Buying A Rental?

by Middleton O’Malley

Owning rental property can return great profits, but buying a rental property requires some serious financial investigation before you part with your cash.  In short, before you buy, investigate the three major components of rental investment.

• Income
• Expense
• Finance

Rentals are only money machines, and you deserve one that runs very well, so do your homework.

Here are examples of calculations to use, before you buy, to determine your return on investment, up front.  Obtaining the advice of an accountant before making any important financial decision is strongly advised.

These calculations don’t assume a return on investment with appreciation.

• Cash Buyers:  Use Cap Rate

Annual Income, minus local vacancy rate, equals gross operating income, minus operating expenses, equals net operating income, divided by Purchase Cost, equals Cap Rate

Ex:  $89,550 annual rental income, minus local annual vacancy rate, (use 10% for this equation) equals $80,595 (GOI), minus $36,260 operating expenses, equals $44,335 (NOI), divided by $585,000 (purchase price), equals 7.58 % Cap Rate

• Financed Buyers:  Use Cash On Cash

Cap rate does not take financing into consideration.  If you finance, calculate the cash-on-cash return for the first year of ownership. Figure out your cash outlay by adding up your cash invested to buy the property.  Divide your cash flow before tax by your cash outlay and you’ll have your cash-on-cash return, which is expressed as a percentage.

Ex: $89,550 annual rental income, minus local annual vacancy rate, (use 10% for this equation), equals $80,595 (GOI), minus $36,260 operating expenses, equals $44,335 (NOI), minus $36,648 (annual debt service, monthly P&I X 12), equals $7,687 (cash flow before tax), divided by $126,000 cash invested, equals 6.1 % cash on cash.

Plug in your own numbers and see your return on investment.

• Even if you are financing it’s good to a use a cap rate calculation as well to compare against your financed interest rate.  The above financed example was calculated using a 7% finance rate.  The cap rate shown above is almost 7.6%.
• If the cap rate is greater than the financed rate, good.  If it is below the finance rate, use extreme caution because you can’t always count on tax advantages and appreciation to give you an acceptable return.

These calculations, and the advice of your accountant, can help you decide which property is the most lucrative, and to compare the yield of a property with that of other types of investments, like Treasuries, Bonds, and Stocks.

• Apartment rents are expected to increase.
• For additional information about local annual vacancy rates consult with other rental owners and seek out on-line information.
• Obtain the services of an accountant, and if you will be financing the deal, make arrangements for finance… before you start looking.

We’ve helped many clients buy and sell rental property, and we have relationships with lending institutions, title companies, and all kinds of contractors, who can help you obtain the right property.

Our experience can help you make smart decisions.  Call us anytime if you have questions, or need assistance with any aspect of rental investment.