If you’ve ever thought about owning a rental property or two, then you will love this month’s Rumor Mill.
I’m a big fan of rental properties, and have even personally owned one. New landlords are sometimes born when people are able to keep their first house after they go on to buy a second house (that is what happened to me), and sometimes people head out there with the intent of buying a rental. Obviously if you are renting your former house the choice just becomes a matter of default, but if you intentionally buying a rental you should evaluate it with a much different eye.
Professional real estate investors use a number of tools to guide their property choices, most commonly “cap rates” (the annual return expected on an investment.) They are not just relying on gut instinct or emotion and hoping that it will someday appreciate for a huge return. Because 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 buy for appreciation alone, and neither should you.
Of course there’s tons of different ways to invest in real estate, but if you are looking for residential rental property, then the primary financial consideration in choosing the house should be the annual income it will generate before the time comes to sell. Unless you can, at a minimum, cover your monthly mortgage amount your property could easily turn into a drain on you and your family — financially and emotionally.
So how do you figure out Cap Rate like the big guys? Just like this:
1) Figure out the annual rent you can expect, based on the current rent and/or looking at similar rents on Craigslist.
2) Estimate the annual expenses you can expect, including the following:
- projected vacancy costs, which are typically calculated 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 you are in between tenants
- real estate taxes utilities that you (not the tenant) might be paying, such as water or gas property and liability insurance (a landlord’s policy)
- 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” (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 three-bedroom house for $3,000 per month or $36,000 per year. You anticipate annual expenses as follows:
Vacancy rate of 5%: $1,800
Real estate taxes : $5,000
Maintenance and other expenses: $3,200
Total expenses: $10,000
Annual net income = $26,000 ($36,000-$10,000)
In the example above, if the asking price for the property were $600,000, the cap rate calculation is: $26,000/$600,000 = 4.3%. This three-bedroom property therefore yields a “cap rate” return of 4.3% (unless you can get the property for a lower price).
The “cap rate” at which you should buy depends on the location of the property where you are looking to buy, 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, and the higher the cap rate, the better the annual return on your investment.
If you are looking to make a certain percentage off your rental each year, you should let that drive your purchase decision. You can divide your calculated net figure by your target cap rate to determine the price you’d be willing to pay for a particular property. For example — let’s say you want to make at least 5% — $26,000/ 5% = $520,000. This reflects the top price you would be willing to pay for this house, if you require a minimum return of 5%. With the current asking price being $600,000, this is a not a good house for you, unless they come down on the price.
Whatever rate of return you are aiming for, make sure the projected income leaves you with a cash cushion after the mortgage payment has been paid. If you have a tenant who doesn’t pay for a few months, and the cap rate is just 2% or less, your property may quickly lose you money. To be safe you need to be sure you can handle carrying the property if it’s unoccupied for an extended period (or if you have to evict some dirt bag loser.)
Appreciation is awesome and over the long term in this area practically guaranteed historically, but it’s not a strategy that can put money in your bank account today. If you buy for income and use the cap rate calculation, you can find rental homes that provide bigger returns for you than just appreciation.
Besides personal residential and of course horse/ranch properties, I also represent buyers and sellers of rental properties as well as landlords in finding tenants. In fact, I have a duplex listing coming up for sale in downtown Martinez within the next couple weeks with an estimated cap rate of approximately 5.7%. Call, text, or email me today if you or your friend wants to invest in real estate.