A rental real estate investment can seem like a great way to build your wealth (and maybe generate a little extra income), but how often does it really work out that way? Unfortunately, turning a profit tends to be more difficult than simply “how to make money in real estate”.
When you’re managing buildings that are occupied by tenants, profit margins on rental properties can be impacted by a huge number of different factors. So what are investment properties and how can you learn the basics of building your wealth on yours?
Introduction to investment properties
Owning a rental property in addition to your primary residence can be a great way for you to build wealth, especially if you may be averse to investing in the stock market. Data released in 2017 shows that 47% of rentals were owned by individual investors. In theory, it seems to make sense. With a rental property, someone else pays your mortgage, and over time your equity grows. You can eventually own a physical piece of property outright that also produces income. However, rental property investments aren’t always a sure thing.
ROI of real estate investing
Like any investment, you need to understand the expected return on investment (ROI):
ROI = (Net Profit / Cost of Investment) x 100
Therefore, before you purchase a rental property and even before you calculate an ROI estimate, research and figure out what return is reasonable to expect on your money. From there, you can calculate the revenue required for the investment to be worthwhile.
Calculating the ROI of a rental property can be complex, however. While there are many different ways to do this, the point of this exercise is to provide you with a “back of the envelope” calculation to help you quickly assess whether or not a rental property has a return potential that is worth pursuing. If your calculation reveals that the return is small on paper, it’s likely going to be small in reality, too.
Before you can calculate the true ROI of a rental property, you have to factor in all the potential income channels and costs associated with holding that property, not just rent paid and the purchase amount.
- Rental Income: How much you can charge tenants for rent each month.
- Mortgage paid down: How much of the property you own.
- Change in property value: How much additional equity you have beyond the amount of the mortgage you have already paid down, based on current housing and rental market prices.
- Financing: If you didn’t buy the property with cash and took out a mortgage, the amount you pay per month in principal and interest.
- Homeowner’s association dues: Fees you pay for community amenities.
- Property insurance: The insurance you carry on your property.
- Property taxes: What you pay in state and local taxes. And remember, property taxes don’t typically stay the same each year. They typically continue to rise unless an economic downturn allows you to have the property reassessed (typically for a fee) and re-adjusted downward.
- Vacancy: The amount of cash you need for covering expenses when you don’t have a tenant. The standard vacancy rate is 5% to 8%, meaning that’s the percentage of the year that the property can be expected to sit empty.
- Your time: The one item many people forget to account for is the cost of their own time. Whether it’s time spent as the handyman or finding a renter, your time is money, and anytime you put into managing the property reduces the return on your investment.
Patience is key
Rental properties can generate income, but the return on investment doesn’t typically happen right away due to high initial costs. Rental property investments are also risky because of how many variables can affect its performance, such as the housing market or your ability to keep it rented. So if you’re wondering if you should invest in real estate, really consider how appropriate this type of investment would be for you and your situation first.
As with any investment, rental properties should be viewed as a long-term investment, not an instant cash cow. If your goal is to grow wealth, there are other ways to generate a return on your income with less risk and headache, like investing in a globally diversified portfolio of stocks and bonds. If you’re interested in comparing them, we discuss the differences between the two strategies here.
If you want to learn how to get started in rental property investments, get in touch with us today!