When it comes to evaluating a real estate opportunity you want to get into the nitty-gritty and really understand the numbers at play.
Here are a few of the key figures you need to be familiar with and a detailed example at the bottom.
The first thing you want to determine is whether or not this is really a good deal. You want to be buying the property for at or under market rates so that you are assured to make money with the purchase (surprise maintenance costs non-withstanding).
You can use websites like https://www.zillow.com/home-values/ which will give you an idea of the average house prices for the area.
Is this investment feasible? Investor mortgages typically require a down payment of 20 to 25% or sometimes as much as 40%. Individual lenders will determine how much you need to put down to qualify for a loan depending on your debt-to-income ratios, credit score, the property price, and likely rent.
When discussing mortgage rates with a bank you should also check the down payment requirements for your particular scenario. How much you put down will also affect your final mortgage rates.
You can work this out in several ways, either ask a real estate agent, use the websites listed below, or if the property is currently a rental you can ask the current owner what the current rent is that they are charging. You should take into account features that you could install to increase the property’s rental value as well.
Websites you can use to help with this research are:
These give you an overview of the average rent in those areas. It’s worth comparing the results given from both to check for discrepancies and get the most accurate estimate.
Once you’ve collected all the above data you can work out a few key ratios that will help simplify your decision for the property.
The gross rental yield for an individual property can be found by dividing the annual rent collected by the total property cost, then multiplying that number by 100 to get the percentage. The total property cost includes the purchase price, all closing costs, and renovation costs. Use our Free Rental Yield Calculator.
(Gross Income / Purchase Price) x 100 = Net Yield
The other and the perhaps more useful number is net rental yield also known as the capitalization rate.
This gives you an idea if you are buying the property at a good deal. It basically compares the return on investment (ROI) to the purchase price.
NOTE: I don’t include the mortgage payment in this calculation.
(Net Annual Income (which is gross income – total expenses) / Purchase Price) x 100 = Net Yield
The lowest cap rate I would ever want to see for any property, whether residential or commercial I don’t care is 6%. The lowest I would want to see on a residential rental property in this market is 8% and even then, there better be a good reason it’s that low (property in a “sexy” market, highly desirable area, etc.). Anything over 8% and you are doing well in my opinion.
You want to ensure that your property has a positive cash flow, negative cash flow, which occurs most often when an investor has borrowed too much to buy the property, can result in a default on the loan unless you are able to sell the property for a profit.
Monthly expected income – monthly total predicted expenses = Cash flow
If this figure isn’t positive, run.
This number is how much return you are getting on the money you invest. If you pay all cash for a property, this number will be the same as the Cap Rate. If you are financing, this number is the most accurate way to see the actual return you are getting on your cash-in and the leverage.
Note: Remember to include the mortgage payment since this one is totally focused on financing.
(Net Annual Income / Total Cash Invested) x 100 = Cash-on-Cash Return
This tells you the return you’re getting from the cash invested which can be a very enticing number depending on how you are leveraged. If you compare the Cash-on-Cash Returns of an all-cash buy versus a financed buy. You may quickly see the benefit of leveraging!
House Price = $200,000
Cash Down = $60,000
Expected Monthly Rent = $2,500
Total Monthly Expenses: $1,312
This looks like a great deal with an 11% cap rate and a positive monthly cash flow of over $1,000! It would definitely be worth securing this deal (if it were real).
We are not licensed financial or legal professionals and as such everything on these pages should be considered general information and ideas and not understood to be financial or legal advice. If you are in need of financial or legal assistance please seek the help of a qualified professional.
Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks.
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