Hello dear reader, and welcome back to the #investmentseries. Your one stop source for real estate investing tips, tools and insights here at Investphilly.com.
In the past, we’ve looked at broad outlines of investment methods and talked about the risks and rewards associated with each.
Today we’re diving into a more detailed analysis of rental investments. Using the terms and numbers that investors, developers and other real estate professionals use regularly to make successful rental investments.
The first consideration is the Capital Cost. That is the fixed, one-time expense for the purchase of the property. This also includes all associated expenses including closing costs, inspections and repairs.
The next term to understand is the Estimated Rental Value, which is the open market rent value that a property can be reasonably expected to ear based on such factors as property condition, amenities, location and local and general market conditions.
Net Operating Income is the income generated by an income-producing property after taking into account all income collected from operations, and deducting all expenses incurred from operations. This is typically calculated on a yearly basis, but it is often useful to calculate monthly.
Another important concept is Cash Flow. Simply put, this is the balance of incoming and outgoing money in a property in a given time frame. Common sources of out flowing money include, maintenance expenses and property taxes. Incoming money is usually in the form of rent, but can also include memberships and subscriptions to property related services such as a gym or parking garage.
If an investor purchases a property with financing, they will be responsible for Debt Service. Just like a non-investment property, this refers to the owners principal and interest payments for the property
The Debt Service Coverage Ratio is the relationship of a property's annual Net Operating Income to its annual mortgage Debt Service.
An investor does some research and decides to buy a 2 bed/1 bath home. The buyer uses leverage and takes out an $60,000 mortgage. After all closing costs and inspections are included, the total price is $80,000. Because he has good credit, he is able to negotiate a $1,800/month for 30 years. Given the location and the condition of the home he can expect to earn $2,500/month in rent.
In order to make the property attractive to potential tenants, the owner pays a landscaper to mow the lawn and trim the bushes at a cost of $100/month. Further, the owner is responsible for $1,200 in annual property taxes, which averages to $100/month. In the past year, the owner had to do $2,400 in roof repairs after branch hit it during a particularly heavy rain storm. This also averages to $200/month.
In this example
Capital Cost = $80,000
Estimated Rental Value = $2,500
Debt Service = ($1,800 x 12 mos) = $21,600
Net Operating Income = ($2,500 x 12 mos = $30,000 rent) - ($1,800 x 12 mos = $21,600 mortgage) ($2,400 repairs) - ($1,200 taxes) - ($100 x 12 mos = $1,200 landscaping) = $3,600 (or $300 monthly)
Debt Service Coverage Ratio = ($3,600 / $21,600) = 0.167
The above example represents a difficult investment because of various factors that have increased the owner’s expenses. But using this framework a sharp investor can navigate the available opportunities to find one that offers a good return.
Please let us know if this brief explanation has been useful and always feel free to suggest other topics at firstname.lastname@example.org!