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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Can You Really Make Money On That Rental? Here's How To Tell...

Updated: October 9, 2013

For investors, being a landlord can be pretty darned cool. 

It's a shame that more individuals don't invest in income-producing real estate, because it's one of the most powerful ways for middle-class folks to generate wealth. And as the housing market has bounced back from the depths of the Great Recession, many investors in 2013 are diving in to take advantage of relatively low mortgage rates. (These investors are taking advantage of what we call "Renter Nation," a phenomenon that is sweeping the country with ever-increasing demand for rental space. Read our report about this trend here.)

There is bit of a catch, though: Buying property and becoming a landlord is a great investment -- but only if you do your homework. And there's a common pitfall that many would-be real estate moguls succumb to: overpaying for property.

When you pay too much, you immediately find yourself in a money-losing hole from which it could take years to recover. Even worse, you might never recoup your money at all.

But if you pay the right amount for your property, there's potential to reap steady, long-term returns as a landlord.

Admittedly, managing tenants isn't always a piece of cake (that's a subject for another time) but focusing strictly on the financial aspects, here are two sure-fire yardsticks to use when evaluating a property:

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The Rent Multiplier

The quickest and easiest way to determine whether a property is suitable as a rental investment is to compare its price to its current gross yearly rental income by using the "rent multiplier:"

Rent Multiplier = (Selling price) / (Gross Annual Rental Income)

Gross income includes rental income as well as other incidental income, such as money from laundry rooms, vending machines and parking spaces.

For prospective landlords, the rule of thumb is this: any property selling for more than seven times total annual rental income will probably end up with negative cash flow. Put another way, your rental income wouldn't be enough to cover your mortgage and minimal operating expenses. Forget making a profit; you'd be losing money on your investment while also dealing with the mundane hassles of being a landlord.

Professional real estate investors use this formula when evaluating the investment potential of a property and as a general rule, they won't pay more than seven times gross annual rental income. Neither should you.

Don't make a common mistake by thinking if you put down a sizable cash downpayment to ensure positive cash flow, you're doing yourself any favors. Remember the concept of opportunity cost. You're sidelining a substantial amount of money that could be devoted, at the very least, to Treasurys or other low-risk securities.

Capitalization Rate

Experienced real estate investors refer to this formula as the "cap rate." Here's how it works:

Capitalization Rate = (Net Operating Income) / (Total Investment)

Net operating income (NOI) is equal to a property's yearly gross income minus operating expenses.  Operating expenses are costs incurred during the operation of a property, like maintenance, repairs, insurance, utilities, property taxes, etc. Expenses not defined as operating expenses include mortgage principal and interest, capital expenditures (high dollar improvements that have a useful life of several years or more), and income taxes.

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#-ad_banner_2-#The capitalization rate is important because it's a measure of how fast an investment will pay for itself. If the cap rate is 10%, then the investment will take 10 years to pay for itself. Most pros insist on a cap rate of about 8%.

The Investing Answer: For both formulas, the old adage "garbage in, garbage out" applies. Be sure to use numbers that are realistic and accurate. Real estate investors eager to make a deal sometimes delude themselves by skewing figures or creating their own exceptions to the rules.

For example, the total amount invested should encompass both the down payment and the money you borrowed to purchase the property. Net operating income should be calculated by deducting all expenses (except mortgage interest) from total rental income.

Word to the wise: Real estate agents and building owners sometimes deploy a sneaky trick known as "bumping to market," meaning they dazzle buyers with unrealistic expectations as to what they can charge for rent. Part of your homework should be to investigate income and rent levels in the neighborhood to accurately estimate what your rental market will bear.

Also examine local vacancy rates. If a lot of rental units are empty, take that into account. On the other hand, if there appears to be a shortage of rental units, you're golden. Multifamily houses or multi-unit apartment buildings are your best bet for investing in rental property; the numbers typically won't add up for single-family homes or condos.

Another warning: Lenders typically request higher down payments for investment properties than for private domiciles. Don't allow your enthusiasm affect your judgment and compel you to pony up too much cash. It's foolhardy to borrow against your home, or cash in other investments, just to meet the down payment on an investment property. Purchasing income-producing rental property is a worthwhile goal, but only if you can afford it — and only if you don’t overpay.

P.S. -- As I mentioned, the phenomenon we call "Renter Nation" is taking the rental market by storm. But there is a way to collect "rents" without repairing a single faucet. Learn more here.