Investing in real estate is an excellent strategy to diversify your portfolio and generate passive income.
However, before you jump into your first rental property, it’s important to understand some key rental property metrics used when evaluating investment properties.
These include debt-to-income (DTI) ratio, capitalization rate (cap rate), gross rent multiplier (GRM), rental income, cash flow, and return on investment (ROI).
DTI Ratio for Real Estate Investing
Debt-to-income (DTI) ratio is a key factor for any potential real estate investor to consider. It helps to determine if the investment property makes long-term financial sense.
DTI looks at how much of your income goes towards paying debt versus other expenses. The lower the DTI ratio, the more available cash you will have for each rental property, and the higher your chance of success as an investor.
Here’s how to calculate debt-to-income ratio for investment property:
– Step 1: Add up all your monthly debt payments on the investment property, such as mortgage payments, condo fees, taxes, home insurance, and any other costs associated with the property.
– Step 2: Calculate your total gross monthly income. Estimate if necessary but be conservative.
– Step 3: Divide your monthly debt payments on the investment property by your total gross monthly income.
Generally, lenders prefer properties with ratios below 43-45%.
For example:
Total monthly income: $4,000
Total monthly debt payments (including mortgage): $1,800
Total DTI: 45%
A 45% DTI indicates that you are in a good financial position and should be able to make timely payments.
High DTIs can indicate riskier investments, as too much of your monthly income may be dedicated to servicing debt.
It’s also important to remember that other costs are associated with owning real estate beyond just having monthly payments due on loans –
- Taxes
- Insurance premiums
- HOA fees
- Utilities, etc.,
These must be factored in when calculating what you can comfortably afford.
Being aware of your debt-to-income ratio can help you decide which investments to pursue, and which are simply outside your budget.
CAP Rate for Rental Properties
The capitalization rate (or CAP rate) is another helpful metric for making rental property investments. The CAP rate is calculated by dividing annual net operating income (NOI) by the current market value and is expressed as a percentage.
A low cap rate indicates more risk in renting out the property since more money has been spent upfront on the purchase price and improvements, while higher cap rates suggest more stable cash flows from rent payments.
Example of a calculation:
Market Value = $1,000,000
Net Operating Income = $100,000
CAP Rate: 100,000/1,000,000 x 100% = 10%.
A good cap rate is considered to be between 4 and 10%.
Gross Rent Multiplier
The gross rent multiplier (GRM) is a metric that quickly estimates an investment property’s potential net operating income. The GRM divides the total annual rent tenants pay by the property’s purchase price, which indicates the possible return on investment. Higher GRMs usually suggest more attractive investments, as they generate more rental income in relation to the purchase price.
Example of GRM:
Purchase Price: $300,000
Annual Rent Paid by Tenants: $30,000
GRM = 30,000/300,000 x 100 = 10.
Generally speaking, a good GRM on a rental property is between 4-7, and the higher, the better.
Each metric provides unique insight into a property’s potential financial performance and helps to inform a real estate investor’s decision-making process.
Understanding how each metric works and how to use them together can help investors make better decisions regarding their real estate investments.
Other Key Performance Indicators (KPI) in Real Estate
Real estate metrics measure the performance of an investment property.
Typical metrics include debt-to-income ratio (DTI), capitalization rate (CAP rate), and gross rent multiplier (GRM). However, there are other metrics investors can use to evaluate potential investments:
Cash on cash return – the annual before-tax cash flow ratio to the total money invested in a property.
Debt service coverage ratio (DSCR) – measures a property’s ability to cover its debt obligations from operating income alone.
Loan-to-value ratio (LTV) – measures the loan amount compared to the value of a property.
Operating expenses ratio (OER) – measures the operating expenses of a property to its revenue.
Return on investment (ROI) – reflects the return investors can expect from their real estate investment.
Net operating income (NOI) – indicates the property’s total income after operating expenses.
Cash flow – an immediate indicator that measures the amount of money left over after paying all expenses.
By analyzing these KPIs, real estate investors can better understand a property’s performance and make informed decisions.
Understanding the Risk Factor of Investing in Rental Property
Risk is an inherent part of any investment, including real estate. While potential returns can be high, so too can the potential losses. Investors should ensure they are comfortable with the level of risk involved and that their time frame for investment suits their goals.
It’s also essential to have a plan in place to mitigate potential losses. This could involve diversifying investments, engaging in meaningful due diligence, and working with experienced professionals who can help guide the process.
Ultimately, investors should know all metrics associated with a particular property or portfolio and assess their risk tolerance accordingly. By understanding these KPIs, they can make educated decisions and increase their chances of success.
How Do You Know if a Rental Property is a Good Investment?
Ultimately, the best way to determine if a rental property is a good investment is to weigh your options and research. Analyzing the DTI ratio, cap rate, and gross rent multiplier will help you decide whether to pursue that property.
Additionally, understanding local market trends regarding rental prices and vacancy rates can help determine whether your rental property will be profitable. Professional real estate specialists can create a personalized investment strategy.
Professional Property Managers in Hemet, CA
After the purchase, professional property managers can help you manage your rental property, ensuring it generates the expected returns.
If you’re looking at investment properties in Southwest Riverside County in California, Scout Property Management will help you choose the best property and then maximize your returns on it.
Investing in rental properties in Hemet, CA, and surrounding areas can be incredibly rewarding and lucrative when done correctly. By researching and using metrics like those discussed above, you can make more informed decisions and potentially increase your return on investment.
Scout Property Management is here to help guide you through the real estate investment process.
Want to learn more about real estate investing in SW Riverside County? Check out this blog on other things to look for when buying rental property.