Is Now the Time to Invest in Rental Properties?
Real estate investing is logically one of most effective ways to build wealth in this country. An appealing aspect of this type of investing is it allows an investor to diversify their portfolio with a tangible asset (a structure, land, fixtures). It is especially practical for those who prefer ‘hands-on’ projects where they can become personally involved with the investment’s revenue, cash-flow and returns. The ability to start collecting rent immediately and seeing funds in your bank account adds to the sense of security, where stocks, bond, and mutual funds tend to be risker investments with no real way to see how your investment is performing other than quarterly reports.
There is always demand for real property because there will always be a need for housing, places to shop, places to gather for leisure and land for development. The mantra I always use is ‘the world is real estate and real estate is the world.’ A rental property will hold value depending on the location and if it is properly maintained. An investor has the ability to utilize various types of functions for a rental property and can determine highest and best uses based on zoning, subdivision configuration, and societal/economic necessity meeting the demand with a specific locale at a given cycle.
The first thing to look at of course is the sales price. The second thing to consider is the property revenue. One way to quickly determine if the income is sufficient or the property is priced too high is to calculate the Gross Rent Multiplier (GRM). This is the sales price divided by all of the property revenue (rents, late fees, laundry revenue, garage rentals, etc.) known as the Scheduled Gross Income (SGI). A duplex being listed for $750,000.00 with an SGI of $60,000.00 would bring a GRM of 12.5 (below 15 in this market is good).
The most used manner to determine a possible return against future revenue is called Cap Rate which is Net Operating Income (NOI) divided by sales price. It is deemed a more reliable means to determine if an investment is worth looking at because it factors in expenses where GRM does not. With an NOI of $ $43,650.00 and a sales price of $750,000.00, the cap rate would be 5.82, which would be great in this market. Note: higher the cap rate (4.5% or more) usually favors the buyer in this market.
The primary goal of any investment is its value based upon how it appreciates or increases in equitability. As real estate owners, you are well aware of appreciation and how it works. The same holds true with investments even more so. Most new investors have cash flow as their objective. This is considered the Net Operating Income minus the mortgage payment (Debt Service).
Loans on rental properties (where the owner lives off-site) will more than likely have a vacancy factor deducted from the base income which is usually 3-5% of total revenue depending upon the area density where the property is located. The example below shows how an investor looks at financial information to get what is called EOI (Effective Operating Income). Note: rental property financials are based on annual figures
Duplex listed for $750,000.00 brings in $5,000.00 per month in rents.
SGI (All property revenue collected each month multiplied by 12) = $60,000.00
Minus Vacancy Factor (3%) = $1,800.00
Most rental properties with five or more units have commercial lending standards that factor 35% for the expenses even if the expenses are less (an investors should always look through the eyes of the lender when analyzing the financials). Depending upon the sales price, a duplex may have expenses between 22 and 27%. When considering your first purchase, your broker should factor in an expense factor based on the type of property and ask the seller for documentation of actual expenses to have a clearer picture.
Minus Expense Factor (25%) $14,550.00
EOI minus Expense Factor = NOI $43,650.00
The next thing to consider is pre-tax cash flow which is obtained by deducting the ‘annual’ mortgage payment or ‘Debt Service’ from the NOI. A 30-year mortgage at 5.5% interest with 50% down on a $750,000.00 list price would equate to a monthly mortgage of $1,226.50 so the debt service would be $14,718.00.
Minus Debt Service $14,718.00
Equals Pre-Tax Cash Flow $28,932.00
Those who start out as in real estate investing should be mindful to start slow and purchase a single family home or duplex rental. This way it will be more feasible to learn the nuances of determining the right investment, calculating/interpreting the financials and dealing with tenants and legal ramification of residential occupancy.
Keep in mind to know the market for the area you are considering and take into account ‘upside’ value or the ability to increase rents depending upon the area (there is now state-wide rent control – AB 1482 and still some COVID restrictions on rent increases). Consider profit potential by not over-paying for a property or paying above the market value and try not to utilize too much of your personal liquidity. Perform due diligence by checking for unpermitted add-ons like rooms and garage conversations. Make sure you have exit strategies in place and by all means obtain assistance from an experienced real estate broker to help you through the process.
If you need assistance in purchasing your first rental property, give me a call (310) 538-6884