The point of buying an income-producing, rental property is for it to produce income, but how can you decide if a rental property is providing a good return on investment? The obvious cost of owning a rental property is its purchase price, but there are also other costs that have to be factored into the equation. As well as your down payment, you will have closing costs and taxes to pay, as well as the costs of running your property. Insurance, property taxes, management and maintenance are just some of the after purchase costs that need to be considered. Unfortunately, when considering a rental property purchase, you don’t always have all the expense information required. Some sellers are better at providing up-to-date, valid information than others. At the end of the day, the rental property should provide a good return, or else there’s really no reason to take your money out of the bank!
Here are a few quick calculations that help determine if the rental property you’re considering is a good purchase.
The Capitalization Rate
The capitalization rate (Cap rate) is a quick way to compare the net income of a property to the building’s value. The higher the Cap rate, the better the annual return on your investment. The Cap rate can also be used to determine if the net income of a property supports the listing price of a property for sale. Different investors are happy with different Cap rates. Some will be satisfied with a Cap rate of 5 or 6%, while others will not accept anything less than 10%. It’s important to remember that Cap rates vary from city to city, and sometimes even neighbourhood to neighbourhood. Also, different property types generate different Cap rates.
Gross Rent Multiplier
The gross rent multiplier (GRM), or gross income multiplier (GIM), expresses the relationship between the gross income of a property and its selling price. This general rule of thumb allows you to compare how well your property, or the property you are considering, is performing compared to other properties in the area. The GRM is calculated by dividing the price or value of the property by the gross rent, or the annual rent before expenses if all the units were rented for the full 12 months. In this case, the lower the multiplier, the better the investment. It is important to remember that this is before any expenses are deducted from the income being produced by the property. While it is a quick and easy way to compare rental returns of properties, the actual return can vary significantly once expenses have been deducted.
The One Percent Rule
Some investors use the one percent rule to decide if a property is performing. Again, this is a rule of thumb that gives a general idea about the property. The one percent rule is another way of expressing the relationship between the gross rent and the building’s list price or value. The one percent rule states that the gross monthly rent must be equal to at least one percent of the value or selling price of the property. As a result, the gross income of the property should be equal to or more than 12% of the value of the property. After expenses, the net revenue is usually much lower. The calculations using the net income give the Cap rate (as above).
While some investors are happy with the one percent rule, there are others who prefer and follow the two percent rule. Same idea, but they want the gross monthly rent to be equal to or greater than two percent of the purchase price or value.