Investing in real estate is often considered a profitable path to gain financial freedom. However, it involves making huge investment—and that is where it gets tricky. Investors are lured by the notion of making easy money from the booming property prices, which often leads to wrong and hasty decisions.
So, when it comes to investing in a rental property, it is important to get your facts and figures right. Your decision should be a calculated one, made according to certain rules and formulae. Read on to find out what you need to know while calculating the worth of your property.
Brokers’ Best Kept Secret: The 1% and 2% Rules
According to The 1% Rule, the monthly rent should be equal to or more than 1 percent of the purchase price of the asset, including additional expenses on repairs and renovations to make it rent-ready.
Hence, a property that cost you around $100,000 for acquisition should rent for at least $1,000 per month.
The property should be considered further only if it meets The 1% Rule.
This rule is applied according to the type of neighborhood where your property is located. If the house is located in a high-class area where you can get high-income tenants, top-class amenities, low turnover and vacancy rates, only then is this rule applicable.
For less desirable locations, such as high-risk neighborhoods where you can only get low-income tenants andwitness longer vacancies and high turnover, you should be using The 2% Rule.
Why Apply These Rules?
So, now that we know when a property is worth investing in, let’s see how the calculations for The 1% Rule work out.
Before I proceed, let me introduce The 50% Rule. This rule says that your non-mortgage expenses will amount to 50 percent of your rental income, on average. In other words, half of your gross revenue will be consumed by operating expenses such as taxes, insurance, utilities, maintenance, vacancies, turnover costs and so on.
This does not mean you will be spending that much every year, since there will be times when your annual expenses will be negligible. However, there will also be times where you will be engaging in major renovations like replacing the roof or the heating system.
Coming to The 1% Rule, if the asset has the potential to earn 1 percent return each month, then it earns 12 percent annually. Taking The 50% Rule into consideration, if half of your income is being used up, you are left with 6 percent annual return as the net cash inflow from your asset.
We know that a property also creates returns by appreciating in value. Assuming a 3 percent rate of inflation annually, your asset will generate a total return of 9 percent (6 percent cash inflows plus 3 percent appreciation).
Considering that other investment options will easily generate a return of 7 percent to 9 percent, it is reasonable to invest in a property that gives a guaranteed return of 9 percent.
Hence, these two rules can be used as a yardstick to decide whether the asset in question is seriously worth your time and money.
Role of Capitalization Rate
After your property clears The 1% or The 2% test, the next thing to look at is your capitalization rate or the cap rate. It measures cash flow return relative to property value (total acquisition price).
For example: Assuming your house cost you $200,000 and you rent it out at $1200, going against The 1% Rule.
- Total rent received annually = $14,400
- After deducting vacancy rate and adding some other income, we get Gross Operating Income = $14,000
- Overhead expenses = $6000
- Net Operating Income (NOI) = Gross Operating Income minus Overhead Expenses.
- Hence, the NOI = $14,000 minus $6000 = $8000
- Capitalization rate = NOI divided by Acquisition price
- In this case, Capitalization rate = $8000 divided by $200,000 = .04 (or 4 percent)
This means a 4% return of cash flow on our asset’s value, which does not sound like a good deal at all. Better to invest in the stock market, don’t you think?
Now imagine, your house cost you $100,000 initially. So by renting it out at $1200, you do adhere to The 1% Rule. Your new capitalization rate will be calculated as $8000 divided by $100,000 which equals 8 percent.
Assuming an appreciation rate of 3 percent, your total return comes out to be 11 percent. This proves to be much higher than the rate of return one gets from other investment options. Therefor, it will be a good idea to make this investment.
Cash on Cash Return
This is another formula to consider while determining the worth of your rental property. Cash on cash return holds importance in the real-estate world as it difficult to judge the Return on Investment (ROI) of rental properties. Unlike with other investment options, you will not know the actual ROI until you sell the house.
The cash on cash return is much easier to calculate, as it considers the cash return from rental properties compared to the initial cash invested. The formula for calculating the same is annual cash flow (before tax) divided by total cash invested.
Suppose you receive a cash inflow (before tax) of $60,000 in the first year. The purchase price of the property was $1,200,000 and you secure a loan for $900,000. That means you made a down payment of $300,000. So, your first-year cash on cash return is $60,000 divided by $300,000 which equals 0.20 or 20 percent.
The high return value indicates why real estate can be so powerful when it comes to investment. However, keep a check on the mortgage amount. You do not want to end up with a high debt value. Decide on an optimal range of the amount you want to borrow for your house.
Final Thoughts
Buying the right rental property can be a challenge. It is not an easy decision to make but can be quite rewarding in the long run, if things are done right. Your success or failure as an investor depends on the factors you consider before you make the decision to buy. So, make sure you have the right figures and rules at hand while evaluating your property.
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