As a real estate investor, your objective is to maximize your Return on Investment (ROI). However, to master ROI, you must think beyond profit. You will need to balance the concepts of cash flow versus equity growth (with an implication of long-term implications), as well as key terms such as capitalization rate, etc.
This guide provides an overview of these key principles, also highlighting common pitfalls associated with them, so that you can make wiser and more informed investment choices.
There are really two main ways to conceptualize the profitability of your rental property: The money collected each month and the money you accrue as time goes on. That is, it is important to distinguish between cash flow and equity growth.
Cash flow is the amount of money your property is producing. It is simply the rental income collected minus your monthly expenses, including the mortgage, taxes, insurance, and any maintenance.
For example, if you collect $2,500 in rent and your expenses are $2,000, you have $500 of positive cash flow. This is your real, consistent return that pays for the investment and pays for the management.
Strong positive cash flow is especially important because it provides a cushion against vacancies and costly repairs.
Equity growth, however, refers to the appreciation of your property over time. Equity builds in two main ways. First, as your tenant pays down the mortgage principal each month, you own a larger part of the asset, which is also referred to as forced savings.
Second, if the property value increases over time (known as appreciation), your equity grows even more. For example, if you buy a property for $400,000 and it later appreciates to $450,000, you gain $50,000 worth of equity growth, in addition to your loan being paid down.
In the end, prudent investors do not choose one over the other. Instead, you want to look for a measure of balance when buying a property in today’s economy. A property that produces a lot of cash flow can sustain itself, while consistent equity growth will increase your wealth long term.
Therefore, when you are gauging an investment, you should be evaluating your income for the current month, as well as your opportunity for future appreciation.
Understanding the cap rate for rental property is crucial for investors to evaluate potential returns and compare investment opportunities.
In simple terms, the cap rate provides a quick glimpse of potential return irrespective of your unique financing. It answers the basic question, "How quickly would this investment pay me back if I purchased it with cash?"
To calculate the cap rate, take the net operating income (NOI) of a property in one year and divide by its present market value or purchase price. The formula looks like this:
Cap Rate = Net Operating Income (NOI) / Property Value
The first step is to calculate the NOI or net operating income. This is what the rental property's annual rental income is, less all of the annual operating expenses necessary to operate the property, but does not include mortgage payments.
Therefore, the NOI includes items such as property taxes, insurance, maintenance, repairs, and property management fees, among others. For example, if a property has an annual rent income of $36,000 and its annual operating expenses are $14,000, the NOI would be $22,000.
If you purchase that property for $400,000, the cap rate would be: $22,000 (NOI) / $400,000 (Price) = 0.055, or 5.5%
What does this 5.5% mean? It is your expected return when you purchase the property as a total cash purchase. Therefore, you could use this number or percentage to compare two or more properties that are relatively similar.
It is generally understood that a higher cap rate gives you the opportunity for a higher return; however, it probably is a higher-risk property or market. Conversely, a lower cap rate is usually a "safer" investment or a stable investment in a desirable market.
Recognizing limitations is important. The cap rate is a useful figure, but it does not take into account your own loan terms or what can happen to income and value over time. Therefore, when calculating the cap, it is always done in conjunction with other calculations, such as the cash-on-cash return, which includes your financing costs.
Using the cap rate as your first filter will allow you to quickly gauge which type of real estate you may want to spend more time examining in an economic analysis.
Real estate investing is an exciting chapter, but many beginners often make mistakes that will destroy their ROI. If you identify and correct these mistakes promptly, you can maintain your assets and build wealth efficiently in the long run.
Many investors only consider their rent and mortgage payments, but do not account for all the additional costs, including maintenance, vacancy, and property management, which can result in a negative cash flow. You should always plan for any repair expenses and establish a fund for capital expenses that can be utilized when an unforeseen expense arises.
Hastily selecting a tenant can lead to problems with late rent payments or damage to the rental property. As a result, you need to ensure that you have a stringent procedure in place for credit checks, income checks, and reference checks; a good tenant can lead to a consistent income that is also free of headaches.
However, screening tenants thoroughly is challenging, especially when you have to create a checklist or ensure compliance with anti-discrimination laws. This is why savvy investors hire property managers to handle everything. Landlords trust Boston property management to handle emergencies, collect rent, and maintain property value.
It does not matter how beautiful the rental property is if it is not in a desirable area, as it will not appreciate and may not even attract good tenants. The area should be prioritized, and you should invest in an area with good job growth, quality schools, and a location with a low crime rate, since living in these locations can provide better long-term value and less vacancy risk.
Comprehending rental property ROI requires an excellent balancing act. You will need to weigh maintaining a solid cash flow against promoting long-term equity growth. Use tools such as the capitalization rate (cap rate) for clear evaluation to help support your objective.
With fundamental knowledge and some awareness of common mistakes that new landlords make, you will transition from a passive landlord to an active investor. That's the mindset behind building a sustainable, rewarding real estate portfolio.
