When considering a residential investment property, you'll want to run a few key numbers to evaluate the potential profitability and risk. Here's a general process you can follow:
- Property Price and Financing: Consider the purchase price, loan terms, and any other costs related to the acquisition. These might include closing costs, rehab expenses, etc. The way you finance the property can drastically affect its profitability.
- Gross Rental Income: How much income will the property generate monthly? This amount is typically based on the fair market rental value of the area.
- Operating Expenses: These include recurring costs like property taxes, insurance, property management fees, maintenance, and utilities (if you pay them). It would be best if you also accounted for vacancy rates. A general rule of thumb is to set aside 5% to 10% of the rent for vacancies and another 5% to 10% for repairs and maintenance.
- Net Operating Income (NOI): Subtract your total operating expenses from your gross rental income. This gives you the NOI, a critical figure representing how much revenue your property generates after operating expenses but before mortgage payments.
- Cash Flow: Deduct your monthly mortgage payment from your NOI to calculate your cash flow. Positive cash flow means bringing in more money than you're spending, which is generally the goal of real estate investment.
- Capitalization Rate (Cap Rate): Your NOI is divided by the purchase price. It represents the return on investment if the property was bought in cash. A higher cap rate typically means higher risk but also higher potential return.
- Cash-on-Cash Return: This is your annual pre-tax cash flow divided by your total investment (down payment + closing costs + rehab costs). It measures the return on the actual cash invested.
- Return on Investment (ROI): This is the ratio of annual net profit to the total investment cost. It's calculated by dividing the net profit by the total amount invested, then multiplying by 100 to get a percentage. The higher the ROI, the better.
- Total ROI or Return on Equity (ROE) over time: This is a longer-term perspective and includes appreciation, mortgage paydown, and other factors that increase your equity position.
- Gross Rent Multiplier (GRM): The ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, and utilities. GRM provides a rough measure of the value of an investment property.
THE BOTTOM LINE
Each of these measures provides a slightly different perspective on the property's potential return, and together, they can provide a comprehensive view. It's important to note that these are only estimates, and actual results may vary depending on various factors, including changes in the real estate market, unexpected expenses, and changes in rental income. Always thoroughly analyze before making an investment decision, and watch out for our next posts as we dive deeper into each step of the process.