As a real estate novice, not having a solid grasp of the numbers behind your first investment can mean the difference between a successful future as an investor and immediate failure. This is true if you are looking to invest passively into REITs, but especially true if you want to become an active investor and landlord.
To avoid making early and costly mistakes, be sure to protect yourself by learning how to calculate and use these 7 most important real estate investing numbers:
1. The One Percent Rule
When you’re just starting out as an investor, it can be overwhelming to see all the options around you, and it can be hard to know where to begin narrowing them down.
The one-percent rule is a great way to simplify this complicated decision into a simple rule of thumb that helps you narrow down your options quickly and efficiently.
All the one-percent rule says is that a property’s monthly rent should be one percent or more of its total cost.
- A property that costs $80,000 should rent for at least $800 per month
- A property that costs $500,000 should rent for at least $5,000 per month
Keep in mind that this rule looks at a property’s total upfront cost, which means the purchase price plus closing costs and renovation costs you will need to pay to make it rentable.
If a property passes the one-percent rule, it’s worth considering. If not, move on. It’s as simple as that.
2. The Mortgage (Debt-to-Income Ratio)
For most of us, our first investment starts with a mortgage.
For a standard home, banks usually offer loans with a total debt-to-income ratio of 36%, and as high as 45% if other factors, such as your credit score and cash reserves, are exceptionally good.
However, if you are buying an investment property, your income can be a lot bigger than it first appears – thanks to the rent you will receive from your investment!
In Canada and the US, lenders usually let you add around 50 – 70% of your expected rent to your income to offset property expenses such as your mortgage payment, taxes and utility costs, and help you qualify for a bigger loan.
3. Down Payment Requirements
If you plan to live in the property you are buying, you can usually find a mortgage with a downpayment as low as 5%. For investor mortgages, however, you will usually need to put down a higher percentage, with banks preferring 20% or more.
As a novice investor, you need to calculate how much you need to save for a down payment and raise those funds before you start your first investment.
4. Price to Income Ratio
This ratio compares the price of a home to the total household income, and it’s one of the best measures of housing affordability we have. Typically, a ratio of 5 to 1 or higher (housing that costs 5 times the household’s yearly income) is considered unaffordable.
Sadly, this ratio has been on the rise for decades. In the early 2000’s the standard price to income ratio for Canada was 3 to 1. Since then, property prices have exploded, and the ratio currently stands at 7 to 1, going as high as 14 to 1 in Vancouver, Canada’s least affordable city.
4. Price to Rent Ratio
The price-to-rent ratio is a calculation that compares the price of buying a home to the cost of renting it for one year. It is calculated by dividing the house price by the annual rent.
As a general rule of thumb, a ratio under 15 is considered a great investment opportunity, and a ratio above 20 is considered a poor opportunity. In general, we recommend avoiding investing in areas with a high price-to-rent ratio.
6. Capitalization Rate
Once you’ve narrowed down your options to a handful of potential properties, it’s time to look at the capitalization rate, or “cap rate” for short. This helps you calculate the property’s potential return on investment.
To find the cap rate, you need to calculate the property’s net income (total rental income minus operating costs like property management, vacancy costs, repairs and utilities) and divide that number by the property’s purchase price.
Each investor has his or her own idea of what they consider an acceptable cap rate. But generally speaking, you want this number to be as high as possible. The properties listed for investment in our AQRE platform have a cap rate of 10% or higher.
7. Cash Flow
The most important element of calculating cash flow on your real estate investment is to make sure that it is positive. If you can cover your mortgage, taxes, insurance and operating expenses with the monthly rent you receive from your property, you have a positive cash flow and are in good shape as a landlord!
Negative cash flow, which happens most often when an investor has borrowed too much to buy the property, can result in having to urgently sell your property or risk defaulting on your mortgage – a situation where no investor wants to find themselves.
The Bottom Line
We hope these calculations have helped you think like an investor, separate the good properties from the lemons, and make an informed decision about your next real estate investment.
Are there any important numbers that we missed? Let us know in the comments!
And join us next week for another installment in our AQRE series on How to Make Money in Real Estate.