- What returns can an investment property generate?
- An investment property, which is a real estate asset that is bought to produce income, can deliver stable, immediate returns. In the right market, a rental property can generate regular rent payments and has the potential for asset appreciation. As a result, many investors can make profits from the sale and rental of their investment property.
- The yearly returns on rental properties can vary based on many factors, such as the location of the home and how fast the economy is growing in that area. Some US cities can experience stronger price appreciation and better rental values than others. Based on 2016 data from BiggerPockets.com, an online hub for real estate investors, returns can range from a mere 5% (in the worst markets) to as high as 20% in booming economies.
- When compared to stocks, which produce returns between 7% and 10% on average, it’s easy to see the appeal of an investment property. However, investing in Google stocks is nothing like buying a rental home, which is a very hands-on experience. The challenge is in finding the right property, maintaining it, and hosting the right tenants. While some people will be drawn to invest wholly in real estate, most would do well to diversify their portfolio by leveraging a few suitable rentals.
- What makes a good real estate investment?
- Real estate investments can be extremely lucrative, but that doesn’t mean all rental properties will be profitable. Rookie mistakes like underestimating the cost of repairs or not having enough savings to handle vacancies early on can collapse your ROI.
- The best investment properties will consider a few key factors:
The location (town, neighborhood, and economy). Location is one of the most critical aspects of a successful investment. The location of the property can indicate how much it might appreciate and if you will attract the right tenants. It’s always recommended to invest in growing economies where the job market is healthy, and vacancies are low.
Look for neighborhoods that are close to schools, universities, retail complexes, and/or transportation systems. Communities with these features will have a better supply of tenants, allowing you to charge more for rent according to market demand.
>>Want to learn more about where to invest? Click here to check out our list of the nine best US cities to invest in as of 2017<<
Repair needs. Your ability to gauge the repairs needed for a home (and how to budget for it) can make or break your investment. You’ll have to consider if you want a property that needs minimal work or if you are comfortable with a total overhaul. Beyond that, your decision to do the repairs yourself or hire a contractor can create a huge variance in your bottom line. For those newer to real estate investments, it’s usually better to start with homes that need less work so that you can accurately gauge your financial position going into the venture.
Financials. Using an in-Depth financial analysis, you can determine if a home is a good investment. With some basic information, you can figure out how much income the property can produce, what kind of ROI that generates, and if that warrants an investment.
- In the next section, we’ll go over the basic financial analysis you should ALWAYS do when considering a real estate investment. In the meantime - don’t forget to bookmark this page and save it to the home screen of your smartphone. Having the right tools at your fingertips will help you make savvy investments. If you found this page useful, please promote us on social media by giving us a follow and sharing this page.
- How to calculate the returns on a rental property
- Before jumping into any deal, it's essential to analyze your overall financial position. In this chapter, we’ll go over the following:
- ✔ How to figure out your net operating income (NOI), which is the total income that the property can generate.
- ✔ How to work out your cash flow, which is your yearly earnings after debt costs.
- ✔ Two ways to calculate the annualized return on your investment.
- ✔ An example financial analysis of an investment property.
- To figure out a property's NOI, you have to take the income generated by the rental minus its expenses (not including loan costs).
- NOI = income – expenses
- Financing offers can change between lenders (and properties!), so it's imperative to analyze the investment before your financing needs. This simple calculation will help you compare real estate options equally.
- Income generated:
- Income can come from various sources such as tenant rent, parking, or use of other facilities (laundry, storefront, etc).
- Expenses can come in many forms. Common expenses can be broken down into property taxes, HOA fees, maintenance, insurance, and management costs (property manager or advertising).
- It goes without saying that when a property has higher expenses, it’s potential for income drops.
- If you buy the home using cash, your NOI and cash flow will be the same. But in most cases, investors need a mortgage. If this is the case for you, you’ll have to adjust your cash flow based on your loan expenses.
- Cash flow = NOI – Debt costs
- Debt cost typically refers to your mortgage payments for the year.
- As you get a larger loan amount or higher interest rate, you will have less cash flow and smaller returns on your investment. Now, you can figure out your annual rate of return.
- The most straightforward way to gauge your returns is to divide the NOI by the price of the property. This is called the cap rate, and it's important because it measures the performance of the investment independent of your financing.
- Cap rate = NOI / Purchase price of home x 100.
- To account for your ROI when you have a loan, you can use the total ROI formula.
- Total ROI = cash flow / initial investment x 100
- This type of ROI is useful because it takes into account the loan service costs, and as such, can be the most accurate measure of your returns.
- While only you can decide on a fair rate of return, it’s typically only worth investing in real estate if you are making more than 10%. Otherwise, you can invest in stocks and get the similar results with less effort.
- Example financial analysis
- Let's imagine an investor that wants to buy a fourplex. The property is listed for $350k in Coconut Grove, FL. The investor has to pay $70,000 (20%) as the down payment, plus an extra $30,000 for closing costs and improvements. Therefore, the investor’s initial investment will be $100,000. The units in the fourplex rent out for $1,000 each, while each parking space rents for $150. Do you think this would make a good investment?
NOI: If all four units are occupied the property can make $4,000 per month (and $48,000 per year) solely on tenants. If all the parking spots are rented, that brings an extra $7,200 a year, raising the total income potential to $55,200
When it comes to expenses, this hypothetical property consumes about $11,900 per year. [Insurance: $2,000, Maintenance: $5,000, Property taxes: $5,300, HOA: $900. Utilities and Internet: $5,000]
Therefore, Income ($55,200) – Expenses ($11,900) = NOI ($43,300)
- Cash flow: The yearly cost of a $280k mortgage at 4% is $17,724
Cap Rate: To figure out the cap rate we have to divide the NOI ($43,300) by the purchase price of the home ($350,000) x 100.
In this example, the cap rate is 12.3%. In many areas of the US, 12% is a reasonable cap rate for an investment property.
Total ROI: Earlier, we figured out the cash flow to be $25,576 per year. We have to divide that by the initial investment ($100k) times 100.
That means the total ROI on this property will be 25.5%.
So, NOI ($43,400) – Debt costs ($17,724) creates a cash flow of $25,576. That means this investor could see net earnings of $25,576 from this investment each year.
- Not too bad, huh? Based on these figures and the location of this property, this fourplex would likely make a good investment.
- Financing a rental property
- There are many ways to approach the financing of a real estate investment. The most common options are to pay with your savings, get a conventional mortgage, or tap into the equity of your primary home.
Pay with your savings. Some investors choose to finance 100% of their investment property using their available savings. Doing so can drive up the cash flow from your investment and minimize any complications in the future. However, this is usually not an option for many investors. Also, consider this: Even if you have the cash to buy an investment property outright, you could leverage your money against a number of properties to diversify your risk and increase your returns.
Conventional mortgage. Most investors prefer to finance an investment property using a mortgage loan. Creditors typically require a 20%-30% down payment to lend money on a rental. You'll also have to show enough savings to cover six months of vacancies.
The main advantage of getting a mortgage is your ability to leverage your initial investment for better profits. From there it’s up to you if you want to use your down payment for one property, or a few properties of lower value. Regardless, you'll be hard-pressed to find a stock that allows you only to pay 20% of the price and still enjoy maximum returns.
Equity Takeout. Many investors decide to take equity out of their existing home (using a HELOC) to finance a real estate investment. Since the loan is leveraged against your primary residence, creditors likely won't need to know too much about the property you want to purchase. This can make the process of getting a loan much easier. However, you may be limited to the amount of money you can draw, based on how much equity you have built up. Most creditors will go up to 80% of the home value, minus what is currently owed.
- Using the calculator
- The calculator is very simple to use and is designed to help you analyze returns from an investment property. You’ll need to include some financing details to get an accurate estimate of your earning potential. Let’s review this together.
- Step 1. On the first line of the calculator, indicate how much of a loan you need to purchase an investment property. You can use your keyboard or the arrow features to make this input easier.
- Step 2. Next, you can add the loan term (in years) followed by the interest rate you have been offered.
- Step 3. In the next section, you can start by adding the value of your initial investment. Typically, this is the value of your down payment, plus closing costs and essential repairs.
- Step 4. On line five, indicate the rate of return on your investment. If you are unsure, refer to the previous section where we review how to calculate your total ROI. In short, you’ll need to divide your cash flow from the property, by your initial investment, times 100. It’s not unusual to have an ROI of 15% or higher, depending on the location of your investment property.
- Step 5. If you intend to re-invest your profits, you can add it to line six of the calculator. Landlords can either prepay their loan or use the earnings for additional renovations, if applicable. Ultimately, it depends on what your financial goals are.
- Step 6. Once completed you can view your results in the form of smart prompts and information summaries.