Rental property investment is one of the best ways to create passive income. However, it does require a lot of time and money upfront before you start seeing that return on investment. First, you must decide where you want to buy and how much you are willing to spend. Then you have to evaluate the property, which will help you determine whether or not the rental is worth the investment. Whether you are looking to purchase a property to use as a single-family home, an apartment building, or a vacation rental, performing some simple calculations and comparisons can help you choose the property that will yield the highest ROI.
1. Look at the Big Picture
It takes time to find the perfect rental. Before getting out your calculator, spend some time getting to know the area where you are considering purchasing a rental property. Look at what properties have sold for recently and what rents look like in comparable buildings/homes. Consider what job opportunities are nearby. How will this neighborhood look in another five or ten years? Will the property value increase? You want to choose an area within your price range that will be enticing for renters. Consider the age of the investment property. Older buildings tend to have higher maintenance costs. Estimating recurring expenses like property tax, maintenance fees, and necessary improvements will help determine your ROI.
Suppose you plan on using the property as a vacation rental, comb through similar properties on Airbnb. You’ll also want to look at how similar rentals are furnished. There is an opportunity to earn more monthly income with a vacation rental, but it also includes investment in property management and cleaning fees. Luckily, since vacation rentals are a business, you can write off any business-related expenses when it comes time to do your taxes. Many tourist locations have rules and regulations about where and how to operate vacation rentals, be sure to check local laws. You will also have to consider seasonality in your calculations, as many vacation homes have more traffic during a specific time of year.
2. The One Percent Rule
Monthly Rent = 1% of Purchase Price
Do this quick calculation to see if the property is worth your attention and possible investment. A $300,000 property should rent for $3,000/month. You could earn this in a one-time payment from a tenant or multiple clients in a vacation rental. If there are any upfront repairs, include estimates in your purchase price to get a clear picture of the investment. If your result is less than 1%, consider alternative properties.
3. Net Operating Income (NOI)
NOI = Monthly Income X 12 – Monthly Expenses (fees other than mortgage payment)
While calculating your Operating Net income doesn’t include your mortgage payment, it can help you compare a group of similar properties. You’ll use this number to find your estimated cash flow by subtracting your mortgage from the NOI. The property isn’t worth the investment if the cash flow is negative.
4. Estimate Your ROI
Cash flow + Principal Payment X 12 – Monthly Expenses = Annual Return
Annual Return ➗Total Investment cost = ROI
You can use your estimated ROI to compare properties at different price points. Will you have a higher ROI by making a more significant upfront investment? Is the more expensive property not quite worthy of the price tag? This number will help you decide your offer amount and be able to substantiate it when it comes time to negotiate a purchase price.
5. Capitalization (CAP) Rate
CAP Rate = NOI ➗Price of the Property
CAP rate does not factor in financing. Instead, it shows your return as if the property were paid off in full. It can be another way to compare properties in different areas or price points. Real estate advisors recommend your cap rate be between 8-12%.
6. Cash on Cash Returns or CCR
CCR = NOI ➗Investment Costs
CCR allows you to see how your property might perform based on the amount of cash you put into the investment. Investors typically aim for about 10%, but you may have a different number based on your specific investment goals and strategies.
7. Speed Up the Process Using a Real Estate Investment Calculator
If you are new to real estate, creating a spreadsheet to crank out all these calculations may feel intimidating. An online real estate investment calculator can help you quickly plug in the numbers and see all your assessments in one place. This can save you time and ensure you get more accurate results.
8. Don’t Have Enough Cash on Hand to Get Started? Consider Fractional Ownership
There is more than one way to make a rental property investment. Buying an entire apartment complex or a vacation home to rent on Airbnb requires a hearty upfront investment. If you don’t have that kind of cash, fractional ownership makes investing more accessible. Consider using a company like Here, which allows you to invest in vacation rentals for as little as $100. They handle the property management, and you’ll receive a proportional share of the income. It’s a low-cost and low-effort way to get started in the real-estate game.