August 10th, 2011
The cost of rent is on the rise here in Maine and across the nation. This suggests that there is a rise in demand, and with demand comes opportunity. For people who can afford it, investment properties with rental units may be a great chance to make some extra cash. So how do you determine if the investment will be worth it in the long run?
In his blog post “Buying Investment Property – What is a ‘Good’ deal?” Leonard Baron explains that real estate investments are comprised of two parts: operating positive cash flows and long-term appreciation.
With today’s market, you can’t necessarily depend on long-term appreciation. Investors don’t buy and flip houses like they used to because the appreciation isn’t guaranteed due to falling property values. Instead, most investors buy properties and rent them out, which yield an investment return based on operating positive cash flows.
To determine whether an investment property is worth the risk, you want to focus on cash on cash return. For every dollar you put it, how much will you get back?
Baron gives this example:
If one is buying a $200,000 investment property they probably put down 25% or $50,000 plus another 5% or $10,000 for closing costs, loan fees and rehab costs. So the mortgage is $150,000 and a buyer’s cash equity is $60,000 from the start. Again: The property price of $200,000 is important too, but how much cash equity one invests is much much more important.
See Chart Below – Using a conservative estimate, depending on the local market, that property might generate $1,800 per month in rent and have 33.3% operating expenses ($600) leaving net operating income of $1,200. Then subtracting the monthly mortgage payment of $900 leaves $300 of monthly cash flow or $3,600 per year.
Divide that $3,600 by the $60,000 of cash equity and this property has a first year cash on cash return of 6.0%. And it should increase a little each year as rental income increases, as do general expenses, but the mortgage stays constant.
A 6% return for the first year is pretty good, considering tax benefits and appreciation you’ll hopefully get it the future. Plus, as time goes on and the mortgage balance is paid down you’ll see more of a yield.