It's a shame that more people don't invest in income-producing real estate, because it's one of the most powerful ways middle-class folks can generate wealth.
There is one major catch, though. Buying property and becoming a landlord that actually makes money renting houses means you must do your homework. Because if you don't, you risk overpaying for your investment property.
When you pay too much for a rental property, you immediately find yourself in a money-losing hole from which it could take years to recover. Even worse, you might never recoup your money at all.
On the other hand, if you pay the right amount for your property and attract reliable tentants, there's potential to reap steady, long-term returns as a landlord.
With that in mind, here are two sure-fire yardsticks to use when evaluating an investment property:
Landlord Yardstick #1: The Rent Multiplier
The quickest and easiest way to determine whether a property is suitable as a rental investment is to compare its price to its current gross yearly rental income by using the 'rent multiplier:'
Rent Multiplier = (Selling price) / (Gross Annual Rental Income)
Gross income includes rental income as well as other incidental income, such as money from laundry rooms, vending machines and parking spaces.
For prospective landlords, the rule of thumb is this: any property selling for more than seven times total annual rental income will probably end up with negative cash flow.
Put another way, your rental income wouldn't be enough to cover your mortgage and minimal operating expenses. Forget making a profit; you'd be losing money on your investment while also dealing with the mundane hassles of being a landlord.
Professional real estate investors use this formula when evaluating the investment potential of a property and as a general rule, they won't pay more than seven times gross annual rental income. Neither should you.
Don't make a common mistake by thinking if you put down a sizable cash downpayment to ensure positive cash flow, you're doing yourself any favors.
Remember the concept of opportunity cost. You're sidelining a substantial amount of money that could be devoted to government bonds, CDs, or other low-risk securities.
Landlord Yardstick #2: Capitalization Rate
Experienced real estate investors refer to this formula as the 'cap rate.' Here's how it works:
Capitalization Rate = (Net Operating Income) / (Total Investment)
Net operating income (NOI) is equal to a property's yearly gross income minus operating expenses. Operating expenses are costs incurred during the operation of a property, like maintenance, repairs, insurance, utilities, property taxes, etc.
Expenses not defined as operating expenses include mortgage principal and interest, capital expenditures (high dollar improvements that have a useful life of several years or more), and income taxes -- so don't input these costs into capitalization ratio equation.
The capitalization rate is important because it's a measure of how fast an investment will pay for itself. If the cap rate is 10%, then the investment will take 10 years to pay for itself. Most pros insist on a cap rate of about 8%.
Don't Cheat Yourself Out of Real Success
For both formulas, the old adage 'garbage in, garbage out' applies. Be sure to use numbers that are realistic and accurate. Real estate investors eager to make a deal sometimes delude themselves by skewing figures or creating their own exceptions to the rules.
For example, the total amount invested should encompass both the down payment and the money you borrowed to purchase the property. Net operating income should be calculated by deducting all expenses (except mortgage interest) from total rental income.
Don't let the real estate agent fool you either. Real estate agents and building owners sometimes deploy a sneaky trick known as 'bumping to market,' meaning they dazzle buyers with unrealistic expectations as to what they can charge for rent. Part of your homework should be to investigate income and rent levels in the neighborhood to accurately estimate what your rental market will bear.
Also remember to examine local vacancy rates. If a lot of rental units are empty, take that into account. On the other hand, if there appears to be a shortage of rental units, you're golden. Multifamily houses or multi-unit apartment buildings are your best bet for investing in rental property; the numbers typically won't add up for single-family homes or condos.
One final heed: Lenders typically request higher down payments for investment properties than for private domiciles. Don't allow your enthusiasm affect your judgment and compel you to pony up too much cash. It's risky to borrow against your home, or cash in other investments, just to meet the down payment on an investment property.
In the end, purchasing income-producing rental property is a time-tested way to build wealth, but only if you can afford it — and only if you don’t overpay.