Buying Rental Property: How to Make a Good Investment
Don't wear your homeowner hat when you go out to buy rental property, because the elements to consider are very different. You may love houses with big backyards and picket fences, but the most important factor when buying a rental property is financial. Whether it's determining your return on investment (ROI) or per-unit cash flow, it's important to do the math first rather than buying based on "intuition."
Cash Flow Counts Most in Evaluating Investment Property
When someone says their rental building is a "cash cow," it highlights the most important factor in selecting rental property for investment — cash flow. Think of cash flow this way: If you put all of the rental income from a property into a bank account and use it to pay all of the rental property expenses, the remaining money represents your cash flow.
If you get $2,500 a month in rent and your expenses for the month on the building total $2,000, you would have $500 in positive cash flow.
Property Appreciation Is Uncertain
You've heard the stories about people who buy an apartment building for $1 million and sell it for $2 million one year later, thanks to surging property values. That's called appreciation.
But market values go up and they go down. Unless you have a crystal ball, your guess as to future property values is just that — a guess. This is why analyzing a rental property has more to do with cash flow than with appreciation.
Return on Investment Analysis
One way to evaluate a rental property is to use an ROI analysis. Once you figure out the annual ROI the property offers, you can compare it to the returns offered by other potential investments.
The first step is to figure out the cash flow by subtracting all expenses — mortgage and non-mortgage — from the total rental income. For this type of quick analysis, many investors assume that the non-mortgage expenses on the rental property will approximately equal one-half of the rent received.
For example, if a property brings in $2,000 rent every month, the non-mortgage expenses are estimated to be $1,000. To find the monthly cash flow, total the non-mortgage expenses — $1,000 in this example — add in the mortgage expenses, and deduct that figure from the $2,000 rental income.
To figure out the building's ROI, divide your annual cash flow by the amount of the down payment on the building. If you put down $40,000, and the annual cash flow is $4,000, your estimated return on investment will be 10 percent. This calculation is easier using a good, online rental property calculator.
For an even faster analysis than the ROI calculation, look at whether the property will yield a profit per unit. To do this, figure out if you will realize a reasonable cash flow from each unit.
First total the rental income from all units, then compute the non-mortgage expenses using the 50-percent rule and add the mortgage expense. Divide the total expenses by the number of units.
For example, if you receive $2,000 in rent every month on a four-unit building with non-mortgage expenses estimated at $1,000, and a monthly mortgage payment of $600, your cash flow will be about $400 per month or $100 per unit. Now, you can compare this figure to the cash flow per unit of other investments.