How to Analyze a Rental Property

Investing in real estate is a great way to make money.  In fact, over the last 200 years, more than 90% of millionaires were created through investments in real estate.  Like Mark Twain said, they aren’t making it anymore.  There are two ways investing in real estate can make you money.  

The first is through equity.  Real estate is tangible, and shelter is a need.  There will always be demand.  Because of this, real estate is generally protected against inflation.  That’s not to say that some areas lose desirability, but on the whole, prices rise.  

The second way real estate generates money is through cashflow.  If you own a rental property, the point is to rent it out.  Your tenant will pay you whatever the market rate is to occupy the space.  

Generally, investors primarily look at cashflow.  While building equity is great, it usually takes a lot longer.  Especially if you’ve financed the property.  In this post, I’m going to break down how to thoroughly consider cashflow of a potential rental property.

First off, you need to know what the income will be.  That’s going to be how much you collect in rent plus any other potential income, for example, if you have coin-operated laundry in the basement.  You’re also going to need to know your monthly expenses.  If you’re buying a property that’s already used as a rental, this information should be easy to find.  If not, your Realtor (me) can help you determine the expenses.

You’ll need to know how much your monthly mortgage payment will be.  This is going to be determined by how much you’re putting down, interest rate and term of the loan.  You’ll also need to know how much your taxes will be, if there’s an home owner’s association and how much the monthly fee is.  Insurance is something you’re going to want to have.  Maintenance and capital expenses are also things you’ll need to plan for.  Maintenance is going to be unexpected repairs, like fixing a broken dishwasher.  Capital expnses are going to be major projects that you’re saving for, like a new roof, or if you know in the next 12 years you’ll need a new oil burner.  Generally, plan to put away 10% of the rent for maintenance and capital expenses each.  If the property under consideration has multiple units, you may need to factor utilities.  Tenants are only required to pay for utilities that are individually metered.  It’s not uncommon for water or heat to not be individually metered.  Also consider that your property may not get rented immediately.

Now that you know the rent, and the expenses, add them all up.  Remember, the expenses are negative numbers, and the rent is positive.  The result is how much cash is left over every month.

While you need to know the cashflow before moving forward with an income property, there are other metrics to consider.  Knowing your expenses and rent, we can also calculate the cash-on-cash return on investment and the Capitalization Rate (cap rate).

The cash on cash ROI is your annual return divided by your initial cost.  Your initial cost is going to be down payment, closing costs and any other expenses required before you can start collecting rent from your tenant.  Essentially, it’s what percentage of your initial cost your recouping yearly. 

The capitalization rate can be helpful when you don’t have all the information.  While you’ll need to have an idea of the cashflow, you don’t need to know your monthly mortgage payment.  For cap rate, take the cashflow without mortgage payment, and divide that by your initial investment.  It’s very similar to cash-on-cash ROI.  For this, your mortgage payment isn’t important because you’re building equity.  You’re paying the mortgage, but get more ownership of the property in return.

If you know even less information, but want to get an idea if a property is profitable, you can divide the total cost of the property by the rent.  This can be helpful when you’re looking at a number of properties and want to compare them.  This is called the gross rent multiplier, and the lower this number is the better.  If you’re comparing two properties, and one has a multiplier of 250 and the other 100, the property with at 100 will probably cashflow better.

Real estate, when done correctly, can be a great investment.  It’s a good way to protect your principal from inflation, while also generating cash flow.  When determining these metrics, over estimate your expenses.  Having a little extra money is a nice surprise, while finding out you have negative cashflow is not.

If you’re ready to buy an investment property, and therefore, become a millionaire, give me a call!  I’d be happy to help get you set up.  Feel free to reach out with any questions or if you’d like the spreadsheet.  You can call or text me at 617 528 8461 or email me at willy.charleton@nemoves.com.