Low interest rates and high rental demand have opened up the door for amateur real estate investors across many US markets. While there’s real potential for financial gain, there’s also the possibility you’ll wind up in significant debt if you don’t do your homework. Before you dive in head first, familiarize yourself with these six important metrics to make sure you have the best chance of long-term success.
Evaluating a Property
Gross Rental Yield:
If you’re torn between multiple properties or you want to be sure you’ll achieve a high enough ROI on a particular property, start by calculating the gross rental yield. Simply divide the projected annual rental income by the total cost of the property, and then multiply the result by 100 to get your percentage.
Property purchase price = $450,000
Weekly rent = $400
((400 x 52) / 450,000) x 100 = 4.62%, which means your Gross Rental Yield is 4.62%
So what are you looking for exactly? The gross rental yield is usually less than 10 percent, and even savvy investors would consider 7 percent a good number. In some cases, you may find that properties with a lower up-front costs generates less ROI in the long run.
Capitalization Rate (CAP):
Also known as the net rental yield or the CAP rate, this number takes the gross rental yield to the next level. To calculate it, subtract your estimated annual operating expenses from your annual rental income and divide that number by the total cost of the property. Be sure to include taxes, insurance, vacancy costs and fees paid to agents in your total property cost. Then multiply the number you come up with by 100 to get your capitalization rate. Investors generally aim for a CAP rate of 10 percent or higher.
Annual operating expenses: $55,000
Total cost of the property: $475,000
(55,000 / 475,000) X 100 = 11.5%, so your CAP rate is 11.5%
To get a better view of the local market, calculate the area’s price-to-rent ratio. This simple calculation divides the median home price of the area you’re looking in by the median annual rent. If the number is 15 or lower, it’s generally a good time to buy.
Median area home price: $480,750
Median annual rent: $22,272
480,750 / 22,272 = 21.58, which tells you now may not be the best time to buy.
Preparing to Buy & Asking for Financing
Investors are treated a bit differently than the average home buyer when it comes to taking out a mortgage. While a home buyer may wind up putting down less than 5 percent on an owner-occupied home, investors are usually required to put down 20 to 25 percent, and some lenders even require up to 40 percent. Consider the percent required and determine whether or not you can afford the up-front cost before you jump into a new investment opportunity.
Debt-to-Income Ratio (DTI):
Your total recurring debt as a ratio of your total income is a critical metric that lenders look at when putting together a mortgage package, and this particular number favors the investor over the average home buyer. When purchasing an owner-occupied home, lenders generally require a debt-to-income ratio of 36%, but many allow up to 45% for investors.
To calculate this, you have to add up all your monthly debt payments and divide them by your gross monthly income (monies earned before taxes).
Monthly debt payments: $2,600
Gross monthly income: $5,800
2,600 / 5,800 = .4482 which works out to a 48% debt to income ratio.
If you plan to use the future rental income on the property to quality for the mortgage, you may be out of luck. Most lenders won’t consider the rental monies as income unless:
- You have a proven track record of managing other investment properties, and have been in the business for a minimum of two years.
- You have taken out a rent loss insurance policy that covers at least six months of monthly rent.
- You have included any negative rental income as debt in your debt-to-income ratio calculations.
Loan-to-Value Ratio (LTV):
Lenders also place a lot of weight on the loan-to-value ratio, especially for investment properties. To calculate this number, divide the total mortgage amount by the purchase price of the property, and then multiply the result by 100. This is a simplistic version of the equation. Other factors may be considered depending on the financing situation. You can use this calculator from bankrate to figure out your LTV.
Your LTV should theoretically be between 80-95%, but no higher than that, to be considered for a loan. Lenders look at cases with a high LTV as very risky deals (although they generally allow slightly higher LTVs for investors), and it can have big implications for you as the borrower. You could be subject to additional fees, or you may be required to take out private mortgage insurance (PMI) until your equity reaches a minimum of 80 percent.
Once you know how the metrics are shaping up for a potential investment, you’ll be able to make a much more educated decision on whether or not it’s going to be a great buy for you.
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