How do I find a profitable rental property? What is a good deal for a rental investment? What costs should I plan for? How much will it rent for?” There are many items to consider and several steps to take when determining if a property will ultimately make a good rental property. Above all else you should always know the numbers first. If the numbers do not work, walk away. Save yourself some time and emotional stress by running the numbers before you even see the property. Numbers, Numbers, Numbers. Sound fun? Let’s get started.
Step 1. Monthly Income: Typically this is going to be the rental amount received on a monthly basis. However, there are other potential income sources associated with certain properties that should also be factored into this calculation (parking, vending etc.). Determine what a reasonable and obtainable rental rate is for the rental property. Do this by taking into consideration available comparable properties actively being marketed in the immediate area and dial in the ability to compete and attract quality renters. When in doubt, ask an experienced property manager for a price opinion.
Step 2. Monthly Expenses: Mortgage Payment, Property Taxes, Insurance, Property Management Fees, HOA Fees, Utilities, Anticipated Vacancy, Maintenance & Repairs. Keep in mind that some of these expenses may not be applicable for your rental property type or financing approach.
- Mortgage Payment– Talk to your lender to confirm your payment based on purchase price, down payment and interest rate.
- Property Taxes– An annual number typically provided with the listing information, divide by 12 for the monthly number.
- Insurance– Get a quote from an insurance provider.
- Property Management Fees– Contact us and we’ll explain why our pricing is highly competitive and worth every penny.
- HOA Fees– A monthly number, typically found with the listing information – ask your agent if you are not sure.
- Utilities– An owner may elect to provide all, some or none of the utilities as part of the rent. Check comps to see what is being offered by other landlords in the area. Keep in mind that certain utilities may “run with the property” (depending on location/jurisdiction). This means the owner can ultimately be held responsible for delinquent accounts not paid by the tenant.
- Maintenance & Repairs– A good rule of thumb is to take 1% of the value on an annual basis. Example: If the property is worth $200,000 – estimated repairs would be $2,000 per year or $166 a month. Adjust accordingly for the condition of the home and critical infrastructure. Even if you do not spend 1% in a given year you may consider saving the balance for larger repairs that will undoubtedly be required down the road (roof, furnace etc.).
- Anticipated Vacancy– This is perhaps the most challenging category to estimate. We generally recommend a reserve of 5% of Monthly Income. However, a good Property Manager can drastically reduce vacancy periods by ensuring you are priced appropriately for the current market, attracting the largest possible number of potential renter and effectively managing the move out and move in periods between tenants.
Step 3. Calculate Monthly Net Income (Monthly Income MINUS Monthly Expenses) and Annual Cash Flow.
Is your Monthly Net Income number positive? Good start. If the number is negative, delete the rental property from your memory banks and move on. Multiply Monthly Net Income by 12 to get the Annual Cash Flow.
Step 4. Calculate Annual Net Operating Income– Annual Net Operating Income (NOI) is simply your Annual Income (Monthly Income x 12) MINUS Annual Operating Expenses. Annual Operating Expenses can be calculated by taking the Monthly Income figure from above, removing any Mortgage payments and then multiplying it by 12.
Step 5. Time to calculate your Return on Investment (ROI)– Cap Rate and Cash-on-Cash Return are two great calculations to determine if a rental property is a “good deal” and what type of relative return on investment you can expect.
Cap Rate = Annual Net Operating Income / Purchase Price (Asset Value)
The minimum Cap Rate to consider is certainly debatable and will be different for different markets. Many will say that anything lower than 6-8% may not be worth the time or risk. A higher Cap Rate means a higher return. However, Cap Rate is often based on risk or at least “perceived risk”. Just because a property has a high Cap Rate does not necessarily mean it is great deal for your particular situation. You must also take into account factors such as market conditions, neighborhood characteristics, area developments, etc. Ultimately you must determine your threshold for risk and the associated return when talking about Cap Rate. (NOTE: For purposes of Cap Rate, DO NOT use the Mortgage payment in the Income calculation. You should be using Annual Net Operating Income which excludes any Mortgage payments).
Cash-on-Cash Return = Annual Cash Flow/ Total Cash Invested
This number is used to determine how much return you are getting on the actual money you invest. If you pay all cash for a rental property, this number will be the same as the Cap Rate. If you are financing, this number is the most accurate way to see the actual return you are getting on the cash you invested. (NOTE: For purposes of Cash-on-Cash Return, DO use the Mortgage payment in the Income calculation. You should be using Annual Cash Flow).
Do you understand the difference of these two formulas? In review, use the Cap Rate to determine the quality of deal you are getting based on the purchase price. Use Cash-on-cash Return to calculate the estimated return on your money invested. They are the same for an all-cash purchase but can be very different for a leveraged/loan purchase.
Deciding between paying cash or getting a loan? Compare the Cash-on-Cash Returns of each option. You will quickly see the benefit of leveraging can give you more bang for your buck!
Do not forget these formulas do not include expenses for rehab or any work that may have to be put into a rental property once you purchase it (Capital Improvements). These expenses should be added to the purchase price number for your calculations. Do your best to conservatively estimate these expenses from your experience (or from your agent’s).
The numbers should not be the only determining factor in finding a successful rental property but the numbers are the crucial first step. If the numbers do not work, move on and find a rental property where they do.
Having fun yet? Practice. Practice. Practice. Go put your new number knowledge to work and compare the properties you’ve been considering. You may just be surprised at the results!