More and more people are getting started in real estate investing and are looking to rental properties as a way to diversify their investments and securing cash flow for the future.
- The cap rate can help you compare real estate investment opportunities.
- The cap rate is calculated by dividing the net operating profit by the purchase price.
- As a general rule of thumb, investors should ensure that their rental will generate at least 1% of the purchase price in gross monthly rent.
The Benefits of Rental Properties
Rental properties can round out an investment portfolio and create an ongoing income stream. Several major factors have made this a popular investment option:
- The meager returns provided by savings accounts and investments such as certificates of deposit are causing many people to take a closer look at rental property investing.
- Several years of record-low interest rates have made people wary of future inflation, which drives them away from the bond market. As an alternative, people invest in physical assets like commodities and real estate, which have the perceived benefit of inflation protection.
- Many want to diversify their investments, which means moving away from solely investing in the stock market.
If you want to get into rental property investing, you need to learn how to evaluate whether or not a potential rental property is a good investment. The following two formulas will help.
The Cap Rate
First, calculate the capitalization rate, or "cap" rate, on your intended investment. That is the profit you can make from net income generated by the property, or the rate of return you'd make on a house if you were to buy it with cash.
The cap rate is the net income divided by the asset cost. For example:
- You buy a home for $200,000.
- It rents for $1,500 per month.
- Your expenses (taxes, insurance, management, repairs, maintenance) average out to $500 per month. (Remember, that does not include the principal and interest payments on your mortgage, but it does include the escrowed sum for taxes and insurance.)
- Your property's net operating income is $1,000 per month, or $12,000 per year.
- Your cap rate is $12,000/$200,000 = 0.06, or 6%.
Whether 6% makes a good return on your investment is up to you to decide. If you can find higher-quality tenants in a nicer neighborhood, then 6% could be a great return. If you're getting 6% for a shaky neighborhood with lots of risks, then this return might not be worthwhile.
The One Percent Rule
This is a general rule of thumb that people use when evaluating a rental property. If the gross monthly rent (before expenses) equals at least 1% of the purchase price, they'll look further into the investment. If it doesn't, they'll skip over it.
For example, a $200,000 house—using this rule of thumb—would need to rent for $2,000 per month. If it doesn't, then it doesn't meet the One Percent Rule. Under this rule, the house brings in gross revenue of 12% of the purchase price each year. After expenses, the property may bring a net revenue of 6% to 8% of the purchase price. That is generally considered a good return, but, again, it depends on what area of town you're considering. Nicer neighborhoods tend to have lower rental returns, while rougher neighborhoods tend to have higher returns.
Keep in mind that 6% or 8% doesn't mean as much if that interest is non-compounding. To give your returns the same benefit and the same chance of growth as money in the stock market, you'll need to reinvest 100% of the proceeds so your returns can compound upon themselves.
Frequently Asked Questions (FAQs)
How do you calculate the ROI on a rental property?
The calculation for the return on investment (ROI) of a rental property is similar to the cap rate. One difference is that the ROI is a more accurate measurement that includes more costs, such as the borrowing costs associated with a rental property mortgage. The cap rate assumes that you bought the house with cash to give you an overall sense of the rental's profitability, while the ROI is a more personal measure of how much you will earn.
How do you calculate the depreciation on rental property?
The cost basis of a residential rental property can be depreciated for 27.5 years. That means you just need to divide the total cost basis by 27.5 to figure out how much to claim in depreciation on your taxes annually. The cost basis is the cost of the property, plus any costs associated with preparing the building for renters, minus the value of the land that the rental building sits on. There are some quirks as to which costs are included in the cost basis, so check IRS Publication 527 for more information as to how to calculate your basis.