Are you afraid to overbid on an investment property? This detailed article explains how investors calculate the quality of the investment they make in a property, which helps determine what they can pay. We will begin with rental properties, and stay tuned next week to hear about flip properties.
Evaluating a Rental Property
There are two main ways of calculating the quality of the return on investment for a rental investment property. The first involves using the cap rate to determine if the ROI is in the range you need to make the deal worth it. The second is calculating your monthly cash flow. We will start with the cap rate.
Tip: If you are looking for rental properties in your area, try creating a free account on our site. Many deals include a rental value in their description.
Method 1: Cap Rate
The cap rate is the ratio of net rental income compared to the purchase price of the property.
To calculate your estimated gross rental income earnings, total up your rental income for the entire year, and subtract 5% for potential vacancies.
(Rental Income x 12) – (Rental Income x 12 x 0.05) = Gross Rental Income Earnings
Next, add together all your expenses throughout the year.
- Insurance – Contact your insurance agent to run over the specifics of the property and get a quote for the coverage you need.
- Property Taxes – The property taxes are going to be different from what the former/current seller is paying since the property will not be owner-occupied. Contact the local county assessor to find out what the property taxes will be for the rental.
- Utilities – You may decide to have your tenant pay most of the utilities, but make it very clear in your agreement with them what they are responsible for. Many landlords choose to absorb the fees and to account for the costs via the rent. Utilities can include water, gas, electricity, pest control. We recommend NOT absorbing fees such as electricity into the rent, as research shows costs are lower when tenants are directly responsible.
- Maintenance – We suggest accounting for maintenance by estimating 5% of your gross income.
- Mortgage or Other Lender Fees – If you do not pay for the investment property in cash, be sure to calculate the monthly mortgage amount and another other fees and costs.
- HOA Fees – You can find out what the HOA fees are by contacting the former/current seller, but be aware that the fees could change. Investigate beyond the current fees to determine whether the fees are scheduled to rise or if an assessment is coming. (Source).
- Property Management – If you plan to hire a property manager, be sure to include this monthly fee in your costs as well. Many property managers charge around 10% of the rental price. (For example, if the property rents for $1,500 per month, the property manager would receive around $150).
Lastly, to calculate your cap rate, divide your net operating expenses by the purchase rate.
Example:
Annual gross rental income: Let’s say you buy a rental property that rents for $1,000/month. Multiply $1,000 by 12 to get the annual gross income. That equals $12,000 per year in gross rental income. Then, subtract 5% for potential vacancies, and the new total comes to $11,400. This is what you should use for your projected actual gross income.
Gross Rental Income: $1,000 x 12 = $12,000
Potential Vacancies: 12,000 x 0.05 = $600
Projected Gross Income: $12,000 – $600 = $11,400
Operating expenses: Let’s use arbitrary numbers for this example, but you can find many of these estimations on real estate websites that include properties in your market area (Zillow.com, for example). For this example, let’s say the taxes and insurance are $200/month, the utilities are paid by the tenant, maintenance is estimated to be $600/year, and there is no HOA fee or property management. Add it all up, and you end up with $3,000 in operating expenses for the year. This example also assumes the buyer paid in CASH, so no mortgage or loan amount was factored into the calculation.
Operating expenses: ($200 x 12) + 600 = $3,000
Net operating income: The gross rental income minus the operating expenses comes to $8,400, which is the net operating income in this investment property example.
Net Operating Income: $11,400 – $3,000 = $8,400
Cap rate: Lastly, to calculate your cap rate, divide the net operating income by the purchase price. If the house costs $100,000 in this example, then the cap rate is 6.7%.
Cap Rate: $8,400 / 100,000 = 8.4%
What is a good cap rate for a rental investment property?
It depends on the house. For a newer house in a decent neighborhood that does not require major repairs, maintenance or other risks, 4%-10% is a reasonable return rate. (Source.)
However, in a higher risk property, a rate of closer to 20% might be more reasonable.
Other considerations:
The example above assumed the property was paid for in cash. If you borrow from a lender, be sure to include the fees involved when calculating your operating expenses for the initial loan and recurring mortgage.
The example above also did not mention 1) rising rental rates and 2) property value appreciation. If you’re in it for the long haul, your investment property WILL appreciate, and the rents will rise with appreciation (if you’re in a good market). While you cannot include these estimations in your initial calculations, it’s good to keep in mind that there is great potential for the cap rate to improve as the property gains equity.
For these reasons, cash flow is often a more popular way for investors to calculate what they are willing to pay for a rental investment property.
Method 2: Cash Flow
Most rental property investors are more likely to make a buying decision by looking at monthly cash flow of their investment.
In order to calculate your monthly cash flow, simply add up all your monthly expenses and subtract the total from the rental amount.
In this example, let’s use a property from MyHouseDeals, 5602 Lakefield Dr., and include a monthly mortgage of $500/month (ARV is estimated to be $75,000). If taxes and insurance are $150/month, utilities are paid by the tenant and estimated repairs are $600, or $50/month, then your cash flow is:
Monthly Costs: Mortgage ($500) + Taxes/Insurance ($150) + Maintenance ($50) = $700
Monthly Cash Flow: Rent Price ($1,000) – Costs ($700) = $300
Let’s perform one more example. This house has an ARV of $100,000. The interest rate is 5%, making the monthly mortgage $737. The insurance and taxes add up to be about $225 per month. The rental prices in the area are closer to $1,300, so we will use these numbers below.
Monthly Costs: Mortgage ($737) + Taxes/Insurance ($225) + Maintenance ($65) = $1,027
Monthly Cash Flow: Rent Price ($1,300) – Costs ($1,027) = $273
Some investors accept as low as $100 cash flow, so it’s up to you to determine what an acceptable monthly cash flow is. If the property is expected to appreciate and there are no major problems with the house, $100 cash flow could work great.
Method 3: Stay Tuned Next Week!
Hopefully the information above provides an introduction into evaluating the offer price of a rental investment property. Next week, in Part 2 of this post, we will talk in detail about pricing flips.
If you have follow-up questions, or if you think we left something out, comment below! Not only will we include the update in the post, but we will also give you a shout out (unless you prefer to keep your genius brain private).
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