Return On Investment Assessment – Is The Rental Property Worth Buying

Which property will make money?  How do we select the right real estate investment?  Whether you want to invest in residential or commercial real estate, assessing the potential return on investment is important.  The information I provide pertains to investing in rental properties that you will lease to tenants.  In other words, being a landlord. Now, how do we assess return on investment for rental properties?

There can be a lot involved, yet it’s easy to do.  In simple terms, a return on investment assessment tells you what you may receive back from your real estate investment.  Obviously.  And with real estate investing, return on investment typically refers to money.  Yet, it can refer to more than just money.

A return on investment for rental properties assessment – the money version – compares the cost of the investment to the investment’s monetary gain (like rent).  Preferably, I suspect, we want our real estate investment monetary gain to be more than our investment’s cost.  Is there a way to assess this before buying that property – before potentially wasting our money on a bad investment?  Yes, sort of.  Let’s review this.

The costs with investing in rental properties are many, and they can include the following:

1. Closing costs for the purchase (taxes, deed registration, brokerage fees, lender fees, settlement firm fees, and more)
2. Property inspections pursuant to the purchase contract
3. Loan payments (Principal and interest. Interest is the real cost since this is payment to the lender you won’t get back. Principal is the loan amount itself that was used to buy the rental property and the amount you paid off equates to equity that you will hopefully get back in the form of money when you sell the property.)
4. Property taxes
5. Income taxes (profits on rental income are taxable)
6. Insurance (home owner’s insurance, business insurance)
7. Business licenses (Required for business entities you form to own the real estate. Some localities require landlords to have local business licenses.)
8. Renovations (these may be needed to prepare a property for leasing)
9. Maintenance (landlords may be responsible for some maintenance and repair)
10. Listing services (brokerage advertising and tenant hunting)
11. Build-outs you offer to tenants for your commercial real estate
12. Property management fees (property managers help get rental properties ready for renting, find tenants, prepare and sign leases, coordinate maintenance and repair activities, ensure tenant compliance with the lease, process rent payments, prepare statements and IRS documents, liaise with HOAs and condo associations, inspect properties, and more)
13. Legal actions you take against clients who breach the lease
14. Closing costs for the later sale

Revenue is easier to identify.  It’s essentially just rent and possibly profit on the sale.  That’s it.  It’s rent collected from tenants and, hopefully, cash-out when selling the property years later for more than you paid to buy it. When projecting how much rent you will receive over a period of time, note that you may not receive rent for the whole period. There will likely be months when you don’t have a tenant or months when one of your tenants doesn’t pay rent.

Identifying rent potential is a product of market analysis and this can be easy.  Research the amount of rent that tenants pay for real estate, either the commercial space or a home, that is like the one you are considering buying in the same area.  There are a couple of important points there.  One, identify the renting information before you decide to buy the property and, two, identify that renting information for similar types of properties.  Don’t look at the rent amounts being sought on properties that are still available for leasing.  Those don’t matter since no one is renting those properties yet.  Look at properties with recently signed leases.  Real estate agents have access to this information and can provide valuable assistance.  Know the potential amount of rent you could seek from tenants so you can assess your potential return on investment before deciding to buy that property.

Here’s another market item to research.  It’s the length of time that landlords wait for leases.  Often this is referred to as “days on the market”, in other words the number of days a property is advertised for leasing before a lease is eventually signed.  Less days on the market is better, of course, so you aren’t waiting for a tenant a long time and losing out on rent and still paying bills on your property.

It’s also important to decide whether you are looking for positive cash flow while leasing or looking to make a profit selling in later years at a higher price than your purchase price.  You may be able to have both.  If you’re interested in positive cash flow while leasing your property, consider purchasing with as small of a loan as possible or, even better, with cash.  In doing so you minimize your monthly expenses with only a small loan payment or none at all.  With a loan payment you may find that you can at most hope to break even each month, and sometimes you may operate in the red.  (Operate in the red occurs when expenses are more than revenue.) Whether you’re breaking even or spending extra while leasing your property, you could still enjoy a respectable profit when you eventually sell the property.  This happens because you would be using your tenant’s rent payments to pay on your loan for some number of years and accruing equity while doing so.  And, hopefully, your real estate value increases and you sell for a higher price than you paid.

With knowledge of expenses, revenue, and equity accrual for a specific time period, you can assess potential return on investment for your rental properties. Click here for Investing In Rental Properties.