Are you about to start investing in real estate? Or maybe you’ve already stepped foot in the water but want to know more. Here is an overview of the factors you need to consider in order to project your potential return on investment.
- Purchase price – obviously the amount of money you shell out for the property is important in determining the outcome of your investment.
- The annual rate of appreciation at which you expect the value of the property to increase.
- How many years you expect to hold the property. Combined with the 2 figures above, this will allow you to estimate a future sale price.
- Number of rental units and rent you expect to receive from each unit.
- Annual rate of rent appreciation.
- Expected vacancy rate – it is important to remember that tenants come and go and will sometimes leave you with empty rental units. It is best to plan this into your projection.
- Any miscellaneous income you anticipate (laundry, etc.) and the rate at which you expect that income to grow.
- Property management fees. Even if you plan to manage the property yourself, it is best to budget for an allowance for professional property management. First, it rewards you for the time and effort you invest. Secondly, it ensures that you are covered if, for some unforeseen reason, you need to leave the management to a professional at some point in the future.
- Last but not least, you need to know your opportunity cost, what big investors would call the “cost of capital”. For example, if you can earn 5% by keeping your money in the bank, you will want much more than 5% to take on the investment of time and risk required by a rental property!
- Annual operating expenses and the rate at which you expect these expenses to increase over the life of your ownership.
- Property taxes and annual rate of increase.
- Insurance and rate of annual increase. It is essential to ensure your substantial investment!
- All miscellaneous expenses and annual rate of increase.
- Depreciation expense. To determine this, you will need to estimate the assessed value of the building as a percentage of the total purchase price.
- Your annual capital investments in the property. You were planning to budget for capital improvements, right?
- Down payment – how much money do you put up front?
- Bank charges – how many points do you expect to pay and what closing costs do you expect to incur if you put a mortgage on the property?
- What mortgage interest rate do you expect? And how long will the repayment period be?
Now that you have all the numbers in front of you, all you need to do is create a financial model that will allow you to project cash flow over your lifetime of ownership, then use the time value calculations of the money to create a present value of these flows. Compare the present value of your future receipts with the amount of money you will initially spend. If it’s bigger, congratulations – you have a positive net present value and that property looks attractive. If the result is negative, it’s a red flag – you need to take another look, because it may not be a good deal for you.
The obvious comment you might get is…”This all sounds awfully hard! Aren’t there any tools that can help me?”
The good news is that there are! In fact, you can use a online real estate investment calculator which will do all the heavy lifting for you. You simply plug in the numbers and examine the results. Now that’s a smart investment!