The passive income that a rental property offers makes it a very appealing investment for many. However, before choosing to invest in any rental property, it is important to determine whether that property is profitable on its own and how profitable it is when compared to what other rental properties have to offer.
In this article, we will look at different measures that present the profitability of rental properties, how to calculate them, and the factors that affect each measure.
To get a full picture of what a rental property has to offer, an investor should start by estimating the net operating income the property would generate. Net Operating Income is calculated by subtracting operating expenses from the total rental income and other income.
Operating income involves two main components. First is rental income, which is the monthly rent that is charged for a property multiplied by 12 months of the year to find the annual rental income. Additional income can be generated if you decide to charge for amenities, such as laundry, vending machines or parking passes. However, getting rent for 12 months of the year is the ideal scenario.
It is necessary to also account for the occasion when you do not receive rent during certain months. There are a number of reasons why this can happen. For instance, when one tenant moves out and you have yet to find another one. During the time that the property stays empty, you would incur vacancy losses. Another example would be if the existing tenant refuses to pay rent, in which case, you would incur credit losses that also include the costs associated with evicting the tenant. Both vacancy and credit losses are to be deducted from operating income.
Operating expenses are all the costs that you will incur to operate the property on a daily basis. These will include costs such as property taxes, the cost of maintaining and repairing the property, property insurance, management fees if you would rather have someone else manage the property, utilities that could also be shared with the tenant, and landlord’s insurance. It is important to note that costs associated with financing the purchase of a rental property will not be included in operating expenses.
Mortgage payments and interest, income taxes, depreciation, and other large capital expenditures should not be included in operating expenses when calculating the net operating income.
The Cap rate of your rental property
The net operating income on its own tells little about where the property you have chosen stands as an investment opportunity relative to other similar properties. To make a proper comparison, you need to calculate the capitalization rate or the cap rate.
The cap rate is the property’s net operating income as a percentage of the total cost of the property or the current market value of the property. The cap rate assumes that the property was bought using only cash, thus, it does not account for any financing costs or interest expenses. You can use the cap rate of the property you want to invest in to compare it with the average U.S. cap rates of that type of property.
The cap rate is also an indicator of the payback period. The payback period is the time it will take for you to break even on your investment. A higher cap rate means that a shorter time will be needed to break even, which is attractive to investors. By calculating the cap rates of different investments, one can understand about the level of risk these investments present. A higher cap rate shows a higher level of risk and vice versa.
Using mortgage to purchase a rental property
Until now, we have assumed that the rental property is purchased using cash only. However, this is rarely the case. Getting a mortgage to finance the purchase of a rental property has more strict financial requirements than a mortgage for a primary residence.
Starting with the down-payment, an investor will typically need to put at least a 20% down-payment to get a mortgage for his rental property. Moreover, the interest rates for mortgages on investment properties are usually higher than regular interest rates. This means that you will need to pay higher interest on your mortgage, which will reduce your monthly cash flow.
Return on Investment
While before we calculated NOI as a measure of return on our cash-financed investment, now, we will consider the case of the return on investment when the property has been purchased through a mortgage.
In this scenario, other costs such as mortgage payments and interest are to be included when calculating your net operating income. These costs will bring your net operating income down if all the other factors are the same. The ROI is then calculated by dividing the net annual income by the total amount that you put down for the property and other closing costs.
In conclusion, to evaluate how profitable an investment property is, it is important to look closely at the net income and costs associated with the property. These will be different when you choose to purchase a rental property using cash only versus when you finance the purchase through a mortgage.