turned into income in a CD or some other passive income without having to worry about renting a house. Again, it's not a judgment on if rents are appropriate or not. It's just a way for you to do the math to see what your landlord's actually paying, so you can compare it to what they're asking to see if it makes sense.