Rental Property Investments
Rental property investment refers to real estate investment that involves real estate and its purchase, followed by the holding, leasing, and selling of it. Depending on the type of rental property, investors need a certain level of expertise and knowledge to profit from their ventures. Real property can be most properties that are leasable, such as a single unit, a duplex, a single-family home, an entire apartment complex, a commercial retail plaza, or an office space. In some cases, industrial properties can also be used as rental property investments. More commercial rental properties, such as apartment complexes or office buildings, are more complicated and difficult to analyze due to a variety of factors that result from the larger scale. For older properties, it is typical to assume higher maintenance and repair costs.
Rental property investments are generally capital-intensive and cash flow dependent with low levels of liquidity. However, compared with equity markets, rental property investments are normally more stable, have tax benefits, and are more likely to hedge against inflation. Given proper financial analysis, they can turn out to be profitable and worthwhile investments. The Rental Property Calculator can help run the numbers.
There are several ways in which rental property investments earn income. The first is that investors earn regular cash flow, usually on a monthly basis, in the form of rental payment from tenants. In addition, as with the ownership of any equity, rental properties give the investor the possibility of earning profit from the appreciation, or increase in value over time, of the property. Unlike rental income, a sale provides one large, single return.
Rental property investing is not passive income. It requires time and work. The investor or owner has to take on the role of the landlord and all the job responsibilities associated with it.
General responsibilities of owning a rental property include:
- Tenant Management—finding tenants, performing background screenings for potential tenants, creating legal lease contracts, collecting rent, and evicting tenants if necessary.
- Property Maintenance—repairs, upkeep, renovations, etc.
- Administrative—filing paperwork, setting rent, handling taxes, paying employees, budgeting, etc.
It is common for rental property owners to hire property management companies at a fixed or percentage fee to handle all the responsibilities. Investors who have limited time, who don’t live near their rental property, who aren’t interested in hands-on management, or who can afford the cost can benefit from hiring a property management company. This is roughly estimated to cost about 10% of rental property income.
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, and it is very possible that these guidelines will not work for certain situations. It is important that they be treated as such, not as replacements for hard financial analysis nor advice from real estate professionals.
50% Rule—A rental property’s sum of operating expenses hover around 50% of income. Operating expenses do not include mortgage principal or interest. The other 50% can be used to pay the monthly mortgage payment. This can be used to 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 of people who use the 2% or even 3% Rule – 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 the investment.
IRR is one of, if not the most important measure of the profitability of a rental property; capitalization rate is too basic, 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.
Cap rate is the best indicator for quick investment property comparisons.
It can also be useful to evaluate the past cap rates of a property to gain some insight into how the property has performed in the past, which may allow the investor to extrapolate how the property may perform in the future.
If it is particularly complex to measure net operating income for a given rental property, discounted cash flow analysis can be a 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 identify the losses/gains associated with ongoing cash flows. Sustainable rental properties should generally have increasing annual CFROI percentages, usually due to static mortgage payments along with rent incomes that appreciate over time.
Things to Keep in Mind
Generally, the higher an investment’s IRR, CFROI, and cap rate, the better. In the real world, it is very unlikely that an investment in a rental property goes exactly as planned or as calculated 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. Whether a short recession depreciates the value of a property significantly, or construction of a thriving shopping complex inflates values, both can have 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 rent 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.
Other Types of Real Estate Investments
Aside from rental properties, there are many other ways to invest in real estate. The following lists a few other common investments.
Real Estate Investment Trusts (REITs) are companies that let investors pool their money to make debt or equity investments in a collection of properties or other real estate assets. REITs can be classified as private, publicly-traded, or public non-traded. REITs are ideal for investors who want portfolio exposure to real estate without having to go through a traditional real estate transaction.
For the most part, REITs are a source of passive income as part of a diversified portfolio of investments that generally includes stocks and bonds.
Buy and Sell
Buying and selling (sometimes called real estate trading) is similar to rental property investing, except there is no or little leasing out involved. Generally, real estate is purchased, improvements are made, and it is then sold for profit, usually in a short time frame. Sometimes no improvements are made. When buying and selling houses, it is commonly called house flipping. Buying and selling real estate for profit generally requires deep market knowledge and expertise.
Wholesaling is the process of finding real estate deals, writing a contract to acquire the deal, then selling the contract to another buyer. The wholesaler never actually owns the real estate.