Updated Spring 2008

Many of our clients have a common goal: they want to maximize the total return on their Emerald Coast property investment – including price appreciation, rental income, and tax benefits – while owning a property that they and their families can enjoy from time to time. The 1990's and the early part of this century were kind to people with these objectives who purchased well-located Emerald Coast property. Since early 2005, however, we've seen a significant market correction that has brought many prices back to or below the levels seen in early 2004. In our opinion, this has created a major buying opportunity.

Today, as we deal with clients in person and field a growing number of inquiries through our web site, we often encounter questions about rental rates, investment returns, mortgages, and taxes such as those in this section. Here we’ll do our best to provide some opinions, rules of thumb, and guidelines based on our experience, but we hasten to add that we are not qualified accountants, property managers, or mortgage brokers. These specialized sources should be consulted where needed to deal with an investor’s unique economic and tax situation.

Are mortgage and insurance rates and availability more difficult for rental properties than for second homes that are not rented?

Generally, yes. Mortgage lenders consider rental properties with absentee owners a higher risk and, in today’s market, are charging ¼ to ½ % more interest when a property’s financing depends heavily on obtaining rental income. Some buyers prefer to qualify for their financing based entirely on their own income (claiming the property as a second home) and keep the rental income between themselves and the IRS. Mortgage companies frown on this, but there is little they can do about it unless they conduct an audit of the borrower’s property, which is rare. Insurance is similarly more expensive for rental properties, and claims for damages caused by renters may be problematic where the property was declared to be non-rental.

How much financing can I get for my property, and is it better to seek financing locally in Florida or through my primary home’s lender or bank?

80% financing is common for both second homes and rental properties. Based on the property and the borrower’s credit, an additional 10-15% may be obtained, usually in the form of a second mortgage at a higher or variable rate. Since the market heydays in 2004-05, lenders have become stricter in granting credit based on stated income and in funding second mortgages. Some clients with large equity in their primary residence have found the least expensive combination to be a first mortgage on their beach property and a second mortgage on their primary home.

How much rental income can I expect from my property if I decide to put it on the rental market?

Gross rental income is a simple calculation of the number of weeks the property is rented times the average rate per week. In our market of prime waterfront and near-waterfront vacation homes, rental rates and occupancy can vary widely depending on the property’s location, beach access, sleeping capacity, furnishings, and amenities such as swimming pools, BBQ, etc. It’s also a seasonal market, with prime summer rates often more than double those of the off-season and occupancy falling off in the winter months. Where the property you’re interested in has a rental history, ask to see it. Where it hasn’t, get an estimate from a local property management firm and ask for the basis for that estimate. Generally, rental occupancy for good properties should be 14-18 weeks per year, with the bulk of that in the peak season. Higher priced properties on the beach with lots of sleeping space do very well in the summer with families and groups, then fall off in the fall and winter. Smaller properties with lower price tags often do well with “snowbirds” and have a higher year-round occupancy. Be skeptical of claims of over 60% rental occupancy. Of course, the more time you spend in the property yourself, the less time it’s available for rental.

What expenses do I need to deduct from my rental income?

Utilities, taxes, insurance, maintenance, rental management and cleaning costs all need to be considered before you even get to financing. There are a number of property management companies that will provide rental management services. Some are full-service, where the management company markets the property, books and collects rentals, handles key distribution and cleaning, and accounts for and distributes funds to the owner. Other arrangements are also available for where the owner secures the rentals (either personally, through advertising, or through web sites such as VRBO.com) and the management company simply administers the property. Property management fees are most often a percent of gross rentals, typically 25-35% depending on the arrangement. Cleaning costs are sometimes figured separately. Once a client has identified a specific property or properties of interest, we can assist them with a cash flow model of rental income, expenses, and financing costs to help them make a decision.

What expenses for my rental property can I deduct from my income for federal income tax purposes?

This can get complicated very quickly, and we urge you to seek the advice of your accounting or tax professional before committing to a plan of action. Deductibility of items can depend on many factors, including your total income, your ownership of other “passive” investments, whether you declare your property as a second home or an investment property, how much you use it personally, and whether you qualify as a “real estate professional” in the eyes of the IRS. For most of our clients, though, it boils down to this. You should be able to deduct all of your mortgage interest and taxes, and other rental expenses, including depreciation, up to the amount of your rental income. You will probably not be able to deduct depreciation expense in excess of rental income. However, you will be able to accumulate it and use it to offset any gain you might have on the sale of the property.

Will my rental property pay for itself?

Followers of the Carlton Sheets (and others) “no money down and no net out-of-pocket expenses” philosophy probably aren’t going to find happy hunting around here. The popularity of prime resort properties makes it highly unlikely that you will be able to break even “cash on cash” on an annual basis. With good rental income performance, however, you may be able to cover all of your operating costs and pay for 40-60% of your financing costs as well. Depending on your tax situation, your after-tax costs considering deductions for mortgage interest and property taxes may be further reduced. And, you’ll have a beautiful beach home building future wealth for you and your family!

When is the best time to buy (or sell)?

There really isn’t a “best” time. We've been in a buyer's market for over two years, and asking prices as well as actual sales prices have declined to where we think the bottom may be behind us (see What's Happening in Today's Market). In general, however, it may be more possible to negotiate more favorable terms on an existing property once the peak rental season is over. For new construction, it really doesn’t make any difference.

What is a “tax-free exchange” of property and will my investment property qualify?

Tax free exchanges, or more correctly tax-deferred exchanges under section 1031 of the Internal Revenue Code, are simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction. The gain on the sale of the first property is deferred until some time in the future, usually when the newly acquired property is sold. The requirements of section 1031 must be carefully met to qualify, but it is easier than many people think to accomplish this type of transaction. We’ll be glad to discuss specifics with anyone who is interested and to provide referrals to experts on this type of sale.

What other things should I consider when purchasing a property to maximize rental income and returns?

Here are a few thoughts:

• Seek newer developments, but with some established rental history
• Developments that are “built out” will probably do better, because new construction in the neighborhood won’t interfere.
• Be close to the beach with good beach access and a pool nearby. This is often better for net rental/investment economics than being right on the beach itself.
• More beds is better, including sofa-beds, for family and group-oriented properties
• Provide kid-friendly touches such as DVD/VCR’s in bunk bedrooms, etc.
• Furnish nicely but not elegantly. You want renters to feel comfortably “at home.”
• Promote the property yourself even if you have hired a property management company. A few extra weeks of rental secured through your efforts can make a big difference in total returns.