There are different types of real estate – commercial (offices), residential (flats), industrial, retail and others. Regardless of the type, you would like to buy, most investors earn a passive income by leasing their property.
In spite of it, there are a couple of things you must consider before getting into this business.
This article is a four-step guide for people who want to join the rental business.
Step 1: Evaluate The Potential Rental Income
The first step prior to buying a property is to estimate the potential rental income. The whole process includes assessment of the area, the type of property and the condition. In order to do that, you need to use four main approaches: Sales Comparison Approach (SCA), Capital Asset Pricing Model (CAPM), Income Approach (IA) and Cost Approach (CA).
The first one (SCA) compares prices of properties which have been sold, let's say over the last year. Keep in mind that you have to narrow down the comparison to real estate only in the area. Also, compare the same type of property. It's advisable to use a longer period since it reflects price movements better and might show some negative trends in the long run.
The second indicator, Capital Asset Pricing Model, is a model which aims to determine the potential rate of return of the given asset. This model explores the relationship between an expected return on investment to all the risks associated with it.
Then, once you have evaluated the potential price and rate of return, it's time to use the Income Approach. This tool is primarily used when comparing commercial real estate and relies on one major thing: the annual capitalization rate.
How to calculate it?
Multiply the gross rent income by 12 (the number of months in a year) and divide it by the current price of the asset.
The price of a rental property is currently $200,000 and the expected rent is $2,000. So, the formula will be: (12x$2,000)/$200,000= 0,12. Turn it into percent and you will have an annual capitalization rate of 12%.
The last method to use is the Cost Approach. The main idea behind this is to show a buyer how much the desired property would cost if it were built today a new. Take into account also the value of the land and any depreciation.
The general formula is: value=reproduction cost – depreciation + land value
Step 2: Calculate The Annual Expenses
Once you have finished the first step, you can move on to the next one – calculation of the annual expenses.
They are usually two types – fixed and variable expenses:
1. Fixed Annual Expenses
Fixed expenses are those that your property will incur each year – taxes, maintenance, and insurance. If the property is located in the city, the taxes will be higher if it's in the country. Moreover, the tax rate on properties varies within a city.
In the central parts, it tends to be higher in comparison with real estate on the outskirts. Occasionally, the taxes on a property are higher if it serves the purpose of investment rather than home.
2. Variable Annual Expenses
In this category, you might include annual repairs, new furniture, roof repair, plumbing services and others. Even though it is hard to estimate how much the variable annual expenses will be, set aside an amount of money equal to fixed annual expenses. Assuming the latter is $1,500, then set aside $1,500 for variable expenses. This makes $3,000. If the annual rent is $10,000, then you will make a $7,000 profit
Bear in mind:
This calculation is valid only if you have tenants throughout the whole year. There is always the possibility of months when you won't collect rent.
Step 3: Evaluate Market Sentiment
One of the main factors which affect any type of asset, both its price and future income, is the so-called market sentiment. This indicator is also known as investor attention, and it shows the prevailing sentiment of investors towards the price of a specific asset.
If you start understanding the market and all the forces that drive it, including crowd psychology, most probably you will end up making the right decision. For example, most investors buy properties when the market is euphoric (it's at its peak). However, when the market is down, you can buy many cheap assets which you can resell later or let them.
10 Years Cycles
According to analysts, in the real estate market, there are cycles which last for 10 years. Normally, during a decade there is a bottom as well as a peak.
Generally speaking, there are two key factors that drive all markets: demand and supply. The basic principle is that if there is a higher demand for an asset, its price will start increasing. Also, if the supply is low, in a condition where there are enough buyers, the price will go up.
In our particular case, large cities are a place where more people live as well as salaries are higher. Therefore, the demand for rental property is higher which will eventually lead to higher rents.
Step 4: Evaluate Risks Associated With Rental Property
Even though investing in real estate is a relatively risk-free endeavor, as with anything else you need to have a risk-management strategy.
Let's look at the main risks associated with owning a property:
- High Expenses: the property generates more expenses than initially planned and calculated. This includes months when there are no tenants occupying the place. This, of course, will negatively impact and lower the potential return on the estate.
- Problematic tenants: sometimes, tenants “forget” to pay their bills or refuse to leave the place even though they don't pay the monthly rent. This will result in unwanted expenses to evict the tenants and also bills which you have to cover yourself. It's recommended to consult with a property management company prior to any action you might take. They are professionals and know their job. However, they will charge approximately 10% of the rent.
- The housing market: there is no need to lecture you on this since we all remember the US housing bubble in 2008-2009. What if you invest in a property in a city whose economy starts going down? This is a serious risk since the expected rent might go so low that won't cover all the expenses or you won't be able to find tenants.
By following these four steps, an investor can have an actual and accurate idea as to how much income to expect from a property. It's crucial not to skip any of the steps so that you can have a broader picture.