Few business opportunities provide as much return on investment as real estate. With continuing historic low interest rates, even amid recovering home prices, there are compelling reasons to consider real estate as a means to gain significant earnings. There are pitfalls in the business, however, so it is critical to carefully evaluate the market and your commitment so you can make informed, competent decisions.
Determining what type of real estate investment to make is as essential as the monetary consideration. Property is abundant, but there are many variables that determine the relative return. Are you interested in buying a single-family or multi-family investment property, restoring and reselling properties, owning commercial real estate or investing in vacation property? Each type of procurement and management comes with advantages and consequences that require expert navigation.
In this series we’ll detail the basic types of real estate investments most commonly explored by potential entrepreneurs, starting with investing in residential real estate, specifically single-family rental homes.
Single-family rental property
When people think about investing in a single-family rental, they often imagine buying it for a great price, securing a loan and easily finding great tenants who help pay the mortgage, make minimal demands, and don’t damage anything. After a few years they imagine that the property’s loan is clear, they only had to spend a little money for basic maintenance and the house actually appreciated in value. Sounds good! Unfortunately, there are usually wrinkles in this ideal investment plan.
Single-family investments have their share of initial and recurring obstacles. Unless a potential investor has the financial resources to fund the purchase, just getting past the lending institution’s litmus test can be tricky. Considerations for loans as well as income calculations for the investment include:
Mortgage Payment – Lending institutions typically calculate total gross income to debt payment ratio. A primary home ratio usually falls around 36 percent, with some lenders going as high as 45 percent. For income property the ratio of income to total debt is typically maximized at 45 percent.
Down Payment – Calculations for down payments differ for income property versus owner-occupied homes. An applicant can get into a primary residence with a down payment as low as 3.5 percent for FHA loans. Rental properties usually will require a 20 percent to 25 percent down payment.
Qualifying Rental Income – Many applicants assume the projected revenue from rental property can be calculated as income offsetting the income to debt ratio. This is not the case in most loan assessments. Lenders consider projected rental income only if the applicant has more than a two-year history as a property manager or landlord. Securing a reputable management company may satisfy the requirement. In all cases mortgage companies use an individual’s debt to income ratio, credit score, property value, and potential to rent in the loan approval process.
Price to Rent Ratio – This calculation compares the median price value of houses in a market to the median monthly rental fee. It is a good rule of thumb to consider investment decisions on this ratio. A high price-to-rent ratio does not represent a positive investment potential.
Gross Rental Yield – Is your money going to work for you? Divide the annual projected rent projected by the total property cost (purchase price, closing fees, and renovations) multiplied by 100 to get the gross rental yield percentage.
Capitalization Rate – This important number takes into account ongoing expenses including repairs, insurance, taxes, vacancy cost, management/agent fees, etc.. Calculate rent minus expenses divided by property cost times 100 for the capitalization rate.
Cash Flow – Cash return is the ringing endorsement for any investment. If income from rental property consistently covers the mortgage, interest, insurance, and associated management fees, the owner should be in good financial shape with the investment. There also should be some buffer in the rent to cover non-recurring costs (damages, vacancies, replacements, repairs).
Even great houses in wonderful neighborhoods can become revolving doors for renters. Each day a house is vacant results in negative cash flow. Advertising, showing the property, screening tenants, collecting rent, and ensuring proper maintenance add up to significant investments in time for the owner. It is a huge commitment, and often novice landlords aren’t prepared to take on the daily management aspects of rental properties. Failure to do so can result in significant financial loss.
The real estate professionals at Gordon James Realty Services understand the complexities of the market and consider every client a partner. With more than 30 years of combined experience, we can help with your property investment opportunities. Our expert team is dedicated to exceeding clients’ expectations and maximizing the value of your property.