Have you considered buying a rental property, or converting your current home into a rental? Here’s a rental property cost analysis guide to help you get started.
If you’re thinking of converting your current home into a rental, read my article about converting residences to rentals. You can count 75% of market rent toward your income qualification for the purchase of your next home.
Rental Property Cost Analysis – Collect the Data
Here’s what you need to know for a rental property cost analysis:
- Purchase price
- Cost of any make-ready repairs
- Monthly market rent
- HOA fees
- Any utilities not paid by renters
- Interest rate (if financing)
- Down payment percentage (if financing)
Rental Property Cost Analysis – Calculations
Four helpful calculations are Net Operating Income, Net Cash Flow, Capitalization Rate, and Gross Rent Multiplier (GRM).
Net Operating Income
Net Operating Income tells you how much money the property generates each month. The formula is
Net Rental Income minus Total Expenses = Net Operating Income
Net Rental Income
The Net Rental Income is the Gross Rental Income minus expected vacancy. In San Diego County, many investors use 3% vacancy rate. For example:
$1500 gross rental income, minus 3% vacancy, or $45, makes $1455 Net Rental Income.
Total Expenses
Some investors estimate expenses to be 30-35% of collected rents. If you want more accuracy, here’s a list of expenses to use for your rental property cost analysis, and what percentages to estimate. Debt service is not included:
- Property management fees – 8%
- Maintenance reserve – 5%
- Any utilities not paid by tenant
- Property taxes – 1.2% annually
- Landlord’s insurance – approximately $50
- HOA fees
To use the previous example, based on $1500 gross rental income and $150,000 purchase price:
Property management fees – $120
Maintenance reserve – $75
Any utilities not paid by tenant or HOA – n/a
Property taxes – $150
Landlord’s insurance – $50
HOA fees – $250
Total Expenses – $645
Net Operating Income = $1455 Net Rental Income minus $645 Expenses = $810
Net Cash Flow
In a rental property cost analysis, Net Cash Flow is the Net Operating Income minus any debt service.
A $150,000 purchase with 25% down and a 30-year fixed mortgage at 4.5% interest will have a monthly mortgage payment of $570.
Net Cash Flow = $810 Net Operating Income minus $570 Debt Service = $240
Capitalization Rate
The capitalization rate is calculated by dividing the annual Net Operating Income by the property value. When you analyze a rental property as an investment, the property value is your purchase price.
Capitalization Rate = Annual Net Operating Income / Property Value
In the above example, the estimated capitalization rate is $9,720/$150,000 = 6.4%
In San Diego County, the average cap rate is approximately 3.5%.
Gross Rent Multiplier
The Gross Rent Multiplier, or GRM, is the sale price divided by the annual rental income. In general, the higher the GRM, the more expensive the property. If a GRM is 17 or higher, the property is probably so expensive that you can’t collect enough rent to pay for it. A GRM between 8 and 16 is a good range, because the property value is still high, you can expect long-term appreciation, and you either break even or enjoy good cash flow. When the GRM falls below 6-7, the property values, rents, and appreciation are all low.
Gross Rent Multiplier = Purchase Price / Annual Rental Income
Using the above example, the GRM is $150,000/$18,000 = 8.33
How Do I Decide Whether to Buy?
The numbers you want to see on a rental property cost analysis depend on your goals. Many investors are satisfied with little to no cash flow, so long as they are not losing money each month. When I shop for investment properties, I am satisfied with $50 cash flow, and a cap rate of 3%.
Why so little return? Because it’s not about the short-term return. Appreciate the long-term advantages of owning investment property. Rental rates usually increase each year, bumping up your cash flow. Over time, you pay off the mortgage, which builds your equity and net worth.
If that isn’t enough to convince you, read this Business Insider article about what Warren Buffett’s investing philosophy, and investment real estate.
Bottom Line
Real estate is an investment you can finance. When I invest in the stock market, I need to pay 100% of the investment up front. With rental real estate, you can often put only 25% down and finance the other 75%. If you buy a home that you occupy for only 3% down, you can keep that 97% loan when you convert it to a rental property.
Same goes for VA borrowers who buy for $0 down! They can convert their existing residence into a rental property, and keep the 100% loan. Read my article for military investors.
While it’s daunting to consider real estate investing, it’s also one of the most direct ways to become a millionaire. Almost anyone can do it, with little cash down and a good property manager. The sooner you start, the sooner you can reap the rewards.
Contact me for more information about investment rentals, and how to get started.
