In our last blog post, we discussed how to appropriately use Cap Rate to evaluate real estate investment opportunities.
How do you calculate the actual rate of return you can expect from this opportunity, that is tailed to your specific financing method?
We will use a quasi-quantitative model that many investors can apply easily.
The essence of this model is to figure out the positives and negatives of a real estate opportunity.
Let's start with the following assumptions:
The property's price is $200K, you will purchase it with 20% down and rest with a loan at 5% interest rate. The rent is $1,500 per month, estimated expenses (excluding mortgage expense) combined are $200 per month.
The Positives of Owning This Property
a. Property value appreciation
Let's assume its annual appreciation rate is 2% (which is norm for most of the nation). Please note this 2% is based on the entire property's value.
b. Rental income and potential increase
Assume rental income has no projected increase, also, it's normal to expect average 1 month's vacancy each year, so the annual return from the rental income is $1300*11/$200K = 7.2%. Please note this rate is based on the entire property's value of $200K.
The Negatives of Owning This Property
a. Property Tax
Local government relies property taxes to support its operation, let's assume your property tax rate is 1.2% - please note this is based on property value.
b. Insurance/HOA
We will assume annual insurance and HOA cost is $1,200, it is 0.6% of the property value ($1200/200K).
c. Mortgage Expenses
You are paying 5% interest rate on a $160K loan, this is equivalent to 4% of the property value ($200K).
d. Opportunity Cost
Your down payment of $40K (=20%*$200K) has opportunity cost. If you don't use it for this property, you can very well be investing it in stock market which has average 6% annual rate of return. This is equivalent to 1.2% of the property value (=$40K*6%/200K).
In Summary
Positive rates of returns = 2% + 7.2% = 9.2%
Negative rates of returns = 1.2%+0.6%+4%+1.2% = 7.0%
Note the above comparison is based on apples to apples basis with both using the property value of $200K as the basis. Since the 9.2% is greater than the 7%, it appears to be an investment worth pursuing.
A warning, the above calculations fail to consider any labor costs incurred by you, as the property owner. Before committing yourself as a landlord, ask yourself - is this party time really for me?
This quasi-quantitative model is fairly easy to apply, but it fails to give you the actual rate of return you will get from this investment.
We will develop a truly quantitative model to evaluate your actual rate of return on any investment opportunity, and discuss in our next blog post.
How do you calculate the actual rate of return you can expect from this opportunity, that is tailed to your specific financing method?
We will use a quasi-quantitative model that many investors can apply easily.
The essence of this model is to figure out the positives and negatives of a real estate opportunity.
Let's start with the following assumptions:
The property's price is $200K, you will purchase it with 20% down and rest with a loan at 5% interest rate. The rent is $1,500 per month, estimated expenses (excluding mortgage expense) combined are $200 per month.
The Positives of Owning This Property
a. Property value appreciation
Let's assume its annual appreciation rate is 2% (which is norm for most of the nation). Please note this 2% is based on the entire property's value.
b. Rental income and potential increase
Assume rental income has no projected increase, also, it's normal to expect average 1 month's vacancy each year, so the annual return from the rental income is $1300*11/$200K = 7.2%. Please note this rate is based on the entire property's value of $200K.
The Negatives of Owning This Property
a. Property Tax
Local government relies property taxes to support its operation, let's assume your property tax rate is 1.2% - please note this is based on property value.
b. Insurance/HOA
We will assume annual insurance and HOA cost is $1,200, it is 0.6% of the property value ($1200/200K).
c. Mortgage Expenses
You are paying 5% interest rate on a $160K loan, this is equivalent to 4% of the property value ($200K).
d. Opportunity Cost
Your down payment of $40K (=20%*$200K) has opportunity cost. If you don't use it for this property, you can very well be investing it in stock market which has average 6% annual rate of return. This is equivalent to 1.2% of the property value (=$40K*6%/200K).
In Summary
Positive rates of returns = 2% + 7.2% = 9.2%
Negative rates of returns = 1.2%+0.6%+4%+1.2% = 7.0%
Note the above comparison is based on apples to apples basis with both using the property value of $200K as the basis. Since the 9.2% is greater than the 7%, it appears to be an investment worth pursuing.
A warning, the above calculations fail to consider any labor costs incurred by you, as the property owner. Before committing yourself as a landlord, ask yourself - is this party time really for me?
This quasi-quantitative model is fairly easy to apply, but it fails to give you the actual rate of return you will get from this investment.
We will develop a truly quantitative model to evaluate your actual rate of return on any investment opportunity, and discuss in our next blog post.
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