How to evaluate rental properties
In part one of Real Estate Investing Basics, I reviewed some simple reasons why real estate can be a great investment. But how do you determine which properties are the best buy and hold investments? I suggest learning the concepts, terminology, and metrics (calculations) to compare properties. Here is a quick explanation of definitions and metrics that summarize some of the basics of real estate investing (REI).
- Gross Income: All income received from an investment, rents, and other (subtract vacancy costs and collection loses).
- Operating Expenses: All recurring expenses from an investment.
- Includes: insurance, taxes, HOA fees, maintenance, repairs, property management fees, etc.
- Does not include: loan principal and interest, income taxes, capital improvements, depreciation
- Net Operating Income (NOI): Net operating income is the actual income stream from the property after you subtract operating expenses.
- NOI = Gross income – Operating expense
- Cash Flow: This is a measurement of the profit or loss from a property for ALL money in and out.
- Cashflow = All income – All expenses
Below are very simple metrics for qualifying the investment of multiple properties:
Monthly Percent Rule (AKA 1% Rule or 2% Rule)
- This metric is a quick and simple rule of thumb for evaluating properties before putting a lot of effort into an in-depth analysis. It is a ratio of the monthly rent to the total sales price and rehab of the property.
- % Rule = (monthly rent / total sale price + other costs to ready the property for rent) * 100
- For example, if you bought a property that cost $180,000 + $20,000 for rehab and it would rent for $2,000 per month = ($2,000 / $200,000 ) * 100 = 1%
Yearly Percent Rule
- This metric is similar to the monthly percentage rule but it is the ratio between the yearly rent and the total sales price and rehab of the property.
- Yearly % Rule = (yearly rent / total sale price + other costs to ready the property for rent)
- From the same property example above = ($2,000 * 12 / $200,000) = 12%
Below are more advanced metrics for analyzing properties in more detail:
Capitalization (CAP) Rate %
- The CAP Rate is the rate of return on an investment based on expected income. This calculation intentionally does NOT include mortgage payments as a cost in this calculation. Loan payments vary by the type, duration and terms of loan. Removing these from the calculation allows you to compare properties using an unbiased, apples to apples comparison.
- CAP Rate = ((Net Operating Income / Property Value) * 100)
- For example, if you were looking at a duplex that would cost $300,000 to buy and rehab, and it produced a net income of $30,000 per year, the Capitalization (CAP) Rate would be: CAP RATE = ($30,000 / $300,000) * 100 = 10%.
- You can get more information about CAP Rates at PropertyMetrics.com.
Cash On Cash (COC) Returns
- Cash on cash returns is a simple and effective metric to calculate your return on investment (ROI). It DOES include mortgage payments. It is a percentage that shows the ratio of annual income to the original amount of money invested. The initial amount of money invested is not necessarily only the sale price but it also includes the costs to purchase and rehab the property.
- COC Returns % = ((Annual cash flow / Amount invested in property) * 100)
- For example if you bought a $400,000 property for 20% down ($80,000) and then invested $20,000 in repairs, the initial investment of cash would be $100,000. If the property produced a total positive cash flow of $10,000 per year the calculation would be:
- COC%= (($10,000 / ($80,000 + $20,000)) * 100) = 10%
- Check out RyanPrice.ca for more information on how to calculate cash flow.
On the surface, evaluating profitability on buy and hold properties is not extremely complicated. There are many other critical factors that must be taken into consideration such as overall market outlook, financing, property inspections, finding the right renters, exit strategies, and more. It is extremely important to do your due diligence on the market, area, property, and people you are doing business with. At Feel Good Property Management, we can help you find the right property, fill it with the right renters, and maintain it to protect your investment.
Check back soon for part three of Real Estate Investment Basics where I’ll break down the profitability of an actual investment property in San Diego County.
Article by Matthew Burch, Feel Good Property Management Client Relations and Agent