Rules of Thumb in Real Estate
Make life simple
Friends,
Investing in real estate can get repetitive after a while. Once you start looking at multiple properties, you pick up patterns of what makes a deal good or bad.
These patterns can be simplified into several rules of thumb that can make life easier along your journey as an investor.
In today’s newsletter, I will breakdown a few of these for you.
Let’s get into it.
Rule#1: Monthly rent 1% of property value
This is a quick way to know if a rental property will cashflow or not, after all expenses paid.
Generally, if monthly rent on a property is greater than or equal to 1% of the property value, it should easily cover all expenses related to the property including the mortgage, property taxes, vacancies and maintenance.
Of course, this number is hard to achieve in most big cities (especially in single family homes and condos) due to property values outpacing rent. However, it’s still possible in smaller communities and and larger multifamily properties.
Rule#2: Debt Coverage Ratio
This is calculated by dividing the Net Operating Income (all rental income minus all reasonable operating expenses) by the Debt Service (monthly principle plus interest expense).
For example, if your property’s rental income is $2,000 each month and it costs you $500 in expenses along with a $1,200 monthly mortgage payment, then your DSCR would equal 1.25 ($2,000 – $500 / $1,200).
Most lenders want to see a minimum 1.1% return on a rental property—so for every dollar you spend on the rental property, you earn at least $1.10 in income.
This rule puts you in the lender’s seat to evaluate if a property is worth financing. As an investor, that’s valuable information to have.
Rule#3 Cash-on-cash return
Perhaps the most important metric in real estate investing. Cash-on-cash return shows you how much cash return is earned on the cash invested in the property during a particular year.
Simply, cash-on-cash return measures the cash flow the investor made on the property in relation to the amount of expenses (including mortgage) paid during the same year.
Here’a short video that explains it a bit further, including examples. Take a look.
Rule#4 Cap Rates
Cap Rates, you would know by now, expresses the ratio between Net Operating Income (total income minus total expenses) and the Property Value.
For example, a property that generates $50,000 in NOI per year and is valued at $1M would have a cap rate of 5%.
Typically, cap rates are lower in larger markets (e.g. Toronto, Vancouver etc.) than in smaller ones. This is because the market puts a greater multiple on a property’s NOI in big cities due to competition and location desirability.
Mostly used in commercial real estate deals, Cap Rates are still an important rule for all investors to understand.
Rule#5 IRR
Internal Rate of Return (IRR) represents the rate at which your initial investment will compound and grow over time. The higher an IRR, the more desirable an investment is to undertake.
The calculation of IRR is a little complex. However, it can be useful when comparing similar style properties and ranking them against each other. The property with the highest IRR would, typically, give you the best returns.
This short video explains it quite well.
Rule#6 Rule of 72
The Rule of 72 is not specific to real estate, but investing in general. It’s a quick way to calculate how long it will take for an investment to double based on the projected returns.
Time to double investment = 72 / ROI
For example, if a property has an ROI of 12%, it should take 6 years to double your investment (72/12). If it has an ROI of 15%, it should take only 4.8 years to double (72/15).
It’s human nature to think in terms of time instead of a percentage return. The Rule of 72 helps convert a percentage ROI into a timeframe that makes it “feel” a lot more real. It’s simple yet powerful.
Hope you all got something out of this one.
Talk to you all next week.
Cheers!
Hussain