The number of people starting to invest in real estate and looking for rental properties as a means to diversify their investments and secure future cash flow is increasing. Rental properties can complement an investment portfolio and create continuous income flow. Several key factors have made this investment a popular choice:
Benefits of Rental Properties
Rental properties can complement an investment portfolio and create continuous income flow. Several key factors have made this investment a popular choice:
1. The low returns offered by savings accounts and investments like certificates of deposit make many people look closely at investing in rental properties.
2. Several years of historically low interest rates have made people concerned about future inflation, driving them away from the bond market. Instead, people are investing in physical assets like commodities and real estate, which are presumed to have an inflation hedge benefit.
3. Many people want to diversify their investments, meaning moving away from exclusive investment in the stock market.
Net Annual Return Rate
First, calculate the net annual return rate, or the “net annual yield,” on the intended investment. This is the profit you can earn from the net income generated by the property or the return rate you would achieve on a house if you bought it with cash.
The net annual return rate is calculated by dividing the net income by the cost of the asset. For example:
You buy a house for $200,000. It is rented for $1,500 a month. Your expenses (taxes, insurance, management, repairs, and maintenance) balance at $500 a month. (Remember that this does not include principal payments and interest on the mortgage, but it does include the amount set aside for taxes and insurance.) The net income from the rental property is $1,000 a month, or $12,000 a year. The net annual return rate is $12,000 / $200,000 = 0.06, or 6%.
Whether a 6% rate is considered a good return on your investment depends on you. If you can find high-quality tenants in a better neighborhood, then a 6% rate may be an excellent return. If you are getting 6% in a struggling neighborhood with many risks, then that return may not be worthwhile.
The One Percent Rule
This is a general rule that people use when evaluating a rental property. If the total gross monthly rent (before expenses) is at least 1% of the purchase price, they will look more closely at the investment. If not, they will pass on it.
For example, a house worth $200,000 should – using this general rule – rent for $2,000 a month. If it does not, it does not meet the one percent rule. Under this rule, the house generates total revenue equivalent to 12% of the purchase price annually. After expenses, the property could bring in net revenues ranging from 6% to 8% of the purchase price. This is generally considered a good return, but again, it depends on the area you are looking into. Better neighborhoods tend to produce lower rental yields, while tougher neighborhoods tend to produce higher yields.
Final Note
Remember that a 6% or 8% rate does not mean much if this interest is not compounded. To give your returns the same interest and the same growth opportunity as funds in the stock market, you will need to reinvest 100% of the returns so that your returns can compound on themselves.
Frequently Asked Questions
How to calculate the return on investment for rented property?
Calculating the return on investment (ROI) for a rental property is similar to calculating the net annual return rate. The difference is that the return on investment is a more precise measure that includes more costs, such as borrowing costs associated with a mortgage for the rented property. The net annual return rate assumes you bought the home with cash to give you a general idea of the rental property’s profitability, while the return on investment is a more personal measure of how much you will earn.
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How to calculate depreciation on a rental property?
You can depreciate the cost basis of a residential rental property over 27.5 years. This means you only need to divide the total cost basis by 27.5 to find out the amount you can claim as depreciation on your taxes each year. The cost basis includes the cost of the property, as well as any costs associated with preparing the building for tenants, not to mention the value of the land on which the rental building sits. There are some quirky items regarding the costs included in the cost basis, so check the IRS publication for more information on how to calculate your cost basis.
Source: https://www.thebalancemoney.com/rental-property-investing-for-beginners-453821
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