Is It A Good Real Estate Investment?
Six Ways To Evaluate A Potential Rental Property
– What are your real estate goals?
– Early retirement?
– Additional income streams?
– Financial security?
Rental properties can provide all these benefits and more to savvy real estate investors who understand how to evaluate potential properties. Before you go out and grab your beach chair and a cold lemonade though, it’s important to define your expectations and set your goals.
Then, as you view potential rental properties you can determine if those prospective real estate investments will get you to where you want to go. There are six ways to evaluate a potential rental property to see if it will provide you with the returns you need on your investment, but first let’s chat about why you should invest in real estate.
Why You Should Invest In Real Estate
Now we won’t promise that you’ll become a millionaire through real estate investing, but we can’t promise that you won’t either.
Owning real estate and rental properties can help you build wealth.
- Cash flow
- Tax savings
When you invest in real estate, especially rental properties, you get both income and equity.
Why is this important?
Income provides cash flow, while equity is your ownership in an asset.
How To Make A Rental Property Analysis
— Income and Equity
A rental property analysis quickly calculates two main variables that will help you determine whether a real estate investment will provide you with a positive rate of return.
Once you’ve determined your real estate goals, you can then analyze whether the rental properties available on the market are the right investments for you. By defining your investment criteria early, you’ll be able to quickly screen out properties that don’t match your “buy box profile.
Pro Tip: Be transparent with your real estate agent about your investment criteria. They can screen properties against your profile and present you with opportunities from the MLS, pocket listings, and even prospect off-market properties that match your wants, which saves you time!
Cash Flow—How To Determine How Much Income Your Rental Property Will Earn
There is a difference between income and cash flow.
Where cash flow signifies how much money comes into your account, income (or more precisely, net income,) shows how much money you have left after paying expenses such as loan payments, taxes, property maintenance, and insurance.
To determine your potential net income from your rental property, you can use the following six calculations:
- Gross Rent Multiplier (GRM)
- The 1% Rule
- Cap Rate
- The 50% Rule
- Net Income After Financing
- Cash-on-Cash Return
Gross Rent Multiplier (GRM)
Gross rent is the rent you collect before you subtract your expenses and deductions.
Understanding this number is important when evaluating potential real estate investments because you can easily find this information to compare properties.
The Gross Rent Multiplier is the ratio of the property’s total purchase price to its yearly gross rent. Simply take the total purchase price of the property and divide it by the yearly gross rent.
Say you buy a property for $500,000 and it produces $50,000 each year in rent income. This property has a GRM of 10. A property that you purchase for $300,000 but provides $15,000 in income has a GRM of 20.
The higher the score, the less desirable or profitable a property is.
The 1% Rule
The 1% rule in real estate investing determines whether the monthly rent earned meets or exceeds the property’s monthly mortgage payment. To calculate, multiply the purchase price of the property plus any necessary repairs by 1%. This should give you the base level of monthly rent.
Keep in mind that this rule does not take into account taxes, insurance, and other costs associated with the upkeep of the property. So while a property may meet the 1% threshold, it doesn’t mean it’s a good investment. This calculation may simply give you a quick analysis of potential properties that should be analyzed more in depth.
Here’s the 1% rule in action:
Let’s say you’ve found a condo for $180,000 but to get it into shape, you must invest another $20,000 in repairs for a total cost of $200,000. One percent of $200,000 is $2,000. Your mortgage should not exceed this amount.
Make sure to look at rental rates in the area for similar or like properties to see if the rate you must charge to meet the 1% rule would keep your property competitive.
Cap rates are used as a metric when comparing the price of a rental property in the market to other similar properties that were sold in the last 6 months. It tracks trends in the real estate market and takes into account the fluctuating value of property according to market conditions.
A property’s capitalization rate or “cap rate,” is the property’s Net Operating Income (NOI) divided by the value of the property. (This does not take into account your mortgage or financing expenses.)
The Net Operating Income of your property is the gross rent with all of the properties operating expenses and deductions subtracted.
How to calculate your cap rate:
Take the property’s gross income and subtract the operating expenses to get your NOI.
Divide the NOI by the property’s value or the purchase price.
Move the decimal two spaces to the right to get your percentage.
Or, Cap Rate = (NOI/Property Value) x 100%
To illustrate the Cap Rate in action, here’s an example:
Let’s say you purchase a duplex in Salt Lake City for $250,000 that generates $30,000 in annual rent and costs $5,000 in taxes, insurance, property management, and upkeep.
($30,000 – $5000)/$250,000 x 0.1 = 10%
The cap rate for this property is 10%
What Is A Good Cap Rate For Rental Properties?
Most real estate investors look for cap rates between 8-12% but it depends on the property type, location, and rental strategy. For example, you may look for a 5-10% cap rate for Airbnb or short-term rentals but a higher cap rate for long term rentals.
The 50% Rule
The 50% rule is an expense ratio metric that estimates your operating expenses to be at least 50% of your gross income. For example, if your rental property makes $30,000 a year, you should expect that at least $15,000 should go towards expenses.
Expenses may include:
- Property Insurance
- Property Taxes
- Property Management
Keep in mind that this is just a rule of thumb that is based upon the net experience of hundreds of real estate investors. When evaluating a property, you can generalize when deciding whether to put this property into your buy box, but before proceeding on the final purchase, find out the actual numbers to ensure they don’t exceed 50% of your gross income.
Net Income After Financing
Up until now, these calculations have not included financing costs. Not many real estate investors pay cash up front for properties and most leverage debt utilizing smart strategies that reduce their risk.
The net income after financing is the calculation that does take into account your financing costs, including mortgage and debt services.
It’s a simple calculation that takes your Net Operating Income (NOI) and subtracts your expenses and also subtracts your mortgage.
This number is your monthly cash flow.
So, if you have set a goal to receive $1000 a month in extra cash flow and your income properties produce a gross income of $36,000 a year with 50% going towards operating expenses and another $6,000 payable yearly to your mortgage company, then this property meets your criteria.
Most investments calculate the ROI or Return On Investment. However real estate investments are an entirely different animal because you won’t know what the real estate market will look like when you sell your property.
So real estate investors use a different metric when looking at their return on investment called the cash-on-cash return.
The cash-on-cash return is simply the net operating income divided by the total cash investment.
It tells you how much of your initial investment that you put down in cash on the property will return to you year over year.
Here’s an example of how it works:
You want to buy a 3 br/2 bath condo for $250,000 that you are able to rent out for $2400 a month. You have a 30% cash down payment of $75,000.
You get a loan for $175,000 with a debt service of 4% = $7,000
Your NOI is $14,400 – $7,000 = $7,400.
Now, to calculate your cash on cash return you take your NOI/total cash investment which is $7,400/$75,000 = 9.8%
So the cash on cash return you will generate from this rental property if you take a bank loan for 70% of the price is 9.8%
Ready To Invest In Real Estate?
Call Your Utah Realty Today!
Our real estate agents can help you locate and buy real estate properties along the Wasatch Front. To learn more about what we can do for real estate investors, check out our investors page.
Give us a call at (801) 893-8880 or search the Wasatch MLS here.