Know The Profit You Should Make on a Rental Property in 3 Steps
Why are you getting into real estate investing? One of the main reasons is likely money and earning high returns that will help you achieve your financial objectives. But before buying real estate, it’s important to first determine how much profit you are likely to make before stepping into rental property investment.
Investing in rental properties isn’t super complicated and you don’t need tons of experience. For example, you could get started by simply buying a small multifamily home, make it your principal residence by living in one unit, and rent the other unit(s) to earn rental income.
Just like that, you are a real estate investor!
To understand the potential profitability of your rental property, do thorough research first.
Find out about the market you want to invest in and do your math. Have realistic expectations on the value of your property and the expected positive cash flows.
But how do you calculate the profit you should make?
First, there is no standard amount that defines what is a good profit for rental property. The returns you will get depend greatly on your investment goal, property size, and locality. To estimate your potential profits follow these three simple steps.
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Step #1: Determine your rental income
Understand the price of the property and its market rental rates. Having a clear picture of your initial investment is crucial.
You need to know how much money you will use to acquire the property. The less money you spend to buy the investment, the greater the possible return since return is profit divided by initial investment.
Go for markets where you will get properties within your budget. You don’t want to use all your savings to acquire one property.
Then find out how much rent you should charge. The rate should be in comparison with the purchase price of the property. The rental rates vary with the locality of your house.
Collect market information to determine your monthly rental rate. You can get this data from the local municipality, real estate agents, or online platforms like Apartments.com, Zillow.com, and other places that host rental listings. Get a range and use the minimum rate to estimate your rental income.
Step #2: Know your expenses
It will be devastating to acquire a good house, with amazing rental rates, only to incur huge expenses leading to negative cash flows.
To have a practical estimation of how much profit you will make in your rental property, learn all the expenses you will have to pay. Some of the expenses you will come across include:
- Mortgage payments
If you finance the purchase of your property with a mortgage loan, you will make monthly mortgage payments. This amount depends on the down payment you will pay and the interest rates that will be charged.
- Maintenance costs
This is the money you will use in ensuring the home remains in good condition. It includes repairs, replacements, cleaning, landscaping, pest control, and waste management.
- Property taxes
You pay this amount to the local authorities where your property is located. The amount varies depending on your state or municipality.
- Property insurance
These are premiums paid to insurance companies to protect the property and owner from unforeseen events and catastrophes.
- Property management
You can choose to manage the property yourself. But if it is not possible; you will have to hire a property manager. The cost is the fee paid to the manager to be in charge of your property on your behalf. It is mostly a percentage of the monthly rental income.
- Homeowners’ association fees
It is not incurred in all neighborhoods. You will pay a fixed monthly contribution if the property is in this association.
This includes the amount incurred to pay for water and electricity.
- Rental income tax
This is the tax you remit to your state based on your monthly rental income.
Step #3: Calculate your profit
At last! This is the moment you have been waiting for. Let’s now find out, the amount of profit you should make. You can use any of the following methods to estimate your profits.
- Cash flows
Your cash flow from a rental property is the monthly rental income you receive less all your expenses. Depending on your costs, it can be a positive or negative cash flow.
- Purchase price = $100,000
- Annual expenses=$6,000
- Down payment=20%
- Mortgage payment= $4,000
- Rental income= $12,000
- Cash flows= $12,000 -($6,000+$4,000)
- You will get a positive annual cash flow of $2,000.
If your estimation gives you a negative cash flow, you can get a different property to deal in that will get you positive cash flows.
- Capitalization rate (cap rate)
In the cap rate method, you can know the profitability of a house using its market value. It is a percentage of the cash flows based on the property’s value.
- Cap rate= ((cash flows without monthly mortgage payments)/property value))*100
When using the cap rate method, the assumption is that the property is paid for with cash, hence we exclude the monthly mortgage payments.
Using the previous example,
- Cap rate= (($10,000 – $4,000)/$100,000))*100. Which is equals 6%.
Compare properties and choose one with a better capitalization rate.
- Cash on cash return (COC) method
This is the percentage of your net operating income based on the cash you invested.
- Cash on cash return = (cash flows/cash invested)*100
As per most experienced investors, you should aim at COC that gives between 8% to 12%.
Continuing with our example,
- COC = ($ 2,000/ $(20%* 100,000))*100= 10%
Using this method you can adjust your rental rates to get better cash flows that will maximize your profits.
The difference between the cap rate and the COC depends on how you finance your purchase. If you use cash, the rates will be equal. If you use a mortgage loan, they will differ.
- Return on investment (ROI)
In this method, you get a percentage of your income based on your expenses. Going on with the example.
The ROI = ($12,000/$110,000)*100. The ROI is approximately 11%.
An ROI of above 15% is generally recommended.
- The 1% rule / 2% rule
The rule states that your gross monthly income should be at least 1% or 2% of the property’s value. In the example, the property is valued at $100,000. Therefore the gross monthly income should be a minimum of (1%*$100,000) = $1,000.
Final thoughts on Rental Property Profit Calculation
Investing blindly without knowledge of your expected profits is risky. Remember, there is no specific amount of profit you should make from a rental property.
The profit is influenced by a number of factors including the size and location of the property. Use the relevant methods to estimate the profitability of your potential property to make sound investment decisions.
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