Thinking about investing in rental property for the first time? Or just looking for a reality check on what’s a good versus a risky investment?
In this month’s Investor’s Resources post, we thought we’d take a look at some of the financial guidelines investors use for answering that basic question: Should I buy or not? How to decide if a piece of rental property will end up being a good investment or not?
Several standard guidelines always pop up – typically, in the form of “The X Percent Rule,” where the percentage is a generally accepted rule of thumb. Like any rule of thumb, each of these can be very useful, especially when first looking at a property, but none take the place of careful research in each individual case.
So what are some of the most common percentage rules of thumb? These are the ones we see investors using the most.
The 20% Rule
This is the old saw about buying below market price. If you can find a good piece of property and buy it at 20% below market price, you’ll start out with instant equity. Of course this doesn’t mean that a fair price is a bad buy. Just that if you can find a deal, you’re already that much ahead!
If you’re looking to buy a residential or commercial property that is already being rented, look at the percentage of total gross income that’s being lost to vacancy. If it’s higher than 5%, do some more digging to find out why. Or just move on.
8-10% Cap Rate
This one involves a bit more math. The capitalization rate shows the ratio between a property’s value and its net operating income. Cap rate is market driven, which means it can change with market conditions. But it can be a helpful way of comparing properties. Let’s say a property is bringing in $60,000 a year in gross income, and after taxes, maintenance, and insurance, it nets $36,000 a year. If it’s listed for $400,000, we would divide net operating income ($36,000) by the sales price ($400,000) to get a cap rate of 9%. And that falls within our minimum range.
The 50% Rule on Expenses
Another good rule of thumb is to expect to spend about 50% of the monthly rent on non-mortgage expenses. For example, if a property’s rental income is $10,000 a month, you can reasonably estimate that all of your expenses (not counting mortgage) will average about $5,000 a month. From there, it’s easy to estimate cash flow. Simply take what’s left and subtract your monthly mortgage payment.
The 1% Rule
A more ambitious version of this one is the 1.5% or even 2% Rule. The calculation goes like this: You should be able to rent your investment property for at least 1-2% of the purchase price. So if you bought that property in the example above for $400,000, you’d want to make sure you can rent it for at least $4,000 a month – or more, if possible.
The 100% Rule
What’s that? Nothing is 100%, right? Well, we couldn’t resist adding “The DMG Rule of Thumb” (NOTE: shameless promotion ahead): If you’re an investor and you want to be 100% satisfied with your rental property, let DMG help with leasing and property management. It could be the best investment you make!
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