With the real estate market finally taking a breather, it’s time to start considering investing again.  Prices would still have to come down a fair bit in many areas for it to be worthwhile, but other areas are depressed and decent investments can be had already.

The Error In Real Estate Investing

Many people buy rental properties with the single hope that they will cover the mortgage and property taxes with the rent and that they will eventually benefit from the slow build up in equity. This is the wrong way to look at real estate investing; it not only ignores many of the real expenses involved, but it also ignores the cost of capital and the tie up of your equity.

How to Properly Evaluate a Real Estate Investment

The way professionals do it is to start off with something called the CAP rate or capitalization rate.  It effectively works out the return on the actual asset itself, as you were paying cash for it.

The CAP rate is basically the percentage return you have left to cover interest costs with if you are borrowing for the property.  It is also the rate of return you will be getting on any equity you have or will build in the property.

When you have established an acceptable rate of return that you require for it to be a decent investment in that way, you can then decide on the degree of leverage (i.e. mortgage) to use to magnify that return.  Hiding a losing investment by playing with mortgage amortizations or downpayments is doing a disservice to yourself, as using leverage on a money losing property will only magnify your loss!

Calculating CAP Rate

To get the CAP rate of the property you are assessing, you take the gross annual rents, less all non-financing costs, and then divide that by the purchase price of the property.

Non-financing costs are not just property taxes and insurance, but are also provisions for repairs and vacancy as well as for management of the property (or compensation for yourself if you’ll be doing it).  A conservative estimate of expenses (from my own experience and from my research) is 45% of rents, but that will vary with certain factors such as local taxes, quality of tenants, current condition of property, etc.

Using Your CAP Rate to Effectively Plan Your Investment

Once you have your CAP rate calculated, you can now use that as the starting point to see if the property warrants further investigation and analysis.  For myself, I won’t look at anything less than a 7% CAP rate.  That allows me to pay 4-5% on a mortgage and still have 2-3% left as my profit.  With current market conditions, I assume zero growth in the value of the property for the near future, which is being conservative.  If you plan to invest in an area where you expect price growth, you may require a lower CAP rate for your investment.

A Real Time Example

So let’s run through an example; here’s a property I recently looked at:

$250,000 Purchase price

$30,000 Annual rents

$3,000  Property taxes

$2,900  Vacancy provision (10% of rents)

$3,000  Repair/Maintenance provision (1% of property value)

$1,000  Insurance

$1,500  Management fee (5% of rents)

That gives me a CAP rate of 7.4%, not too bad.  That means that if I financed 100% of the purchase price, at a rate of 4%, my annual profit on the property would be $8,500 (7.4% - 4% = 3.4%, multiplied by $250,000 purchase price).

If I financed half of the property, I would earn $4,250 on the financed portion (3.4% x $125,000), and $9,250 on my equity (7.4% x $125,000).

A 7.4% return on equity sounds decent, but consider that real estate investing is a fairly risky endeavour!

Don’t Forget the Associated Risks!

Here’s some of the risks you will have to deal with;

• Housing price declines
• Interest rate increases
• Major unexpected repairs
• Bad tenants

Considering all that, 7.4% sounds about fair but not spectacular.  If you manage the risks well, you could do well at that return.

Also remember that that return is pre-tax.

Putting Your Plan Into Action

So now you have a rental property with an acceptable CAP rate: it’s time for reality!  Your degree of leverage used may depend more on your ability to secure a mortgage and your lenders demands for a downpayment.

If you have a HELOC with lots of room, you could finance it 100%, make interest only payments, and have some decent cash flow to do whatever you want with.  Most of us, though, will take out a mortgage and therefore must factor in that you will be making payments consisting of principle and interest.  Regardless, the next step you’ll want to do is a cash flow analysis.

Analyzing Your Cash Flow

To work out your actual cash flow from the property (as opposed to just your profit, as we did above), you take the same gross rents and expenses used in your CAP rate calculation; you also add in your mortgage (or interest-only) payments.  For myself, I want a property that generates actual cash flow annually, as opposed to building equity in the property, which is the goal of some investors.

What to Do With Your New Found Positive Cash Flow?

So if you have a cash flow positive property, what to do with that cash?

My preference would be to first use it to pay down non-deductible debt, such as my own personal mortgage.  After that it would depend on the economic situation at the time. If the real estate market was still down, I’d use it to invest in more properties.   If the stock market was down, I’d consider putting it there.  If the investment climate was starting to look bubbly again, I’d likely use it to pay down the rental mortgage and build equity.  If I was looking to retire, then obviously I would want to use that cash flow to supplement my income!

That should give a good starting point for how to evaluate and choose an investment property.

Questions or comments are welcome!  I’d also like to hear about your own experiences here. Have you owned (or do you own)  a rental property?