What you need to know before buying a rental property
This article was originally published on Personal Capital's Daily Capital blog. It is not intended as financial advice and is presented for informational purposes only.
Owning rental property is not for everyone, but if you can get rental property right, you’ll be able to develop a terrific passive income stream that will bolster your financial well-being. If you haven’t been through the property buying process yet, you’re in for a very emotional ride. The following advice is designed to help you anchor your emotions so you don’t end up overpaying and regretting your decision later on.
Rental property: The big picture
When owning real estate, it’s important to focus on the big picture. When you’re starting out, consider buying property to live in yourself for at least a couple years first and then rent out. The idea is that if you’re willing to live in the property, so will others.
It’s all about income. As a real estate investor you need to figure out what’s a realistic amount of income the target property can generate every year. Once you have an income range then you can calculate a property’s gross rental yield and price to earnings, which allows you to compare that property with other potential investment properties.
Price appreciation is secondary. One of the big reasons why there was a housing collapse was because investors paid little attention to the income that a property could generate, instead focusing on how much each property would eventually increase in value. Losing money in the short-term didn’t really matter if they could ride the wave and flip within a year or two. Once the party stopped however, speculators got crushed, which caused a domino effect that hurt neighbors who planned to buy and hold. If you are primarily focused on property appreciation and not income, you are a speculator.
Property prices historically rise closely with inflation. Property price appreciation generally follows inflation by +/- 2 percent. In other words, if the latest inflation figure is 3 percent, you can expect a 1 to 5 percent increase in national property prices. Over the years property price changes can fluctuate wildly, but if you look at property prices over a 10 year period you’ll see a relatively smooth correlation.
Property is always local. Be careful not to make assumptions based on national property statistics. Just because one report says national prices are up 10% doesn’t mean you can sell your San Francisco home for 10% higher than a year ago. Those kinds of statistics can only tell you the general direction of prices. The most realistic value for your property is if your neighbor sells and has a very similar layout.
Specific steps to value your property correctly
Here are some specific steps you should take before purchasing any property.
- Calculate your annual gross rental yield. Use comparable properties in the market to create a realistic monthly rent and multiply that figure by 12 to get your annual rent. Next, take that estimated annual rent and divide by the price of the property. That number is your annual gross rental yield.
- Compare your gross rental yield to the risk free rate. The risk free rate is the theoretical rate of return on an investment with no risk. You can use the current rate on a 10 year treasury security to determine the risk free rate. The potential return on investment for your rental property should be higher than the risk free rate, or else there’s really no benefit to buying the property. In other words, if the annual gross rental yield of the property is less than the risk free rate, either bargain harder or move on.
- Calculate the price to earnings ratio of your property. Your net operating profit is basically what’s left over in a given year after you’ve subtracted all of your expenses from your gross rental income. The price-to-earnings ratio is simply the market value of your property divided by the current net operating profit. A property that costs you $300,000 and earns you $8,000 a year in net profits has a P/E ratio of 37.5. That means it will take an owner 37 and a half years of net operating profits to make back his or her investment. (This obviously assumes the owner never pays down his mortgage and does not see an increase in rents which is highly unlikely, but provides another handy snapshot figure you can use when evaluating multiple properties.)
- Forecast property price and rental expectations. The best way to forecast the future is to understand what has happened in the past using some of the information provided by real estate sites like DataQuick, Trulia, and Zillow. You should also have realistic expectations about local employment growth. Are employers moving into the city or leaving? Is the city in financial trouble and looking to raise property taxes?
- Be mindful of taxes and depreciation. Almost all expenses related to owning a rental property are tax deductible, including mortgage interest and property taxes. Your best bet is to consult with a qualified financial planner or tax expert to understand all of the potential ramifications and requirements of operating a rental property.
- Always check comparable sales. The easiest way to check comparable sales over the past six to twelve months is to punch in the property address in Zillow.com. You need to compare your target property’s asking price with previous sales and measure it against what has changed since to make sure you are getting a good deal.
- Check the financial health of your HOA. If you are going to buy a condo, it’s imperative to ask for the Homeowners Association’s financial statements. Take particular note of its reserves and read the meeting notes taken by the HOA secretary. You don’t want to be stuck buying a condo with HOA litigation either. Things can get messy, quickly.
Being a landlord isn’t that bad
Besides following the above steps in figuring out the right value for your potential property, you must screen your perspective tenants like the CIA. Do the aggressive due diligence early so you save yourself the headache later on.
Over time your rent should grow and the interest portion of your mortgage payment should decrease. If you can hold onto your property for the long term, chances are high that you’ll have a fantastic asset as part of your overall net worth.