Rental Property Calculator
Rental property investment refers to real estate investment that involves real estate and its purchase, followed by the holding, leasing, and selling of it. Contrary to popular belief, rental property investment is not passive income, especially if there is no management consultant hired to handle administrative work, a service that usually costs about 10% of income. People with real experience in the field often tout it as exhaustive work, whether standing by for another problem to arise, filing paperwork, or dealing with terrible tenants.
Quick Tip: Performing background checks on prospective tenants can give the lessor a better idea of what to expect about a tenant, how the tenant may treat the property, and how likely the tenant may be to consistently pay rent.
Commonly done for better returns, investors purchase cheap and inferior properties, such as foreclosures, then improve them before the leasing stage. For older properties, assume higher maintenance and repair costs. Rental property investments are generally capital-intensive and cashflow dependent with low levels of liquidity. However, compared with equity markets, rental property investments are normally more stable, have tax benefits, and is more likely to hedge against inflation.
That's not to say that rental properties aren't worth the effort nor unprofitable. Given proper financial analysis in the decision making, they can turn out to be profitable and worthwhile investments. The Rental Property Calculator can help run the numbers.
Real estate investing can be complex, but there are some general principles that are useful as quick starting points when analyzing investments. However, every market is different. It is very possible that these guidelines will not work for certain situations. It is extremely important that they be treated as such, not as replacements for hard financial analysis nor advice from real estate professionals, things that should always get the nod over overgeneralized guidelines.
50% Rule - A rental property's sum of operating expenses hover around 50% of income. Remember that operating expenses do not include mortgage principal nor interest. The other 50% can be used to pay monthly mortgage payment. With this, quickly estimate the cash flow and profit of an investment.
1% Rule - The gross monthly rent income should be 1% or more of the property purchase price, after repairs. It is not uncommon to hear it proclaimed as the 2% Rule, but obviously, the higher the better.
A lesser known rule is the 70% Rule. This is a rule for purchasing and flipping distressed real estate for a profit, which states that purchase price should be less than 70% of after-repair value (ARV) minus repair costs (rehab).
Internal Rate of Return
Internal rate of return (IRR) or annualized total return is an annual rate earned on each dollar invested for the period it is invested. It is generally used by most if not all investors as a way to compare different investments. The higher the IRR, the more desirable it is to make the investment.
If there is one figure that is most important in acknowledging the profitability or relative success of any rental property to any other investment, it is the IRR. Capitalization rate is too basic in its computation and Cash Flow Return on Investment (CFROI) does not account for the time value of money.
Capitalization rate, often called the cap rate, is the ratio of net operating income (NOI) to the investment asset value or current market value.
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Cap rate is the best indicator for quick investment property comparisons. It's hard to find another measure that is immediately telling of the potential profitability of real estate.
Cap rates are also useful when evaluated for their historic trends, as sets of data can quickly give future insight into where properties in a specific market might be headed. Just remember to use sample data that are relevant to each other, such as the type of property or specific neighborhood or location. As they say, it is no use comparing apples to oranges, or in this case, a multiplex in Compton to a single family in Beverly Hills!
In regard to rental properties with net operating incomes that are wildly complex and irregular in their income streams, discounted cash flow analysis is the more accurate alternative.
Cash Flow Return on Investment
When purchasing rental properties with loans, cash flows need to be examined carefully. Rental property investment failures can be caused by unsustainable, negative cash flows. Cash Flow Return on Investment (CFROI) is a metric for this. Sometimes called Cash-on-Cash Return, CFROI helps investors being aware of the losses/gains associated with ongoing cash flows. Healthy rental properties should have increasingly higher CFROI annual percentages through the life of it, usually due to static mortgages payments but appreciating rent incomes over time.
Things to Keep in Mind
Generally, the higher the IRR, CFROI, and cap rate, the better.
In the real world, it is very unlikely that a rental property's investment goes as planned according to blueprints such as ones printed out based on the calculations done by this Rental Property Calculator. Making so many financial assumptions extended over long periods of time (usually several decades) may result in undesirable/unexpected surprises. An array of things can go awry, whether a short recession depreciates the value of a property significantly until it rebounds, or construction of a thriving shopping complex inflates values, both with possible drastic influences on cap rate, IRR, and CFROI. Even mid-level changes such as hikes in maintenance costs or vacancy rates can affect the numbers. Monthly rents may also fluctuate drastically from year to year, so taking the estimated rent from a certain time and extrapolating it several decades into the future based on an appreciation rate might not be realistic.
Furthermore, while appreciation of values is accounted for, inflation is not, which might distort such large figures drastically.