If you are just tuning in and are interested in investment properties, take a minute to browse through my previous articles before you get started. Part 1 – Tips for First Time Investors. Part 2 – Is it a Good Rental? Part 3 – How Long is Your Horizon?
So, you’ve found a couple properties that might be a good investment. How do you know if they are worth it? First, when looking at a potential investment property, use actual numbers, not future projected numbers.
The numbers part of purchasing an income producing property can be some of the least exciting work, yet it is key to determining if it has any potential. As with any investment, it is the numbers that really matter and should influence your decision, so take the time to carefully review.
If the property is currently an income-producing property, ask for the rent roll and operating expenses from the owner or property manager. Then, cross check this information with actual leases and area information.
What do you need to know?
Are you going to spend money or make money? Look at the Net Operating Income.
NOI = total income minus expenses.
How fast will it pay for itself? Look at the Cap Rate or Gross Rent Multiplier.
The Cap rate looks at how quickly the property will pay for itself based on the net income, not gross.
Cap Rate = NOI divided by purchase price.
A property that has a net income of $12,500 annually and you purchased it for $200,000. The Cap rate for this property would be $12,500/$200,000 = 6.25%. That means the payback period is essentially 16 years (100/6.25%=16)
The Gross Rent Multiplier basically tells us this same information, but looks at the income before expenses.
GRM = property value divided by gross income.
If the total cost of your property is $208,000 and will bring in a gross income of $13,800, the GRM is 15. In theory (before expenses), the property will pay for itself in 15 years. Not too bad.
When you have multiple properties you are considering, you can use these numbers to help determine which one has the better value.
What should I pay? There are multiple ways to determine the answer to this question. If you know the net income and cap rate you are comfortable with, one way quick way is the True Property Value.
Property Value = net income divided by cap rate.
So if the property brings in $12,500 annually and you want it to pay for itself over the next 16 years (Cap rate = 6.25%), then it’s simple. $12,500/6.25% = $200,000. Now, you can start your negotiations.
It’s been a year. Am I on track? It’s a good idea to gauge how you are doing on your investment each year by taking a look at the Return on Investment.
ROI = rental income divided by investment times 100
Your property brought in $13,800 last year and cost $208,000. $13,800/$208,000×100 = 6.6% ROI. 6.6% was your return last year.
Every real estate market and investor is different. Some investors are comfortable with a Cap rate around 15, some are ok around 20. Some don’t want to pay more than 70% of their estimate after all repairs and upgrades. Knowing your long term goals will help you determine the numbers you are comfortable with and what makes sense for you.
There is no one answer, but paying too much at the beginning will make it much harder to recoup your costs later.
Stay tuned as I discuss ways to make sure your investment remains an investment.
Jen Hudson, GRI (360) 652-1200 or jen@hudsoncreg.com