Does Buying a Rental as an Investment Make Sense?
Original Post Date: February 11, 2011
By: June Fletcher
Q. Since so many people have lost their homes to foreclosures and can’t get credit, I expect that it’s a good time to buy a rental investment place. But I’m also worried that property prices may fall further. Do you think this would be a wise way to spend my money?
A. It all depends. If you’re able to obtain a property that’s deeply discounted from its current market value, can achieve positive cash flow and can handle the out-of-pocket expenses that inevitably arise when you’re a landlord, then it could be a good deal.
But first ask yourself these questions: Do you mind panicked calls at 3 a.m. to deal with stopped-up showers or heat pumps that are on the fritz? Do you have a cushion of cash to tide you over during vacant periods and cover costs like advertising and vetting tenants? Can you afford to put down a hefty down payment to obtain financing? And do you plan to own for a few years so you can benefit from the boost in equity you’ll get as you pay down the mortgage, even if it takes a while for home prices to rise again?
If the answer to all of these questions is yes, then you can go shopping. Ask the current owners for copies of all rental receipts, as well as all bills, including utilities, water and sewer, property management and taxes.
Then you’ll have to do some figuring so you can compare the income potential of your targeted properties.
First, for each property, take annual rental income and deduct the average vacancy rate for your area, which in Chicago was 9.5% in the fourth quarter of 2010, according to the U.S. Census Bureau. Then deduct all of the operating expenses; this will give you your net operating income or NOI.
Once you get this figure, you can divide it by the purchase price to get the capitalization, or cap, rate. This is a useful figure to have when you’re comparing properties, since those with higher cap rates will bring you better returns.
You’ll also want to calculate the cash flow by deducting your annual mortgage payment from your NOI.
From that you can calculate the cash-on-cash return for the first year of ownership. Figure out your cash outlay by adding up closing costs, down payment and any expenses for necessary maintenance that was not done by the former owner. Divide your cash flow by your cash outlay and you’ll have your cash-on-cash return, which is expressed as a percentage.
This figure can help you decide which property is the most lucrative, and also to compare the yield of a property with that of other kinds of investments, like Treasuries and stocks.