The value of a home you own and occupy is calculated differently than an investment property for rental purposes. That’s one of the first things to consider when purchasing a single-family residential property.
The most rudimentary formula for calculating the value of an investment property is the capitalization rate. This is net-operating income divided by the asset value. For example, a $200,000 property with a NOI of $10,000 is a 5% cap rate. (10,000/200,000 = 5%.). This is an important metric to know, as different markets and sub-markets will have an average “cap rate” at which particular types of properties are traded.
The cap rate is not relevant when purchasing a home to live in since the property is not thought of as an income-producing asset. These property values are determined by the more traditional market forces of supply, demand and home-price appreciation.
Often when you buy a “dream home,” you may plan to raise family in it for many years. That means a large price difference amortized over a 30-year mortgage is far less significant than if that property needs to produce income today. In many markets, home-price appreciation will outpace rent growth, so the same property will be worth less to an investor than a homeowner.
With this in mind, here are some key points to consider when analyzing a single-family investment property purchase:
Learn the market. Talk to local brokers and property managers to understand rent rates and cap rates in your given sub-market. Don’t talk yourself into a higher rent rate than is actually viable.
Underwrite accurately. Figure out what your NOI will be. This means digging deep and understanding all the expenses involved in operating the asset. Figure out the low end of the rent range, then go with that number and plan for 5% vacancy.
Decide on property management. Will you be using a property manager? If so, consider all fees involved. If not, account for your time to ensure you are purchasing at the right price, because when you sell the asset most investors will calculate the management fee into their underwriting.
Account for tenancy transition. Think about the cost of locating a tenant through marketing and screening. Also, consider how much it will cost to make the unit rent ready between tenants: painting, cleaning, repairs and utilities while vacant. A safe estimate for a turnover cost is one month’s rent. Ideally, you won’t turn the unit every year, but it’s best to plan for this.
Budget for maintenance and fixed costs. Maintenance will often take place throughout the year and will depend on the age and condition of the property. A good property manager can guide you in this area. Additionally, always account for the ongoing costs of insurance, taxes, business-licensing fees, etc.
Maximize your profit potential. Look for areas of other income and what you can improve to charge more rent. If the market tells you an updated kitchen will produce higher rent, put the income and expense of this into your analysis to see if it will improve your NOI.
Create a profit and loss budget. Put all the data you gathered into a P&L statement (just like any business) and determine what your NOI will be. Divide this number by the purchase price and, if the cap rate makes sense for the sub-market and your investment goals, then buy it!
But remember, while cap rates are critical, goals are equally important. Whether you’re interested in a short-term hold and sell or a long-term play for retirement savings—just make sure your property fits your investment goals.