Property Taxes – How The Tax Rate Impacts The ROI Of Your Rental Property
A couple of weeks ago I wrote about the impact of the property assessment, exemptions and tax rate on your property taxes. I mentioned that the tax rate does not change drastically from year to year. I also wrote that the investor greatly impacts the assessed value and the tax emptions that can be applied. This week I want to focus on the tax rate. It doesn’t change drastically in a given locality from year to year. However, the difference in tax rates from one area of the country as compared to another area of the country is large. It can have a major impact on the ROI of investment properties
Rents Received & Property Taxes Paid
When looking for a place to invest in Real Estate, especially Rental Property, the expected income and expenses need to be looked at. Rent received and Property Taxes paid are two things that change rather largely from area to area of the country. The rest of the items tend to be roughly the same from area to area. These items include management fees, vacancy, repairs, and mortgage interest.
The smart investor then looks for areas that have high rent and low property taxes. The amount you can charge for rent depends on the demand for properties to rent. The demand for properties to rent is based on the number of jobs available, the number of other housing options available, and on people’s preference to rent vs buy. You can quickly find data on jobs growth and rent preferences of all the cities in the United States on the internet.
Cap Rate – Key Investment Metric
My intent of this blog article is to assume that the rent for a given property is equal in all places and just look at the impact of property taxes on the rate of return on a rental property. A common way to calculate the rate of return on a rental property is to look at the Cap rate. The Cap rate is defined as annual gross income divided by the purchase price. Gross income is equal to Gross rents minus property taxes minus other fixed expenses (HOA, Management fees etc)
For example, You buy a rental property for $150,000 and receive $1,400 per month in rent. You pay $4349.25 per year in property taxes, $250 per year in Home Owners Association fee and 10% ($1400*12*.1 = $1680) per year in management fees. The Cap rate = ($1400*12 minus $4349.25 minus $250 minus $1680) divided by $150,000. This would be a Cap rate of 7.01 percent.
Variability of Property Taxes
I have looked at rental property throughout the United States. It seems like the HOA fees are low and do not change much from one location to the next. The management fees typically are around 10% throughout the United States. However, the property taxes have a high degree of variability from one state to the next. They also have a high degree of variability within state as you look at one location versus another. The major impact on the property tax is the property tax rate established by the local governments. This includes, county, city, park districts, school districts etc.
Property Tax Rate
A look at my own property taxes quickly shows that the rate is comprised of over ten different taxing authorities. These include
- Chillicothee Park 0.333905
- City of Peoria 1.12107
- Dunlap USD #323 4.5816
- Greater Metro Airport Authority 0.21516
- Greater Peoria MTD 0.23109
- ICC JC #514 0.49032
- Medina TWP 0.13481
- Peoria County 0.8241
- Peoria County Soil & Water 0.00032
- Peoria Library 0.43032
- RD & BR Medina 0.33067
- Total tax rate 8.6985
The yearly property taxes are calculated by taking the assessed value of the property and multiplying it by the total tax rate divided by 100. Remember the assed value of your home for tax purposes is 33.33 percent of the market value. See my blog from last week for further explanation on this. Then a property with a market value of $150,000 will be assessed at $50,000 dollars for tax purposes. The tax on this property would then be $50,000 * 0.086985 = $4349.25
Buying Decisions based on Property Taxes
It is important that people pay attention to the authorities that are setting your tax rates. Get involved and make sure that the tax money is being spent wisely and that the rates remain as competitive with other areas nationally and throughout the state as much as possible. Investors and to some degree home owners buying decisions are impacted by the amount property taxes paid each year.
For example, I recently purchased a property in another state. The total tax rate was 7.001. A $150,000 property would be charged $3500.50 ($50,000 * 7.001) for property taxes. This would be $848.75 (4349.25-3500.50) less property tax than that paid on a similar property near me.
Dollar Impact of Property Tax Rate
From an investor point of view, the Cap Rate is important. An 8% cap rate is considered to be a good investment. In the example we looked at, a $150,000 dollar property above had a cap rate of 7.01 percent. This same property but with lower property taxes in the example above of $3500.50 would have a cap rate of 7.58 percent. The investor would be making $848.75 more per year on their property. This is substantial.
Property tax rates do impact investors and to some degree home owners as to where they buy their property. The investor is free to buy property where they get the best return on their investment. It does not have to be local. The homeowner, does buy local but will look at the amount of taxes to be paid as one part of their buying criteria. If one area is substantially different than another area in the local community, then the area with the low tax rate will get more consideration as to the preferred are to buy a property in.