The Landlord Files: How do I know if this house will get a good return?

Landlording can be a very financially rewarding endeavor, but it can also suck the money and life right out of you.  How can you tell the difference before you buy an investment property?  If you already own a property that is not being used as a rental, would it make a good rental?  Here is how you can tell.

Calculate Income and "Cap Rate"
1.  Determine how much rent this property can earn in a year.

If it's rented already, you have that number.  Otherwise, research local rental values for similar homes to come up with an estimate.

2.  Determine the annual expenses created by this property.  This includes:

• projected vacancy rate (5-10% of annual rent is typical)
• utilities paid by you (water?  garbage?  Some localities require landlords to pay certain ones.)
• repairs (new roof, new furnace, siding repair, emergency plummer?  These things will come up.  1-3% of the home's value is a good estimate.  I use 3% since I bought a foreclosure, and assume those numbers higher.  If your home is newer, you may use a lower percentage.)
• property taxes
• insurance
• management fees (if you use a rental management company)

3.  Calculate "Annual Net Income"

• Annual Rent minus Annual Expenses
• Mine is:  17400-9800= 7600 (roughly)

4.  Calculate the "Cap" Rate

The capitalization rate is the expected annual rate of return.

• Divide net income by cost of property.
• Mine is:  7600/102500= 7.5% (approximately)

If you took out a mortgage on this home (or plan to), you still do NOT place that number in this calculation.  Once you have this calculation figured, do some number crunching to see if there is still a healthy enough return to account for your mortgage payment AND a few worst case scenarios.  One year you might have more vacancies or late rent payments than usual.  The year you replace a roof or something huge may look a little different.  You may have a series of expenses come up in the same year.   If you don't leave a significant cushion, you could quickly operate at a loss.

Personally, I won't invest in a rental property with less than a 5% cap rate, but that's just me!