Evaluating an Investment Property
Buying an investment property can bring multiple benefits such as building equity and receiving a steady rental income every month. Acquiring this type of income-producing properties is also a great way to diversify your investment portfolio and build wealth. However, as with any other investment, it is important to carefully evaluate all aspects of the deal and of the property that you plan on purchasing. Fortunately for investors, there are many ways in which they can evaluate a property that they are looking to invest in. By evaluating the mortgage, rental income, the capitalization rate, and cash flow, investors will be able to identify which property will be worth purchasing.
From getting the financing fast to calculating cash flow, here are the most important things to keep in mind when evaluating an investment property.
What’s your monthly mortgage payment going to be?
One of the first things you need to evaluate when investing in a rental property is your mortgage payment. This is an amount you need to pay each month to the lender. Keep in mind that investment or rental property mortgage rates are usually a bit higher than rates for owner-occupied loans. That is because a rental or investment property is considered a risky investment since borrowers tend to default on their investment property before their primary residence mortgage if they happen to go into difficult economic times.
The monthly mortgage payments are likely the largest recurring expense that you will have as an investor. Therefore, it is important to know what your final payment will be and find a lender that offers the most affordable mortgage rates.
Here’s how you can calculate your monthly mortgage payments:
- Take your principal (total amount of money you are borrowing)
- Add the monthly interest rate. Interest rates are usually listed as an annual figure, so you’ll need to divide your rate by 12.
- Divide by the number of payments over the life of the loan. If you take out a 30-year fixed-rate mortgage, this means 360 payments (30 years x 12 months).
In addition to the monthly mortgage payment, there are other upfront costs in addition to the down payment. These costs include property and loan-related fees, taxes, insurance, and title fees.
Put Down a Significant Down Payment. 20% – 40%
Another thing that you will need to evaluate when investing in a rental property is to find out the required down payment. To purchase any real estate property, you will often need to put a certain amount of money down to qualify for the mortgage. Usually, it’s 20% to 40%, depending on the type of property. It is important to make sure that a property investment that has a down payment that you can afford and that won’t get you overextended financially. Once you have the required down payment, you will then be able to get financing for the property.
RENTAL INCOME TO QUALIFY
Whenever you are looking to invest in property, it will also be important to evaluate the rental income to qualify. While you don’t need extra income to qualify for the mortgage, it is important to make sure that you have two years of property management experience, have rent loss insurance coverage and have at least six months of the gross monthly rent available in reserves. You will also need to factor in any negative rental income as part of the debt as well. If you meet these requirements as well as determining that the property generates a sufficient amount of rental income, you will benefit by investing in a property.
PRICE TO INCOME RATIO
As an investor, you will also want to evaluate the price to income ratio. This is a ratio that compares the median house price in a given area to the median household income. You will want to make sure that this ratio is no higher than 2.75 percent. However, you will want to invest in properties that have a ratio that is under 2 and between 1.70 and 1.90.
PRICE TO RENT RATIO
The price to rent ratio is a comparison of median home prices and the median rent in a particular market. Similar to the price to income ratio, you will want to make sure that this rate is as low as possible. Investors will benefit most by finding a property that has a ratio below 15%. However, they will want to get a rental property that has a ratio that is between 9% and 12%. An investor will want to invest in a property that is within this range.
GROSS RENTAL YIELD
Another way to evaluate rental properties is the gross rental yield. This is a yield that is calculated by dividing the annual rent collected by the total cost of the property and then multiplying that amount by 100. This measures the total cost of a property which includes the purchase price, renovation costs, and closing costs.
One of the most important things to evaluate when investing in property is the capitalization rate. Investors will want to buy a property that has the lowest rate possible. They will benefit by getting a property that has a rate below 10%. With a low capitalization rate, investors will be sure to get a property that will not be too costly to own.
Anyone who invests in the property will want to not only build equity but also earn an income. As a result, it is important to make sure that your investment property have a positive cash flow each month. While any amount of positive cash flow is good, the cash flow must be at least 10% of the gross rental income. With a positive cash flow at this rate, investors will be able to earn a decent income even when there are vacancies. Properties with positive cash flow will ensure that an investor makes money with their investment.
Property taxes are part of the cost of owning real estate and should be considered when calculating monthly expenses.
Investing in property is one of the best ways to build wealth and achieve financial independence. To have a positive experience with property investing, investors need to evaluate certain things before buying a property. By evaluating things such as cash flow, capitalization rates required down payments and available mortgages, they will be in a position to invest in a property that will benefit their financial situation.