Real estate investment professionals use a number of financial tools to make sound investment decisions, most commonly “cap rates,” or the annual return expected on an investment. In contrast, people who are just starting to look for a single-family home or other residential property in which to invest, too often rely on gut instinct or emotion to drive their purchase decisions. They may simply love the property and hope that it will someday appreciate for a sizeable return. But even if a property appreciates (which isn’t always a given), will it appreciate enough to cover the annual costs to hold the property? The experts don’t invest for appreciation alone, so why should you?
The primary financial driver steering your investment property decision should be the annual income it will generate before the time comes to sell. If you are flipping real estate, this article isn’t for you. This topic is for those who are looking for a residential rental investment property that can be sold down the road, most likely to help with retirement income. If that’s you, then you should be concerned with the annual income potential of the property. Unless you can, at a minimum, cover your monthly mortgage amount with income left over from renting out the property, your investment could easily turn into a monthly drain on you and your family.
Calculating Income and the “Cap Rate”
Here are four steps to make wiser financial decisions like the pros:
1. Determine the annual rent you can expect from a residential rental property.
If the property is already rented, you should have a good idea of this figure. Otherwise, check rents of similar properties on Craigslist and real estate offices.
2. Estimate the annual expenses of owning the property.
This will include the following:
- projected vacancy costs, which are typically calculated by professionals at 5% to 10% of the annual rent and reflect the annual rent loss you can expect when the property is not being rented, such as when a tenant defaults on payment or you are in between tenants
- real estate taxes
- utilities that you (not the tenant) will be paying, such as water or gas
- property and liability insurance, such as a landlord’s policy, and
- repair costs over time to address the wear and tear of the home, including new roofing costs, furnace maintenance, and emergency repairs.
3. Calculate your annual net income
(annual rent, minus annual expenses).
4. Calculate the property’s capitalization rate, or “cap rate.”
This is the annual return you can expect for your investment, arrived at by dividing the net income by the cost of the property.
Example: You rent out a small, two-bedroom house for $2,000 per month or $24,000 per year. You anticipate annual expenses as follows:
|vacancy rate of 5%||$1,200|
|real estate taxes||$3,800|
|maintenance and other expenses||$2,000|
Annual net income = $17,000 ($24,000-$7,000)
In the example above, the asking price for the property was $325,000. The cap rate calculation then is:
$17,000/$325,000 = 5.2%
This two-bedroom property therefore yields a “cap rate” return of 5.2% (unless you can get the property for a lower price).
Understanding Your Prospective Property’s “Cap Rate”
The higher the cap rate, the better the annual return on your investment. If you are looking to make at least 5% income off your investment each year, you should let that drive your decision to invest. You can divide your calculated net income figure by your target cap rate to determine the price you’d be willing to pay for a particular property. The “cap rate” you should buy at depends on the location of the property you are looking to buy in and the return you require to make the investment worth it to you. Professionals purchasing commercial properties, for example, may buy at a 4% cap rate in high demand areas, or a 10% (or even higher) cap rate in low-demand areas. Generally, 4% to 10% per year is a reasonable range to earn for your investment property.
Continuing with our example from above, $17,000/ 5% = $340,000. This reflects the top price you would be willing to pay for this house, if you require a minimum return of 5% on your investment. With the current asking price being $325,000, this is a good investment for you.
Whatever rate of return you are aiming for, make sure the projected income leaves you with a healthy amount of cash after the mortgage payment has been paid. If you have a tenant who doesn’t pay for a few months, and the cap rate on your prospective property is just 2% or less, your investment property may quickly lose you money. Be sure to check your projected return against worst case scenarios for rent loss, to ensure you can handle carrying the property when it’s unoccupied.
Appreciation is great if you can get it, but it’s not a strategy that can put money in your wallet today. If you buy for income and use the cap rate calculation, you can find rental homes that provide higher returns on your investment.
If you’re new to buying residential real estate for investment, check out First-Time Landlord, by Janet Portman, Marcia Stewart & Ilona Bray. This Nolo book provides detailed advice on everything from learning your legal obligations to qualifying for valuable tax deductions.