Rentals: buy and hold

A rental is a simple machine. Rent comes in. Every cost goes out. What is left over each month is your cash flow. That leftover is the whole point.

When cash flow is positive, the property pays you. When it is negative, you pay the property every month, and that is a job nobody signs up for. So the first question on any rental is never "what does it rent for." It is "what is left after every cost is paid."

You will hear people talk about the home being worth more someday. That rise in value is called appreciation. It is nice when it comes. Never count on it. Plan on the cash flow you can count today, and treat any rise in value as a bonus you did not budget for.

The rent looks like money in your pocket. Most of it is already spent. Here are the costs that eat it, including the ones new buyers leave off:

• The loan payment. Your monthly mortgage on the money you borrowed to buy the place.
• Property taxes. The town charges them every year, and you pay a slice each month.
• Homeowners insurance. The lender requires it, and you pay it monthly.
• A repairs set-aside. Stuff breaks. Set aside about 10 percent of the rent every month, even in months nothing breaks, so the cash is there when something does.
• A vacancy set-aside. No rental stays full forever. Set aside about 8 percent of the rent for the empty months, because empty months are certain, never a maybe.
• Property management. If you do not want the calls and the repairs yourself, a manager handles them for about 8 to 10 percent of the rent. Self-manage and you keep that money, but you do the work.

Add all of that up first. Only then do you know what the rental really pays.

Here is the rule that keeps beginners safe: price every cost on a deal before you make an offer. The seller's flyer shows you the rent and the price. It will not show you taxes, insurance, repairs, or the empty months. You add those yourself. If a deal only works when you leave a real cost off the page, it does not work.

Use the tool below. Put in the price, the rent, and the costs. It shows you the monthly cash flow and the yearly return on your cash. If the number comes back thin or red, you walk. There is always another house.

Let's run a real one, start to finish, so you see how the check works.

The price is $160,000. You put 20 percent down, which is $32,000, plus $4,800 in closing costs. That is $36,800 of your own cash in the deal.

The rent is $1,500 a month. Now the costs: taxes $210, insurance $95, a repairs set-aside of $150, a vacancy set-aside of $120, and a loan payment of about $852. Add those up and take them out of the rent.

What is left is about $73 a month. Over a year, that works out to a cash-on-cash return of about 2.4 percent on your $36,800.

A rental is not free money that shows up while you sleep. Being a landlord is a part-time job: real work for real pay. Here is the work.

• Calls. A pipe leaks at 9 at night and your phone rings.
• Repairs. You fix it yourself, or you pay someone who can.
• Tenant screening. You check who moves in: their income, their past landlords, how they paid before.
• The rules. Your state and your town have laws for landlords. You learn them, because breaking one is expensive.

Two habits carry the whole job. Screen slow: a bad tenant costs you far more than one empty month, so take your time picking. Respond fast: when a good tenant calls with a problem, fix it quick, and they stay for years. Slow to choose, quick to help.

You controlled a $160,000 house with $36,800 of your own money. The loan covered the rest. That is leverage: using borrowed money to control something bigger than your cash could buy on its own.

Leverage is a knife with two edges. When the property does well, the loan multiplies your gain. You earn on the whole house while only your smaller cash is at stake. When it does poorly, the loan multiplies your loss. The payment is due every single month, whether a tenant pays you or not.

That is why cash flow and those set-asides matter so much. They are what keep the second edge from cutting you. Respect the loan, keep your reserves full, buy deals that pay from day one, and leverage works for you. Skip the numbers and it works against you just as fast.