On the face of it, buying a rental property may seem like a good idea. There are both pros and cons to becoming a landlord, and many news articlesdiscuss these two sides of the matter. And while there are pitfalls to being a landlord, there are plenty of resources online, such as the absolutely crucial tenant screening services, that can come to your aid.
But most crucial of all is to know if the property you want will actually calculate out as a good investment. To answer this question, you need to know how to assess the true cost and return of a prospective property. Read on for the way to calculate your return on your investment.
What matters in a rental property investment?
The rate of return on rental properties ultimately derives from five factors. These are cash flow, amount of equity, tax advantages, any leverages and the amount of appreciation you can realize over time.
While this may seem complicated, it’s not – and certainly not enough to stand in the way of pursuing property that can generate rental income. To make the process more manageable, we’ll break it down so you can see how simple it really is. You’ll be able to see how seasoned investors consider potential projects.
Of the five elements contributing to the property’s value, three of them are not crucial to the purchase of a potential property. Appreciation, tax advantages and leverage are not things that experienced investors focus on when considering a potential rental property.
The two aspects of a potential purchase that they scrutinize are the combined values of cash flow and equity build-up. It’s as simple as that: cash flow and equity build-up.
Those two aspects of any potential rental property are what successful investors look at when deciding if a property is worth buying as a rental property. Thankfully, these are easy to calculate. Also, investors know that they can easily predict results that they can depend on after the purchase.
Breaking down the Equation
Cash on Cash
To describe the rate of return a potential property has in the rental market, industry professionals call it “Cash on Cash”. This is a phrase that everyone who invests in rental properties learns to love because it represents income.
To determine the cash-on-cash return rate, divide the incoming cash, before taxes, with the amount of money you’ve put into the property. This takes into consideration all of the cash going into the property as well as expenses.
“Cash flow before taxes” is commonly abbreviated “CFBT” in industry lingo. Now we can build out the equation even further.
Cash on Cash = CFBT divided by (the down payment + total cost of acquisition)
This equation lays everything out so that it makes sense. However, even with this information in hand, many people are still a little muddled when it comes to understanding the true cost of purchasing rental property. A down payment will be required to purchase a piece of property. Also, mortgages aren’t free. They have costs associated with them. To make the best decision for your current financial situation, any property purchase much be viewed in the same way that you would view making a cash purchase. The bottom line is the overall amount that you will have to pay and how it potentially impacts your portfolio.
Equity builds up as the direct result of the amortization process. The process of regularly paying the mortgage means that the amount going to interest will decrease. Over time, this means that more of each month’s payment will go towards paying down the amount of the loan principal. Each month, as a portion of the principal is repaid, your equity in the property grows.
By determining the Cash on Cash and the equity build up, investors are able to determine the potential each building has as a rental property. Combining these two values produces the net yield for a property.
Working it in real life
Let’s now calculate the figures for a hypothetical example.
Total Purchase Cost
If the purchase price is $125,000, let’s plan on making 20% down-payment of $25,000. Additional costs of acquisition will be around $3,500 for closing and loan origination costs. So the total purchase cost to you is $28,500.
To finance the project, a $100,000 loan will be needed. Using a mortgage calculator, we can estimate that with an interest rate of 5% and repayment over thirty years, the mortgage payments will be $568 per month.
Gross Cash Flow
Given the neighborhood and the property, a standard monthly rental rate looks like $1,250. This produces a gross annual income of $15,000. You’ll need to adjust for vacancies. We set that at 5% or $750. This leaves a gross operating income of $15,250 annually.
Whether you like it or not, property taxes will have to be paid ($3,000) and insurance premiums covered ($1,200). Factor in the cost for repairs each year ($1,200).
Totaling everything up gives you $5,400 in operating expenses for the year. You’ll pay $6,814 on the mortgage each year. You’ll have $15,000 in gross income. Simple arithmetic of the gross income minus the two expenses then gives a Cash Flow Before Taxes (CFBT) of $2,037.
Cash on Cash= CFBT divided by (the down payment + total cost of acquisition) = $2,037/$28,500 = 7.15%
Equity build-upduring the first year is the amount of principal paid divided by the total acquisition cost to you. A mortgage calculator shows a principal payment o f $1,478 in the first year, and this divided by your total acquisition cost of $28,500 results in a 5% equity build in the first year. This increases each year, but investors use that first year as the determining factor.
With the Cash on Cash at 7.15%, and the Equity Build-up at 5%, this results in a Total Yieldof 12.15%.
Clearly, with a yield of around 12%, this is a better return for an investor than other vehicles such as bonds or CDs. Many investors are also more comfortable investing in real estate, which is less volatile than the stock market.
So congratulations! Now you know how to become a landlord. Now take the time to study how to be a wise landlord – don’t blow that investment with higher costs from bad tenants. Stay smart, and keep that cash flow positive.