With vacancy rates running at all-time lows in the Metro area, both seasoned and rookie investors are taking advantage of the Downtown Denver real estate opportunity and snapping up rental properties as quickly as they can. For the fortunate few, they find a hidden gem that produces a double digit return on their money. For many others, a 7% capitalization (CAP) rate (aka, return on their investment) is far better than the return they are getting from their investments elsewhere. Of course there are plenty of landlords who are asking a premium for their rental properties right now and sometimes finding a “deal” on a rental in the current market has become less and less commonplace.
Every investor has his/her own priorities when it comes to their investments, real estate and otherwise. To keep things simple, let’s assume you are looking at purchasing any rental property that will yield the best return on your money. I believe the following considerations are most important in your analysis of a potential property:
1) What deferred maintenance exists at the property? Are the major mechanical systems in good working order or will they need replacement in the near future? A good inspection will reveal any major problems here and then it’s just a matter of getting estimates for the work and sometimes negotiating further with the seller.
2) What are the ongoing operating expenses for the property? Does the tenant or landlord pay all or some of the utilities? What are the total annual expenses including utilities, maintenance, HOA’s, legal fees, property management fees, etc.? Many listing agents and their landlord clients don’t report expense data accurately, so make sure you know exactly what you are getting into and ask for accurate financial records. If the property isn’t rented or the rents don’t appear to be in line with the market, there are resources available to find going rental rates for specific areas and help with your analysis.
2) What are the gross monthly and annual rents over the past 2-5 years? It is always good to ask for rent rolls here from the seller/landlord. What are the current leases and does the property have good tenants? What has the vacancy rate been over the past few years? Is there potential to increase rents as tenants leave or renew their leases?
4) Once we have answers to 2) and 3) above, we can calculate the Capitalization (CAP) rate (a high level way of saying the return you collect on your investment):
CAP rate = Net Operating Income (i.e., Gross Rental Income – Expenses) / Cost (purchase price).
For example, a property generates $12K in gross rental income in a year, with $4K in expenses and you purchase it for $125K. Your CAP rate is 6.4%...far better than that savings bond of yours!
5) What is the “Cash on Cash” return for the property? Some investors believe cash flow is king and many look for a 20% + return here. For instance, you purchase a rental property for $200K, with $40K down (20% down is the norm for non-owner occupied properties). Assume the net rental income is $12K per year after all expenses. Your Cash on Cash return is $12,000 (net rental income)/$40,000 (down payment) or 30 %! It will take you just over 3 years to pay yourself back on your initial investment.
So what makes a good rental property? It depends what your objectives are. Look for minimum deferred maintenance (unless you are getting a really good price), accurate income, expense and rent roll data which allow for a 6%+ CAP rate (realistic but not always easy to find) or a 20% Cash on Cash return if you are simply looking at paying yourself back on your initial capital investment (down payment) as quickly as possible. A good rental property can be a small one bedroom Denver condo in a hot neighborhood such as LoDo, LoHi or a 50 unit apartment building near DU. Sometimes a higher priced, longer term hold at a lower CAP rate can pay you back nicely over time and appreciate at a rapid rate in a strong rental market. At the end of the day, it all depends on how much you want to spend and the return you want!
There are other considerations I haven’t discussed here including location, competition, tax implications/benefits and more. We can continue those discussions in-person! Shoot me an email and I will send you our rental investment calculator. It is a great way to analyze potential rental opportunities accurately and quickly.