In order to be called an investment property, the property in question has to show some kind of investment return. But what does that investment return actually mean?
It could mean a few different things to different people. Does the investment show a CAP rate return? Will there be capital appreciation over the long term? Can I use the property personally and still have my expenses covered? What is the future use of the subject property (think redevelopment)? Let’s break these various scenarios down in more detail, but remember, the devil is in the details.
What is a CAP rate?
If you look at an apartment building with four units in it (a four-plex), there is a very quick and easy calculation that you can make to determine a CAP rate. You take the gross rent on an annual basis and divide that by the purchase price.
So let’s assume you can get $6,000 a month for the four units, which equates to $72,000.00 for the year before expenses. You then divide that by the list price of $1,000,000, and you get a percentage of 7.2%.
The cap rate on a $1,000,000 four-plex rental investment with gross rents of $72,000.00 is 7.2%. Most investors won’t even look at an investment property for less than 6%, but everyone’s investment criteria will be different.
The CAP rate converts a single period of economic benefit into value. It is a really easy way to do a quick calculation on value to determine if something is worth further due diligence.
To dive a little further into the CAP rate rental property investment model, you also need to look at your down payment, how much you need to finance, and what your mortgage rate will be. Of course, that is an entirely different calculation, but as mortgage rates climb, the monthly net income diminishes potentially to zero or even into a loss position.
Buy and Sell Long-term
This model looks at a continued capital appreciation of the investment over the long term. You buy the investment property for $1,000,000.00 and sell 10 years later for $1,500,000.00. Assuming the rents cover your monthly costs, the $500,000K is your capital appreciation. If you overpay in a declining market, that long-term capital appreciation becomes even longer to manage. This puts more stress on the rental income you can generate to cover expenses.
None of these investment assessments work without the property having some potential value to the Buyer. If the Seller is riding a high market with sale prices climbing and mortgage rates dropping, as we saw during Covid, then clearly that benefits the Seller.
The Buyer, in that case, is hoping the value of the investment keeps appreciating, but what happens when the market turns? Anyone looking to sell an investment property in a turning market must show value to a buyer. What is the upside? If there is no upside, then the property will not sell.
In a turning market, we see sellers trying to capitalize on the market that was rather than realizing they need to get ahead of the market that is. Back to the four-plex example - if the Seller is listing for $1,300,000.00 with gross rents still at $72,000.00, then we only see a cap rate of 5.5%. With mortgage rates climbing north of 4% and annual operating costs of $9000.00 on a building of this size, the CAP rate erodes even further.
3 Signs You’re Ready To Buy An Investment Property
You’re Financially Stable
You are at a point in your life where you have some money saved up, and you want to invest it in real estate instead of the bank or stock market.
The Return On Investment (ROI) Is There
Like any investment, there has to be an ROI. In most real estate transactions, you can reasonably calculate what that ROI will be short-term and long term. But, again, the devil is in the details.
You Have Time To Manage It
A lot of people don’t realize how much time an investment property can take to manage. If it’s a four-plex with rentals and you have all four rented on 1-year terms that renew monthly thereafter, how much time and effort do you require to manage the property? Who does the landscaping? Gutter cleaning? Common laundry maintenance, paint touch up’s, etc.
Things To Consider Before Buying An Investment Property
1) What Are The Housing Market Trends?
Is the market softening or growing? If the market is growing, then the model you use to calculate your ROI may be different than if the market is softening.
Typically rental rates on tenanted properties are set and can only accommodate a minor increase per year, so if the market is softening, then the purchase price had better come down to make the investment worthwhile over the long term.
If the market is growing, the goal is to use the rent to cover expenses and realize some capital appreciation.
2) Should You Buy With A Partner?
Absolutely if the deal makes sense and you need more capital to invest with. What does that partnership look like? Who takes the lead, and are there exit strategies for each partner should they want out of the investment?
3) Should You Hire A Property Management Company?
Some people don’t want the headache of managing a rental property—for example, investing in a ski place at Sun Peaks Ski Resort. Someone has to be up at the mountain to clean the property after every stay if you choose to go the short-term rental route over a long-term rental. In that case, a property management company is fully set up to look after the rental turnover on your behalf, but it comes at a hefty cost, upwards of 40% of the rental income.
Needless to say, there are a lot of factors that go into assessing the merits of an investment property. The key to buying an investment property is recognizing the investment’s potential upside(s). Without some upside, what is the point of the investment?Posted by Andrew Karpiak on