Investing in real estate is one of the most effective strategies for generating a passive income and building wealth. In fact, some of the wealthiest people in the world today attribute their fortunes to real estate investing. Whether you are planning to pursue a traditional or Airbnb investment strategy, owning rental property can be your first step towards achieving your financial objectives.
However, simply buying income property will not guarantee success. There is a lot that goes into learning how to invest in real estate. One of the things to consider when buying investment property is the various metrics that reflect the property’s profitability and earning potential.
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Important Metrics to Consider When Buying Investment Property
Numbers are very crucial when buying an investment property to rent. Each number tells a different story about the potential profitability of an investment property for sale. Getting familiar with these metrics will help you distinguish a bad deal from a great deal.
Here are 7 important metrics real estate investors need to know before purchasing rental homes:
Net Operating Income (NOI)
This metric shows how much cash the rental property for sale will generate after all the operating costs are paid. In other words, the NOI is simply the total income minus expenses.
Net operating income (NOI) = Potential rental income – Operating expenses
Income includes earnings from rent and other monthly fees charged to tenants. Expenses include legal fees, property management fees, property taxes, general maintenance, and utilities. Please note that this calculation excludes mortgage payments.
Cash on Cash Return
Cash on cash return is one of the most common metrics in real estate investing. It simply shows you how much you are earning off the money you invested when buying investment property. Unlike other investing metrics, it takes into consideration your mortgage loan and debt service. The formula is as follows:
Cash on cash return = Annual cash flow (before tax)/total cash invested
Let’s say you want to make a $250,000 down payment for a rental home that could generate a pre-tax cash flow of $30,000. Using the formula, the estimated return is 12%.
So what is good cash on cash return when buying investment property? Many experts believe that a CoC between 8% and 12% shows that a property is a worthwhile investment.
Cap Rate
Capitalization rate is a metric that allows a real estate investor to estimate how much money they can make from investment properties. Though it is mainly used to evaluate large commercial buildings and apartment complexes, it can also be used for multi family homes and single family homes.
You can use the capitalization rate to compare similar homes in different markets. It is calculated by dividing the annual net operating income (NOI) by the total value or cost of the asset.
Cap rate = Annual net operating income/Current home value
Generally, a lower cap rate means lower risk and a higher potential return. Many real estate experts believe that a good cap rate should be in the 8% to 12% range. However, investors need to make sure that the cap rate of the property they want to buy exceeds or equals that of similar homes in the neighborhood.
Cap rate will also give you an idea of how long it will take to recoup the money invested in buying investment property. For example, a home with a cap rate of 5% will take about 10 years to recoup the investment.
Cash Flow
Cash flow is basically the money left at the month or year after all the expenses have been paid. In other words,
Cash flow = Rental income – Rental expenses
When assessing rental homes, it is very important to calculate what you can expect as real estate cash flow. Your expenses should include things like water, sewer, garbage, property taxes, flood insurance, homeowners insurance, rental property management, vacancy rate, capital expenditures, electricity, and general maintenance. Before buying rental property, be sure that your monthly rent will exceed the total costs of running your property.
In addition, you need to research the rental laws of the location where you want to invest. Some cities have rent control laws that determine how much landlords can raise rent every year.
Occupancy Rate and Vacancy Rate
Occupancy rate is simply the percentage of time your property is occupied. Conversely, the vacancy rate is the percentage of time your property is unoccupied. For example, if you have tenants for only 9 months in one year, the occupancy rate is 75% and the vacancy rate 25%.
Though an unoccupied rental property generates no income, it still costs you money. You still have to pay some operating costs even when there are no tenants.
Internal Rate of Return (IRR)
Real estate investors use IRR to estimate a home’s overall profitability. This calculation takes into account the initial investment costs, cash flow, and the proceeds of property sale. Since the formula is very complex, you can make use of the IRR feature in Excel.
Generally, the higher the internal rate of return, the more attractive the project is. IRR typically ranges from 10% to 20%.
Loan to Value Ratio (LTV)
As the name suggests, the loan to value ratio is basically the ratio of the mortgage to the value of the property you are buying.
LTV = Loan amount/Home value
For example, if a home is valued at $300,000 and you have a deposit of $60,000, the LTV will be 80%.
Financial institutions and lenders use this metric to evaluate risk. The higher the loan to value ratio, the more risk is attached to a loan. Though the required loan to value ratio varies from one lender to another, the generally accepted ratio is between 65% and 80%.
When it comes to investment property loans, buying investment property with no money down is an option worth considering. Loans that have friendly mortgage rates include FHA loans, VA loans, and USDA loans.
Related: What Is the Loan to Value (LTV) Ratio in Real Estate?
How to Use Mashvisor Tools
Making all these calculations manually can be very stressful and time-consuming. Even worse, if you make a small mistake, you could end up with misleading numbers.
Mashvisor real estate investment tools make it easier for you to assess the potential profitability of the property. Here are two tools you might want to look at:
- Real estate heatmap – Choosing the right location is crucial for your success when buying investment property. You want to find a neighborhood where you can afford the home prices and make a good return on investment. The real estate heatmap is a tool that allows you to analyze multiple neighborhoods in a housing market. The analysis is based on current real estate trends, predictive analytics, and rental comps. You can narrow your search using the following filters; listing price, Airbnb occupancy rate, cash on cash return, and rental income.
The heatmap makes buying investment property an easy process
To start looking for and analyzing the best investment properties in your city and neighborhood of choice, click here.
- Investment property calculator – Also known as a rental property calculator, this tool is a must for anyone buying investment property. It uses predictive and traditional analytics to show you the return on investment you can expect from the property. Once you enter your financing costs and rental expenses, the calculator will generate 3 metrics; cash on cash return, cash flow, and cap rate. The rental property calculator will also show you the optimal rental strategy.
Conclusion
When it comes to what to look for when buying an investment property, real estate data is very important. In fact, you cannot invest successfully in real estate without relying on analytics. Within minutes, Mashvisor real estate investment tools will help you crunch the numbers and make the right decisions when buying investment property.
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