Are you about to start investing in real estate? Or perhaps you've already put your toe in the water but want to learn more. Here is an overview of the factors you need to take a look at in order to project your potential return on an investment.
- Purchase price - obviously, the amount of money you put out for the property is significant in determining your investment outcome.
- The annual appreciation rate at which you expect the property's value to increase.
- How many years you expect to hold the property. Combined with the 2 figures above, this will enable you to estimate a future selling price.
- Number of rental units, and rent you expect to receive from each unit.
- Annual rate of rent appreciation.
- Expected unoccupancy rate - it's important to remember that tenants come and go, and will occasionally leave you with empty rental units. It's best to plan that into your projection.
- Any miscellaneous revenue you anticipate (laundry facilities, etc.), and the rate at which you expect those revenues to grow.
- Property management fees. Even if you expect to manage the property yourself, it's best to budget in an allowance for professional property management. First, this rewards you for the time and effort you invest. Second, it ensures that you are covered if for some unanticipated reason you need to turn the management over to a pro at some point in the future.
- Last, but not least, you need to know your opportunity cost, something that big investors would call the 'cost of capital'. For example, if you can earn 5% by keeping your money in the bank, you're going to want a lot more than 5% for taking on the risk and time investments required by a rental property!
- Annual operating expenses, and the rate at which you expect those expenses to increase over your term of ownership.
- Property taxes and rate of annual increase.
- Insurance and rate of annual increase. It's critical to insure your substantial investment!
- Any miscellaneous expenses, and rate of annual increase.
- Depreciation expense. To determine this, you'll need to estimate the building's assessed value as a percent of the total purchase price.
- Your annual capital investments in the property. You were planning to budget on capital improvements, weren't you?
- Downpayment - how much cash are you putting in upfront?
- Bank fees - how many points do you expect to pay, and what closing fees do you expect to incur if you will putting a mortgage on the property?
- What mortgage interest rate do you expect? And how long will the payback period be?
Now that you've got all the numbers laid out in front of you, you 'just' need to build a financial model which will allow you to project cash flow throughout your ownership term, and then use time value of money calculations to create a present value of those flows. Compare the present value of your future cash receipts against the amount of cash you will outlay upfront. If it's greater, congratulations- you have positive Net Present Value, and this property looks attractive. If the result is negative, it's a red flag-- you need to take another look, because this may not be a good deal for you.
The obvious comment you might have is... "This all sounds awful hard! Aren't there tools which can help me?"
The good news is that there are! In fact you can use an online investment property calculator which will do all of the heavy calculating for you. You simply plug in the numbers, and review the results. Now THAT's some smart investing!