Use This Formula to Decide if a Property is a Good Investment
What makes a good investment? Is it the neighborhood? The number of bedrooms? The proximity to good schools? The answer, of course, is that all of these things matter – and many other factors as well. However, none of these really offer definitive proof that they’ll be a solid investment. You can have a home in a great neighborhood, but it could need a ton of expensive repairs. Or you could have a property in superb condition, but the location is sketchy.
My point is, all of these factors are a bit subjective. And while this doesn’t mean they don’t matter – because they do, big time – you also want more definitive proof that what you’re considering is a good investment.
And that’s where the math comes in, my friends. There are a few different calculations you need to follow when you’re eyeballing a new investment, and these will tell you down to the penny whether or not a place makes financial sense, now and in the future. Here’s one basic process to follow when considering a new investment:
Step 1 – Figure out the annual rent
If a property is already being used as a rental, this is pretty easy. Just ask the current owner for the last year’s figures and use that as a starting point. I say “starting point,” though, because you’ll also want to research market rates on your own to make sure that you’ll be asking a fair amount – not too low, and not too high.
Step 2 – Calculate annual expenses
Once you’ve got the expected revenue figured out, it’s time to determine the expenses. Again, if the property is currently functioning as a rental, this will be pretty simple. But even if it’s not, as long as you know what you’re looking for, it’s just a matter of finding and adding up some figures. These will include property taxes, insurance, any utilities you plan on paying, repair and maintenance costs, and projected vacancy expenses, which are usually factored in at 5-10% of the annual rent. You may also have other miscellaneous expenses, such as HOA dues, marketing costs, or property management.
Step 3 – Determine net annual income
Take the figures you’ve come up with in the previous two steps, and subtract the annual expense number from the annual income number. Basically, Step 1 minus Step 2.
Step 4 – Figure out cap rate
Capitalization rate, commonly shortened to cap rate, is the annual return you’ll get with your investment. It’s expressed as a percentage, and most investors like to see a cap rate of at least a 4%. To find this percentage, take the net annual income (Step 3) and divide it by the cost of the property.
Example: You buy a property for $125,000 and rent it out for $1,500/month
Annual rent: $18,000
Property tax $2,500
Misc. expenses $1,000
Vacancy rate (5%) $1,020
Total annual expenses: $7,270
Net annual income: $10,730
Cap rate = $10,730 / $125,000
These figures result in a cap rate of about 8.5%, which is pretty dang good. Keep in mind, though, that higher cap rates can sometimes mean higher risk. Plus, cap rates alone are never enough to tell you whether or not something is a good investment. They’re extremely variable and can change drastically from one part of town to another.
So there you have it, in a nutshell. This is the basic process to follow with any rental property investment you’re seriously considering. While the factors I mentioned before – the neighborhood, number of bedrooms, and proximity to good schools – all make a big difference in how successful an investment can be, they are all also open to interpretation. But math isn’t. If the numbers don’t add up, there’s no room for interpretation. It simply is what it is, and if it’s a risky investment, the numbers will say so.