When it comes to investing, it’s safe to say that not all properties are created equal.
In fact, they vary quite a bit.
The nicest property on the block could end up yielding less than you’d hoped. Likewise, that older rental that might not look like too much could turn out to be your diamond in the rough. You never can tell! At least not initially, that is!
You need a way to determine whether a property that you’re investing in is one that’ll perform well as a rental –and an investment.
Fortunately, when it comes to assessing a potential rental, you can usually get a pretty good idea about its performance. How? By running the numbers –and seeing if the returns that you’re likely to generate mean that you’ll be turning a profit, or going into the red.
While it may sound complicated, running the numbers on your property is easy; especially the simple “back of the napkin” number crunching that you can do to determine whether a property even warrants a closer look. Running a few basic numbers will help to screen out properties that don’t meet your investment criteria, and will keep you from wasting time with a property that’s just not worth it.
Ready to get started? Here are the numbers you’ll want to pay attention to before you invest in your rental.
Preliminary Numbers
First up, a look at a few things you’ll want to calculate to make it easier to run your numbers later on.
- Purchasing Costs
Purchasing costs include the purchase price, along with all of the closing costs as well as the interest you will be paying on the mortgage over the years.
- Monthly Income
Your monthly income is the amount you are able to charge for rent.
This can be based on the amount that the tenants are paying, if it’s being sold as an investment property and currently rented. If it’s not rented, then you can head over to Zillow or Trulia and find out what similar properties in the area are renting for. You can also talk with a local property manager or real estate agent to get a better idea on the going price for rentals in the area.
- Monthly Expenses
Here’s a look at some, if not most of the expenses that you’ll have with a rental property. Being clear on the amounts will help to give you an accurate picture of the type of returns that you can expect to get.
- Mortgage Payment
You can use an online mortgage calculator to figure out your monthly payment. You’ll also want to confirm with the bank what your down payment will look like, and what your interest on the loan will be as well.
- Property Taxes
While property taxes might only come out once a year, it’s important to calculate them into the monthly expenses so you can accurately gauge whether you will be making a profit once the end of the year rolls around. You can use an affordability calculator for a fast and easy way to get a ballpark figure on what your property taxes will be.
- Insurance
It’s a good idea to get a quote from an insurance company when tallying up your projected expenses.
- Property Management Fees
While you might be tempted to go it alone, you should calculate in property management fees just to be safe. Hiring a property manager can save you a lot of time, especially if you own multiple properties or rentals that are out of town. Contact local property managers to see what they charge.
- HOA Fees
If you’re buying a property that’s part of an HOA, then you’ll want to find out what the fees are. If you can’t get the total from the seller, then you’ll want to call the HOA itself.
- Vacancies
It’s a good idea to set aside 10% of the monthly rent for vacancy expenses.
- Repairs
While repairs will vary considerably depending on the condition of the property, it’s a good idea to set aside at least 2% of the property’s value annually for repairs.
Running the Numbers: “Back of the Napkin” Calculations
Once you have a potential property in your sights, you can start running the numbers to see how everything stacks up.
Here are some calculations that investors use to determine whether a property meets their investment criteria:
- Cash Flow (Net Income)
To calculate a property’s cash flow, subtract your monthly expenses from your monthly income. If it’s positive, that’s a good sign. If it’s not, then in most cases you’ll want to walk away!
Monthly Rent – Monthly Expenses = Cash Flow
How much cash flow should you be generating? Again, that depends on your investment goals and criteria.
In many cases, though, it’s expected that a property should produce at least 1% of its purchase value in rent. This is known as the 1% rule, and is a fast and simple preliminary calculation that investors use to determine whether a property’s worth pursuing further.
- The Cap Rate
The cap rate is the return that you’d generate if you paid for the property up front in cash. This figure is expressed as a percentage.
To discover the cap rate, take your net income and divide it by the property’s cost.
Annual income / purchase price = Cap Rate
So for example, say your property cost $200,000. It’s renting for $2,000 per month, and your expenses are 1,400 a month, leaving you with $600. So your net operating income or cash flow is $600 per month or $7,200 per year.
$7,200/$200,000 = .036 or 3.6%.
Are these good returns? That depends –on your investment criteria, and the property itself. Many investors will take capital appreciation into consideration as well. If, for example, you expect the property to appreciate considerably in the near future, then you may be more willing to accept these returns. However, if the property is in need of extensive repairs or if it’s in an area that experiences slower appreciation, then these returns would most likely be too low.
- Cash-on-Cash Return (CoC)
Finally, cash-on-cash returns. This figure is important if you’re looking to finance the property. The CoC is the return that you’ll get on the money you’ve invested.
You’ll want to use the amount of money that you’ve invested yourself, rather than the purchase price of the property when tallying up your CoC returns.
Here’s the equation:
Annual Income / Money Invested = Cash-on-Cash Return
Putting It All Together
Now that you have all the numbers, you should have a pretty good idea about whether the property deserves a closer look. If so, then it’s time to put boots on the ground, visiting the property in-person is always a good idea. You’ll also want to talk with a local investor-friendly real estate agent as well as a property manager to get an idea about the local rental market and to see how much they feel the property would rent for.
Finally, while numbers are helpful, they won’t tell you everything about a rental. They won’t give you an idea about things like unexpected vacancies, tax increases, or damage that arises seemingly out of nowhere. Still, when taken together, the numbers will be able to help you make an informed decision; giving you a clear idea on a property’s potential as an investment, and indicating when it’s worth taking a closer look.
Have a rental property in mind? If you’d like to learn more about the local housing market, be sure to head over to the Renters Warehouse Research Center. There you’ll be able to see key data –like home price performance, along with employment and population trends, giving you the data that you need to make informed investing decisions.
Photo by Kelly Sikkema on Unsplash
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