For many landlords, identifying and investing in a good investment property and for investment property owners with multiple units, it is the next opportunity to grow their portfolio. Whether you work with a property manager or not, the profits and losses are yours alone. This business decision is all about numbers and has to be weighed and assessed before making a purchase decision.
What is a good return on a rental investment?
A rental property will not become a cash cow or a passive income immediately after purchase. In fact, it may take a few years for homeowners to break even on their investment. Though many factors involved in calculating the profitability on a rental property, here are some quick-view pointers:
Monthly cashflow: This is the net rental income that the property is likely to generate and is calculated as income after expenses. But this is not as straightforward as it may seem. On a new property, depending on the area, the cashflow may be as low as $100, if it is at least positive. In larger cities, where mortgage rates are high and rental rates are moderated, the first few years may have a negative cash flow.
Appreciation: Unlike other assets, real estate properties tend to increase in value over time. The last few years have seen a rapid increase in values, rising almost by 6-10% and making it a very lucrative market. Though demand drives the rates, inflation plays an almost equal role in the appreciation of property values. And like it every market, there may come a time where property values stay the same too. Consider the long term benefits rather than the everyday fluctuations.
Potential for increasing value: Will you be able to increase the value of your property by making some cosmetic changes? For example, a hundred year old property can do with a good face lift, like fixing walls, floors and even a central air conditioning system. Or it could be converted into a duplex, by following city zoning guidelines to increase the rental income or resale value.
Choosing a property
Every rental property is different and choosing the right one for your has a bearing in helping you achieve your goals for your rental investment.
The neighborhood where you buy a property determines what kind of tenants you will have. Many property managers classify neighborhoods into A, B and C depending on the income levels and demographic A being the highest and C being the lowest. If you buy a property that is near a university, you may expect your tenants to mostly be students who may vacate in a year, sublet the rental, cause more wear and tear etc. A property in the suburbs may attract young families who will prefer proximity to schools and so on.
Property tax is another major expense for the home owner to make on the rental property. It may vary depending on the city, age of the property or even the lot size. A high property tax does not necessarily mean it is bad for the rental income, it may be a prime location that has low turnover. But taxes are a major factor to consider before purchasing a property.
Number of similar vacancies
Do a quick check online to see how many similar properties are up for rent, not just to see your competition but also to determine the demand for rental properties in that area. It will also help to see how long those properties have been on the market so you have an idea of how long it would take for you to fill a vacancy.
Calculate returns using cap rate
A cap rate is one of the most popular ways to determine the risk in investing in a property. A higher rate indicates lower risk, while a lower rate indicates that there is a high risk in investing. Cap rate is basically a formula-
Cap rate = (Net operating income / Purchase price) x 100
Net operating income is determined by subtracting your yearly expenses on the property from the yearly rental income.
This formula assumes you bought your property in cash and does not include the mortgage payment as an expense, thereby giving you the actual return rate on your property.