How To Evaluate Rental Property Investment

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Using The Numbers To Our Advantage

How To Evaluate A Rental Property

We are currently renting our primary residence. Our plan now is to pay off the my student loans by June this year, and then save a 20% downpayment for our next primary residenceWhich should take about 8 months at our savings rate.

So, Ive been mulling this master plan- what if we sell the Nashville house and put the proceeds towards buying our primary residence.

There are a couple of glitches here. If we had lived in the Nashville house for 2 years out of the last 5, we could have not paid any capital gains tax. But unfortunately, we moved out 4 years ago, so we would have to pay capital gains tax . So with $180k equity- 5k in improvements for sale 10k in closing costs- 46k in taxes leaves us with 119k of net gains.

There is a provision called the 1031 exchange which allows rental properties to be traded without paying capital gains tax. So, if we keep the rental and sold it later, we could buy another rental- maybe a multiunit building- and not have to pay any capital gains tax.

I always shoot for the sky.

Things To Keep In Mind

Generally, the higher an investment’s IRR, CFROI, and cap rate, the better. In the real world, it is very unlikely that an investment in a rental property goes exactly as planned or as calculated by this Rental Property Calculator. Making so many financial assumptions extended over long periods of time may result in undesirable/unexpected surprises. Whether a short recession depreciates the value of a property significantly, or construction of a thriving shopping complex inflates values, both can have drastic influences on cap rate, IRR, and CFROI. Even mid-level changes such as hikes in maintenance costs or vacancy rates can affect the numbers. Monthly rent may also fluctuate drastically from year to year, so taking the estimated rent from a certain time and extrapolating it several decades into the future based on an appreciation rate might not be realistic. Furthermore, while the appreciation of values is accounted for, inflation is not, which might distort such large figures drastically.

How To Calculate The Roi On A Property Investment

Real estate investor, Founder/CEO of TurboTenant: rental marketing, tenant screening, rental applications, rent payments, and more.

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Investing in real estate, and more specifically in rental properties, can be one of the most lucrative and safe investments people can make. With long-term appreciation, a monthly cash-flow and tax advantages, owning and operating rental properties will increase your wealth so you can save for retirement, life events or for other reasons. It might seem intimidating to know where to start, but rental property investing is for anyone and everyone no matter your age or experience.

I bought my first property when I was 19 and discovered the hardest part about getting started was finding the right property and knowing if the investment would eventually pay off. Lets break down the basics of rental property investing and, most importantly, how to calculate the return on investment for a property.

Types Of Properties To Invest In

For those new to real estate investing, rental properties can be single-family homes, apartment complexes, townhouses, duplexes, multi-family apartment buildings and more. The main advantage of owning and renting out a property is the monthly cash flow from rent payments many argue it’s one of the safest investments you can make. Another bonus is that landlords can decide if they want a long-term or a short-term rental both of which have different pros and cons depending on your goals as an investor.

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The Feasibility Analysis Mindset

A feasibility analysis is conducted in several stages. The more complex the business proposal, the more stages of analysis needed. At the end of each stage, the business planner is required to do two things:

  • set criteria by which the project will or will not proceed to the next planning phase
  • make a decision to proceed to the next stage or to abandon the idea at this point

These criteria depend on the goals set at the beginning.

Example 1

If the entrepreneur sets a goal to increase profit by $50,000 per year, the criteria may be that profit must increase by at least $25,000 or it is not worth proceeding. But a market assessment shows the business is unlikely to net more than $10,000 extra from added sales, so the entrepreneur decides to abandon the project, looking for a different opportunity.

S To Evaluate A Property Investment

Use our suite of investment property calculators to help evaluate ...

One of the most fun parts of property investment for me at least is spending time looking at different properties you could buy.

But after all that browsing once you’ve found something that’s caught your eye how do you know if it’s a good buy?

This is where many wannabe investors get stuck: they enjoy looking, but can never get to a point of being confident enough that any given property is the right one to buy. As a result, they never buy anything at all.

This is fine in a way there are more unhealthy and expensive hobbies to have than browsing Rightmove in your evenings and weekends. But without the confidence to pull the trigger on a deal, you’ll never actually get closer to your goals.

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How To Evaluate A Rental Property Quickly

One of the most basic skills you need to know as a real estate investor is how to evaluate a rental property. Letâs face it if you cannot quickly evaluate a rental property for sale and determine if it is a good income property, you canât be assured of success in your business. Instinct is always helpful. However, there are some tried and true real estate ratios and metrics anyone can apply to determine if an investment property you are considering buying is a good rental property.

This story will focus primarily on simple math. But, we will also provide some tips on which property features to look for and which to avoid. Here is Mashvisorâs guide on how to evaluate a rental property quickly.

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Dont Forget Rental Property At Tax Time

Theres a singular ray of sunshine that beams down upon income property owners each spring as they hunker down with their accountant to prepare their federal income tax return.

When you have your own home, you can write off the interest and thats about it, George says.

But when you own an investment property, your Schedule E tax form enables you to write off nearly everything under the sun, from painting the home to changing the light bulbs.

So, even though you have rental income to report, you can show less income than youre actually collecting and write off your mortgage payment and interest while building equity at the same time, George says.

Its that powerful combination of tax benefits and investing returns that helps keep investors interested in rental properties.

Cash Flow Return On Investment

How to Evaluate an Investment Property for Purchase – Walk through with Rich The Realtor…

When purchasing rental properties with loans, cash flows need to be examined carefully. Rental property investment failures can be caused by unsustainable, negative cash flows. Cash Flow Return on Investment is a metric for this. Sometimes called Cash-on-Cash Return, CFROI helps investors identify the losses/gains associated with ongoing cash flows. Sustainable rental properties should generally have increasing annual CFROI percentages, usually due to static mortgage payments along with rent incomes that appreciate over time.

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Rule : Use The 55% Rule To Determine Your Net Operating Income

Perhaps the most important number to know for a rental property is its net operating income . This is the amount of money you get after all expenses, except financing costs like principal and interest payments. You dont actually need to know all the expenses a property may have in order to estimate this.

A seller obviously has a great incentive to report that the expenses are very low, but very low reported expenses may mean that you have some large expenses coming up, such as replacing the roof, air conditioner or windows. A good rule of thumb is to multiply the gross rent for the year by 55%. Approximately 45% of the gross rent will go toward vacancies, insurance, maintenance, property taxes, snow removal, lawn maintenance, repairs, and management costs .

How To Evaluate A Rental Property Investment Using Equity Price Appreciation

When talking about the property price increase, we are not referring to the regular change in prices due to inflation. Typically property prices increase at the rate of inflation or around 1-2% above inflation. Based on the Case-Shiller home price index, the average annual home appreciation rate has been 2.5%.

Equity growth dwells on the prediction of the future and is responsible for massive increases in prices. Often policy changes occur, such as a new highway through the town, which can cause rapid growth in prices. Or the opening of a new sizeable stable employer such as a medical center or Amazon HQ2. Unless you have prior knowledge or get extremely lucky, evaluating a rental property investment based on equity growth is harder.

While it is possible to force price appreciation in an income property through value add, it involves a significant expense, especially for a first-time rental property investor. Extensive upgrades also have to be done on the property to increase equity quickly.

Without forced appreciation, the increase in overall property and land price value in the area is unpredictable.

You can, however, pull simple one-time levers to generate additional cash flow even with buying and holding long-term rental property.

Or you might own a fourplex and decide to install a vending machine on site. The tenants dont need to drive to the store for a quick snack, and you get additional income from your real estate portfolio.

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Borrowing Money To Buy

If you borrow to invest, you will have to pay the property mortgage. Don’t rely on rental income to cover the mortgage there may be times when your property is empty.

Many people buy investment property with interest-only loans, but remember the interest-only period will end after a certain time. This means your repayments will increase to pay the amount borrowed, plus the interest. See interest-only home loans to find out how they work.

See what an interest-only loan will cost you.

Why Does Oer Matter

Rules of Thumb for Analyzing Real Estate Investments

A lower OER reflects that youve minimized expenses relative to revenue. If your OER has been rising over time, it could indicate many issues. Perhaps annual rent increases havent matched expense increases. Or, your management company isnt keeping up on routine maintenance, leading to more serious problems down the road. Calculating OER using specific expenses can help you narrow down the reason for its rise and help you get it back under control.

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The Other Side Of The Coin

There are a couple of glitches to this plan.

1) My husband doesnt want to sell. He thinks the house will continue to go up in value and thinks we should keep it because whats the rush? Its true, we do have time and will make out fine either way. But, if were debt free in a couple of years, we can have more freedom to adjust our work schedules the way we want them, spend more time with the kids, and generally this is my whole goal with money- to be able to do what I want when I want! I dont want a bazillion dollars. I just want my freedom and thats why I want to be debt free.

So this whole post was an elaborate plan to convince him to sell ha.

2) We want to stay in the rental business and in the Nashville market. Our plan after becoming debt free is to build a stream of passive income from paid off rental properties. I would love for those properties to be in Nashville as there is no state tax and Nashville is a booming town. So, keeping the rental would mean keeping ties with the management company, the contractors, and realtor we will need to get into the market further.

3) Tax advantages. The government likes rental property ownership and rewards landlords with tax benefits. We get to take depreciation on the property, which is $15k-18k each year. That is free incentive money from the government. We also get to deduct our mortgage interest.

Why Does Cap Rate Matter

Generally speaking, the higher the cap rate, the higher the risk. That is because a high cap rate indicates higher returns, and ultimately higher risk. This why you generally see higher cap rates in riskier markets, versus lower cap rates in stable and larger markets like New York City or San Francisco for example.

Simplify your rental property reporting

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Example Of Sales Comparison Approach

Keep in mind that SCA is somewhat genericâthat is, every home has a uniqueness that isn’t always quantifiable. Buyers and sellers have unique tastes and differences. The SCA is meant to be a baseline or reasonable opinion, and not a perfect predictor or valuation tool for real estate. It’s also a method that should be used to compare to relatively similar homes.

So it doesn’t work if you’re going to value the property you’re interested in, which is 2,000 square feet with a garage, swimming pool, six bedrooms, and five full bathrooms with another property that has half the number of bedrooms, no pool and is only 1,200 square feet.

It is also important for investors to use a certified appraiser or real estate agent when requesting a comparative market analysis. This mitigates the risk of fraudulent appraisals, which became widespread during the 2007 real estate crisis.

Lack Of Property Management

Calculating Numbers on a Rental Property [Using The Four Square Method!]

After all the work included when considering how to evaluate a rental property, many aspiring landlords fail to plan for a property manager. The false confidence comes the assumption that property management tasks are easy.

The problem is that with no knowledge in property management, the smooth running of the property will be difficult. Our list of best real estate books for beginners contains several books on property management.

Besides acting as a point of contact for all tenant issues, property managers help maintain the property and help keep a vigil on all happenings on the property. They also advertise vacancies, respond to prospective tenants, and conduct vetting to comply with local and federal laws governing rental properties. If you take on these tasks yourself without proper knowledge, you risk being sued by tenants or the government for possible discrimination.

The industry rate of payments for the property management company is usually 10% of the rental income.

Even if you decide to self-manage the property, you should factor in the property management company cost because your time is not free. At some point, you should ideally shop around and look at other property managers in the areas to determine if they can take over your property management.

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Gross Rent Multiplier Approach

The gross rent multiplier approach values a rental property based on the amount of rent an investor can collect each year. It is a quick and easy way to measure whether a property is worth the investment. This, of course, is before considering any taxes, insurance, utilities, and other expenses associated with the property, so it should be taken with a grain of salt.

While it may be similar to the income approach, the gross rent multiplier approach doesn’t use net operating income as its cap rate, but gross rent instead.

The gross rent multiplier’s cap rate is greater than one, while the cap rate for the income approach is a percentage value. In order to get an apples-to-apples comparison, you should look at the GRMs and rental income of other, similar properties to the one in which you’re interested.

The Capital Asset Pricing Model

The capital asset pricing model is a more comprehensive valuation tool. The CAPM introduces the concepts of risk and opportunity cost as it applies to real estate investing.

This model looks at the potential return on investment derived from rental income and compares it to other investments that have no risk, such as United States Treasury bonds or alternative forms of investing in real estate, such as real estate investment trusts .

In a nutshell, if the expected return on a risk-free or guaranteed investment exceeds potential ROI from rental income, it simply doesn’t make financial sense to take the risk of rental property. With respect to risk, the CAPM considers the inherent risks to rent real property.

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Factors To Consider Beyond The 1% Real Estate Rule

When trying to calculate the profitability of an investment property, especially a property located in one of the best places to invest in real estate, other factors are also worth considering. One is the net operating income, which is the profit you make on the property after subtracting the operating expenses. This formula takes into account those factors listed above that the 1% rule does not. Youll also want to think about the internal rate of return , which compares the future value of the property to what its worth today.

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