In general, there’s really only one reason as to why you’re setting up a rental property, and that is to make money off of it. However, it is important for you to determine how much profit should you make on a rental property. This way, you can see how much revenue you’re generating and avoid incurring losses in the process.
The operation of a rental property should be treated as a business. Before you come up with your rental price, there are various factors, such as location and expenses, that need to be taken into consideration. To help you, this article covers everything you need to know about how much profit you should make on a rental property as well as some of the things you should keep in mind.
What is the Average Profit on Rental Property?
The average profit from a rental property is $100 per month, as most investors point out. It is a good benchmark to start with since a steady flow of income like this is already conducive to building wealth over the long run. However, it is important to keep in mind that profitability margins for rental properties can vary widely. Because several factors must be taken into account, as mentioned earlier.
What are the Factors to Determine Profitability of Real Estate Investments?
When determining the profitability of your real estate investments, you should consider several factors. Particularly since investing in real estate isn’t as simple as buying and selling pancakes. Some of the factors that can help determine the profitability of real estate investments are the following.
- Return on Investment (ROI)
- Cash-on-Cash Return
- Capitalization Rate
- The 1% Rule
These factors can help you decide if a property is worth your time and money. In the following section, we will discuss each one of them and examine how they can impact profitability.
1. Return on Investment (ROI)
Return on investment or ROI is a financial metric used to measure the total performance of a particular venture. Overall profitability is calculated, or to put it simply, it estimates the total amount of return that an investment will produce in relation to its cost.
When you take this aspect into consideration, you can gain a better understanding of the potential profit you’ll have when investing in a particular property. It is then easy to identify which real estate is a better choice.
2. Cash-on-Cash Return
The cash-on-cash return, also known as cash yield, refers to the yearly rate of income that a property generates in relation to the amount of money put into it. In most cases, the rate does not change unless something significant happens. For example, raising your rental price can increase your cash-on-cash return. On the other hand, costly repairs will result in a lower cash yield.
This aspect provides a clear picture of the annual cash flow, which is important in evaluating the stability of investments made. Consequently, investors generally prefer properties that deliver a high cash-on-cash return, since this effectively proves that the property is financially viable over the long term.
3. Capitalization Rate
The capitalization rate, commonly referred to as Cap Rate, is a measure used in real estate to determine a property’s expected rate of return based on its net operating income (NOI). Basically, it is a ratio that indicates the payback on capital invested.
Considering the capitalization rate will make it easier for you to decide whether or not the property is suitable for investment. There is no doubt that a higher cap rate is the best option, however, it must also be noted that it also comes with a higher risk. In this sense, it’s wise to pick an option that you feel comfortable with both in terms of the rate and the level of risk involved.
4. The 1% Rule
The 1% rule is a method of evaluating the investment property’s price against the expected gross revenue. This is perhaps the simplest method that investors use in analyzing rental properties. In essence, it determines whether the monthly rental income earned from an investment property is greater than the monthly mortgage payment for it.
This approach will give you a basis for comparison since it functions as a great prescreening tool as you search for properties or plan the rental price. This will ensure that the price is not only reasonable but that it can also cover the mortgage payment, which is basically a double win.
What are the Factors that Affect Profitability of Real Estate Investments?
There are a number of factors that affect the property value or the profitability of real estate investments. The lack of consideration for these can ultimately lead to problems or, worse, income loss in the long term. In order to avoid such scenarios, here are a few factors that may influence the profitability of real estate investments.
- Property Location
- Property Condition
- Initial Investment
- Rent-to-Mortgage Ratio
These things are also helpful hints on how to pick a good rental property. Within the next section, we’ll assess each of these points and figure out how they can affect the profitability of any property investment.
1. Property Location
Property location is among the most important elements of real estate investing. In essence, it determines many aspects of a property.
For instance, it plays a significant role in determining the type of tenants that you will attract. When the property is located close to a university, near amenities, and has easy access to essentials, students are more likely to prefer it.
Besides determining who will rent your property, its location can also influence its value. There may be future developments in the area that could potentially increase the value of your real estate investment. This is why it’s also important to consider the long term when making a decision.
2. Property Condition
The condition of the property is perhaps an obvious factor that can affect the profitability of a real estate investment. Truth be told, nobody wants to live somewhere that requires extensive repairs, or worst of all, one that’s dirty. When this is the case, the property is likely to appear very cheap, leaving it with little chance of being rented. In contrast, properties that are in great condition have a better chance of attracting tenants and are more likely to sell for higher prices.
So, before investing in a property, always ask for a thorough inspection from a reputable expert. By gaining a good sense of the property’s current condition, you’re able to prepare and plan a budget for it, whether it’s for repairs or any necessary upgrades.
3. Initial Investment
The initial investment, also known as initial outlay, is the amount of money you need at the start of a business or a particular venture, such as a rental property. It is important to know how much the initial investment will be since you basically need to plan ahead and factor it in when setting the rental rates. It’s just like any business where you add in your expenses and then price your product accordingly.
4. Rent-to-Mortgage Ratio
If you’re thinking about investing in a rental property, be sure the mathematics work in your favour. It is not a suitable investment if the estimated rent payment does not cover your mortgage, insurance, taxes, and association dues.
The rent-to-mortgage ratio can be calculated by simply dividing the adjusted rent by the 100% loan-to-value mortgage payment. The term comes from the price-to-rent ratio, through which individuals can determine whether a property is better suited to be purchased or rented. In general, a lower ratio suggests buying, whereas a higher ratio indicates renting. As an investor, knowing the rent-to-mortgage ratio of your property allows you to establish a profitably-charged rate in the event your tenant becomes interested in buying.
What are the Expenses to Consider that Affect Profitability of Real Estate Investments?
There will be a number of costs involved as you go about your real estate investments. As with the factors mentioned above, it’s equally important to consider these expenses so you can plan ahead and avoid any unnecessary hassles. Particularly when you’re ready in renting out real estate.
Just to give you a quick rundown, here are some of the following expenses that contribute to the profitability of real estate investment.
- Vacancy
- Maintenance
- Capital Expenditures
- Property Management Fees
- Property Forecasting Cash Flow
To help you better understand each cost, let’s go over them one by one and see how we can optimize each to our advantage in the next section.
1. Vacancy
Vacancy cost refers to the amount of money you basically lose when nobody occupies your rental property. Essentially, the longer your property remains vacant, the more money you will be losing.
This type of expense goes against the notion that empty properties will save money since utilities and maintenance will not be required. Because even when the property is vacant, you’re still expected to pay the bills, mortgage, and any other necessary repairs to ensure it remains in good condition.
There are some things you can do to minimize vacancy costs. For example, you may want to consider marketing your property. Consider posting a notice about its availability online or in print. You can also do a tenant screening when somebody expresses interest in renting your property. In this way, you can ensure he or she is a quality tenant and that the property will stay occupied for a reasonable amount of time.
2. Maintenance
Maintenance costs are undoubtedly necessary in order to keep the property in prime condition. It can be easier to attract tenants when the surroundings are clean, the structure is in good shape, and features are well-maintained or upgraded.
Various expenses may be involved in this type of expense, such as pest control, fixtures, and landscaping. This is why it’s important to set a budget for the process in order not to overspend. To start, you can have your home inspected by an expert to see if any repairs or renovations are required. Then, you can simply determine what percentage you’re willing to put out every month for maintenance and deal with specific concerns one at a time.
3. Capital Expenditures
Capital expenditures, or CapEx, are usually funds for purchasing assets or upgrading them. In the case of rental properties, capital expenditures are improvements made to the property that will extend its useful life and increase its value. These expenses are not simple repairs or routine maintenance. Capital expenditures may be major, as in replacing a roof or upgrading flooring, or maybe less extensive, such as purchasing a new refrigerator to replace an old one.
In order to prepare for such a situation, it is a good idea to determine your potential capital expenditures and set aside a reasonable amount of money each month or year. This will help you avoid spending more than you need for your property or getting into debt for it. In the event that CapEx sounds complicated, you can always consult an expert to simplify the process.
4. Property Management Fees
Naturally, you want to be hands-on in your real estate investment. However, if you decide to hire a professional, you should think about the charges that are generally involved. It could include an initial setup fee, monthly charges, maintenance fee, or even termination charges.
There can be a fixed fee for property management depending on the type of property, its condition, services needed, or the arrangement made with the company. Nonetheless, you should take this cost into account as you calculate your rental price since it is a necessity. To get started, you can talk to your property manager about the charges, and then plan accordingly.
5. Properly Forecasting Cash Flow
In essence, cash flow forecasting refers to estimating how much money will flow into and out of a business over the course of a particular period. For rental properties, this can be used to get a better picture of both your income and expenses. By properly forecasting cash flow, you can make any necessary adjustments and be able to earn, as well as have the money for other expenses.
How to Understand that Investing in Real Estate Is Right for You
Considering the pros and cons of investing in real estate can help you decide whether it is right for you. Although there are considerable benefits to investing, such as having a steady cash flow and tax advantages, there are drawbacks that some people might consider seriously.
One of them is that taking risks is inevitable, especially with the shifting market conditions. In the case of rental properties, you can’t always count on having quality tenants and revenue because people move frequently.
In many cases, however, the benefits nonetheless outweigh these drawbacks. But then again, it’s best to take your time. Make sure you consider all aspects before making any final decisions on whether is it worth buying an investment property or if you should invest in real estate in general.