Investing in rental property can be lucrative, and in more ways than one. The basic idea is to buy a property where you can host tenants who pay rent in excess of your monthly expenses.
If you do, you’ll make a monthly profit. You can also benefit from the appreciation of the property, especially if you keep it in good condition.
Of course, investing in rental property isn’t a straightforward money-making machine. Before you invest in your first property, it’s important to understand some basic fundamentals.
Metrics and Calculations
Let’s start by focusing on some of the most important metrics and calculations you’ll need to know for your property. The better you know the numbers, the more confident you can be.
- Capitalization rate. Your capitalization rate (cap rate) is a high-level benchmark, and one of the most popular calculations by real estate investments. You can calculate it by dividing your net income after expenses by the property value. For example, if your net income after expenses is $4,500 and your property value is $110,000, your cap rate is 4.09 percent. A cap rate between 4 and 10 percent is considered good, though this may vary slightly by region.
- Gross rent. Gross rent refers to how much income you’ll generate when your property or unit is occupied, and is the amount stipulated by your lease. You can estimate gross rent by determining what the property has generated in the past, or what people are willing to pay for similar properties in the area.
- Net effective rent. Check out this guide if you want to calculate net effective rent. The high-level view is that net effective rent estimates how much rent you’ll receive after accounting for rent abatement or cash allowances, which apply to certain properties.
- Vacancy loss. Vacancy loss refers to the money you’ll lose while the property is unoccupied (vacant). It’s practically impossible to predict how often or for how long your property will be vacant, but you should know what the damage will be when it happens.
- Operating expenses. Your operating expenses include all the upkeep costs of your property, including things like property taxes, insurance, and in some cases, utilities like water and electricity.
Risks and Responsibilities
It’s also important for you to understand some of the risks and responsibilities associated with being a landlord of a rental property:
- Rental properties don’t guarantee cash flow. It may seem like buying a rental property is a fast-track ticket to income generation, but this is far from a guarantee. Even if you’re charging a fair rental price in a popular neighborhood, there’s no guarantee you’ll find a good tenant in a reasonable time frame—or that your cost estimates are accurate. Buying property always entails a bit of risk.
- Local laws vary. Landlords are always subject to a number of laws, rules, and regulations, including things like safety features of the property, lease structures, and potential price increases. To make matters more complicated, these laws vary tremendously from city to city. If you want to be successful, you need to thoroughly understand these laws, which usually means getting advice from a lawyer.
- Being a landlord is time intensive. Landlords have significant responsibilities, and some of them are time intensive. Depending on the nature of the property, you may need to collect rent, tend to the yard, conduct inspections, and issue repairs. Some weeks, you might only spend a few minutes on your property. Other weeks, you’ll spend many hours. You should be prepared for this time commitment if you want to make the property work.
- Historical numbers and projections may not be accurate. When looking at a potential rental property, you’ll likely see the previous owner’s estimation for the amount of rental income it can generate. However, these numbers aren’t always accurate, nor are your personal projections for the property. Make sure you’re basing your expectations on multiple different sources, and are planning conservatively for your financial future.
- Unexpected expenses can hurt you. Almost every landlord will eventually encounter at least one major unexpected expense. Sometimes, this is a major repair, like a faulty roof that needs to be replaced. Other times, it’s a legal expense, like managing the eviction of a problematic tenant. Your budget should account for at least some of these unplanned expenses, and you should always have an emergency fund ready—just in case.
Rental property investments are a complicated business, but they’re accessible enough that even an amateur property investor can benefit from them. If you’re inexperienced, spend extra time on due diligence and only go after properties you feel very confident about. That extra conservative approach can shield you from many of the risks facing newcomers.