Anyone who is thinking about investing in real estate for rental income always has the same question when they look at a property. They want a simple and efficient method of evaluating the financials to be sure that the property is a good investment and will provide a profitable return. There are no guarantees in real estate but you can use a few simple equations to determine if the investment is sound and that you have the potential and even likelihood of making a good return on your investment.
The rent ratio is the first number to consider. This is obtained by dividing the monthly rent by the total cost of the property. Remember that the total cost must include the purchase price, the financing cost and the rehab cost. As an example, a property that cost $100,000 total and rents for an even $1,000 per month has a rent ratio of 1%. That 1% is the minimum that you would ever want to achieve and my investors are aiming to have a rent ratio of 2% to feel secure in their purchase. Obviously, the higher the ratio the better, but in some areas a 2% ratio is just not possible in the current market. It is also important to note that this number does not account for any expenses such as HOA fees or other monthly costs.
The cap rate, short for capitalization rate, allows you to compare properties without factoring in the financing. To figure the cap rate simply divide the net operating income by the total cost. Your net operating income is the annual gross rental income minus all of the expenses. Do not include the P & I portion of the mortgage payment but it does include expenses such as taxes, repairs, insurance and any vacancy of the property. In general, a cap rate of 6% or better is a minimum and 8 t 10% is a more optimal target to aim for.
The final number to consider is cash on cash return. You determine this number by dividing your cash flow by the cash that you have invested in the property. Cash flow is just the annual rent minus all cash spent. Most investors will look for a ratio somewhere between 15 and 25%.
It is critical that you remember that all of these numbers are to be used as guidelines and that not a single number or any combination of them will guarantee a profitable rental property. These give you a good starting point but you still need to have a knowledge of the area, the potential rental market and an idea of the economy in the neighborhood. There is no reliable shortcut for due diligence when purchasing any real estate investment property. Visit www.azrealestatewholesale.com to learn more about the professional services offered to guide you through your first investment purchases. The mentorship and help from these professionals is a great way to ensure a successful foundation for your real estate investment career.