More and more ordinary people are turning towards rental properties as a way of diversifying their investments and securing cash flow for the future.
Several major factors have driven this shift:
- Many people are dissatisfied with the meager returns provided by their savings accounts and Certificates of Deposit.
- Several years of record-low interest rates make people wary of future inflation, which drives them away from the bond market. As an alternative, they look to commodities like real estate, which contain perceived inflation-protection.
- Many people want to diversify their investments away from solely the equities/stock market.
- Record-low interest rates and housing prices are causing many people to take a closer look at rental property investing.
How can you evaluate whether or not a potential rental property is a good investment?
The Cap Rate
First, calculate the cap rate. This is the rate of return you'd make on a house if you bought it in cash.
Cap rate is the net income divided by the asset cost. For example:
- You buy a home for $200,000.
- It rents for $1,500 per month.
- Your expenses (taxes, insurance, management, repairs, maintenance) average out to $500 per month. (Remember, this does not include the principal and interest payments on your mortgage, but it does include the escrowed sum for taxes and insurance.)
- Your "net operating income" is $1,000 per month, or $12,000 per year.
- Your cap rate is $12,000 / $200,000 = 0.06, or 6 percent.
Is six percent a good return on your investment? That's up to you to decide. If you can find generally higher-quality tenants in a nicer neighborhood, then six percent could be a great return. If you're getting six percent for a shaky neighborhood with lots of risk, though, six percent might not be worthwhile.
Read more: How to Calculate Internal Rate of Return
The One Percent Rule
This is a general rule of thumb that people use when evaluating a rental property. If the gross monthly rent (the rent before expenses) equals at least one percent of the purchase price, they'll look further into the investment. If it doesn't, they'll skip over it.
For example, a $200,000 house -- using this rule of thumb -- would need to rent for $2,000 per month. If it doesn't, then it doesn't meet the One Percent Rule.
Under this rule, the house brings in gross revenue of 12 percent of the purchase price each year. After expenses, the property may bring a net revenue of 6-8 percent of the purchase price. This is generally considered a good return, but again, it depends on what area of town you're considering. Nicer neighborhoods tend to have lower rental returns, while shakier neighborhoods tend to have higher returns.
Remember, six percent or eight percent (or any percent) doesn't mean as much if that interest is non-compounding. To give your returns the same benefit and the same chance of growth as money in the stock market, you'll need to reinvest 100 percent of the proceeds so that your returns can compound upon themselves.