Evaluating a Real Estate Investment
Here are eight real estate investing numbers you need to know before purchasing in investment property.
1. Your Mortgage Payment:
For a standard owner-occupied home, lenders typically prefer a total debt-to-income ratio of 36%, but some will go up to 45% depending on other qualifying factors such as your credit score and cash reserves. This ratio compares your total gross monthly income with your monthly debt payment obligations. For the housing payment, lenders prefer a gross income-to-total housing payment of 28 to 33%, depending on other factors. For an investment property, Freddie Mac guidelines say that the maximum debt-to-income ratio is 45%.
2. Down Payment Requirements
While owner-occupied properties can be financed with a mortgage and as little as 3.5% down for an FHA loan, investor mortgages typically require a down payment of 20 to 25% or sometimes as much as 40%. None of the down payment or closing costs for an investment property may be from gift funds. Individual lenders will determine how much you need to put down to qualify for a loan depending on your debt-to-income ratios, credit score, the property price and likely rent.
3. Rental Income to Qualify
While you may assume that, since your tenant’s rent payments will (hopefully) cover your mortgage, you should not need extra income to qualify for the home loan. However, in order for the rent to be considered income, you must have a two-year history of managing investment properties, purchase rent loss insurance coverage for at least six months of gross monthly rent, and any negative rental income from any rental properties must be considered as debt in the debt-to-income ratio. (Besides creating ongoing income and capital appreciation, real estate provides deductions that can reduce the income tax on your profits.
4. Price to Income Ratio
This ratio compared the median household price in an area to the median household income. Before the housing bubble burst, the price-to-income ratio in the U.S. was 2.75, while at the end of 2010 the ratio was 1.71. The average between 1989-2003 is 1.92 according to Fiserv, Inc., Federal Housing Finance Agency, Moody’s Analytics.
5.Price to Rent Ratio:
The price-to-rent ratio is a calculation that compares median home prices and median rents in a particular market. Simply divide the median house price by the median annual rent to generate a ratio. At the peak of the U.S. market in 2006, the ratio for the U.S. was 18.46. The ratio dropped to 11.34 by the end of 2010. The long-term average (from 1989 to 2003) was 9.56. As a general rule of thumb, consumers should consider buying when the ratio is under 15 and rent when it is above 20. Markets with a high price/rent ratio usually do not offer as good an investment opportunity.
6. Gross Rental Yield:
The gross rental yield for an individual property can be found by dividing the annual rent collected by the total property cost, then multiplying that number by 100 to get the percentage. The total property cost includes the purchase price, all closing costs and renovation costs.
7. Capitalization Rate
A more valuable number than the gross rental yield is the capitalization rate, also known as the cap rate or net rental yield, because this figure includes operating expenses for the property. This can be calculated by starting with the annual rent and subtracting annual expenses, then dividing that number by the total property cost and multiplying the resulting number by 100 for the percentage. Total rental property expenses include repair costs, taxes, landlord insurance, vacancy costs and agent fees.
8. Cash Flow:
If you can cover the mortgage principal, interest, taxes and insurance with the monthly rent, you are in good shape as a landlord. Just make sure you have cash reserves in hand to cover that payment in case you have a vacancy or need to cover unexpected maintenance costs. Negative cash flow, which occurs most often when an investor has borrowed too much to buy the property, can result in a default on the loan unless you are able to sell the property for a profit.
The Bottom Line:
Once you have made all these calculations, you can make an informed decision about whether a particular property will be a valuable investment.