Economics
Value Appreciation
Rental property appreciation occurs when a property’s value increases over time, leading to enhanced equity for landlords. Forced appreciation, achieved through upgrades, favorable deals, or increased income, is one method to boost property value. For those investing for appreciation, thorough research of the rental market is crucial to understand popular living areas. Additionally, staying informed about local housing trends is essential to navigate potential market fluctuations.
Costs to sell
When selling a home, costs can reach up to 15% of the sale price, including real estate commissions, closing fees, and other expenses. Effective planning can reduce these costs to around 7% to 10% of the selling price. The majority of expenses usually come from paying real estate agents, but their expertise is considered valuable in securing the best deal. For a $200,000 home sale, expect approximately $20,000 in total costs.
Home Equity
For homeowners consistently meeting their mortgage obligations, understanding home equity is crucial. Home equity signifies the ownership stake in your property that is free from financing. Since the bank holds a claim on your property due to the mortgage, they have a share in its value. Upon selling, the lender is settled first, leaving you with your home equity. Having a grasp of this concept and knowing how to calculate it empowers homeowners to make informed financial decisions regarding their property investment.
Ratios
Price to rent ratio
The price-to-rent ratio (PTR ratio) is a versatile valuation metric used to determine the affordability of owning versus renting in a specific area. It helps individuals decide on the most economical living option by comparing median home values with average annual rental rates. Additionally, investors can use PTR ratios to identify prime opportunities for buying rental properties in lower-priced neighborhoods with higher demand. Conversely, ratios favoring homeownership may signal investment opportunities in higher-priced areas due to increased demand from competitive homebuyers. The effectiveness of the PTR ratio relies on thorough due diligence by buyers, renters, and investors. Values: 1 to 15 suggests it’s significantly better to buy than rent; 16 to 20 indicates it’s generally better to rent; and 21 or more suggests it’s much better to rent than buy.
Loan to Value (LTV)
The Loan-to-Value Ratio (LTV) assesses the leverage on a specific asset, particularly crucial for those financing deals. It indicates the financing required in relation to the property’s current market value and serves not only as a financing measure but also as a way to evaluate equity in a property and the overall portfolio value, accounting for debt. Lenders typically refrain from financing the entire property value to protect their investment. LTV determines the necessary down payment; for instance, an 80% LTV deal requires a 20% down payment. As the property value increases and the mortgage decreases over time, LTV reflects the evolving equity position.
Cap Rate
Cap rates measure the expected return on a rental property, without factoring in financing. Specifically, it’s a ratio of the property’s annual income over its acquisition costs. Cap Rate is determined by dividing your net operating income (NOI) by the asset value, which is the property’s sale price during the acquisition phase.
Debt Yield
This is a ratio that shows the income generated by a property compared to how much is borrowed via a loan. The yield is calculated by dividing net operating income by loan amount (principal), and it shows what the cash-on-cash returns would be for a lender in the event of foreclosure.
Key Metrics
Cash-on-Cash Return
Cash-on-Cash return gauges the total return on cash invested in real estate, considering debt service and mortgages. It reflects how much money you’re earning from your invested cash. To calculate, divide the net cash flow after debt service by the total cash in the deal, which includes acquisition price, closing costs, subtracted mortgage balance, and added capital expenditures. This metric aids in comparing financing options for new investments and forecasting returns, especially during years with anticipated capital expenditures.
NOI (Net Operating Income)
Includes expenses such as property taxes, insurance, repairs and maintenance, property management costs, and vacancy rate. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI helps assess a building’s revenue capacity, indicating its ability to cover mortgage payments.
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) estimates the interest earned on each dollar invested in a rental property over its holding period, indicating the property’s growth potential. The calculation, involving net present value (NPV) set to zero and projected cash flows, considers long-term yield beyond net operating income and purchase price. IRR is useful for property comparisons but assumes a stable rental environment and no unexpected repairs. Comparable properties should share similarities in size, use, and holding period. IRR typically ranges from 10-20%, providing insight into a property’s performance.
Gross Rent Multiplier (GRM)
Gross Rent Multiplier (GRM) aids in valuing buildings by dividing property price by gross rental income. A “good” GRM depends on the local market and comparable properties. You can project income or use the owner’s rent roll, but since it doesn’t consider vacancies or expenses, it shouldn’t be the sole basis for investment decisions. GRM ranges between 4-8, with lower values being preferable, helping assess investment potential or the worth of a current asset.