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It's likely no secret to anyone reading this that real estate investment is a lucrative way to build wealth and generate passive income. In fact, a 2023 CNN x Momentive survey found that 23% of American adults believe real estate is the best way to build wealth. But only 12% are actually investing in real estate. We're here to help close that gap and introduce more potential investors to the wealth-building power of real estate investing.
The first step is to understand the rules of the game. Across all different real estate investing strategies, all different geographies, and all different asset classes, successful real estate investors share one thing in common: they analyze the economics of potential residential investment properties carefully and quantitatively in order to make informed investment decisions.
Based on our decades of experience in high-scale, high-margin real estate investing, we've boiled down the key to metrics to measure to the tight starter kit below. Together, these six real estate investing metrics help investors understand the profitability of a potential investment property over the long term.
Cash flow is the amount of money that is left over after all the expenses of owning and operating a property are paid. It is the most crucial metric to evaluate when investing in real estate. A positive cash flow indicates that the property generates more income than its expenses, which is essential to make a profit. Real estate investors should analyze the property's cash flow to determine if it is worth investing in.
Cap rate, short for capitalization rate, is a common metric used in real estate to evaluate the potential profitability of an investment property. The cap rate is expressed as a percentage and represents the expected rate of return on a property based on its income and value.
Cap Rate = Net Operating Income / Property Value where:
For example, if a property generates an annual NOI of $50,000 and has a market value of $1 million, its cap rate would be: $50,000 / $1,000,000 = 0.05 or 5%
This means that the property is expected to provide a 5% return on investment based on its current income and value. Cap rates can vary depending on factors like location, property type, and market conditions and are typically used to compare the profitability of different investment opportunities.
The definition of a "good" cap rate varies depending on the type of real estate investment and the market conditions. In general, a higher cap rate indicates a higher potential return on investment, but it also comes with a higher level of risk.
For example, a cap rate of 8% or higher may be considered good for a multi-unit residential property in a stable market, while a cap rate of 10% or higher may be considered good for a commercial property in an emerging market. However, in a highly competitive market with low vacancy rates, a lower cap rate may still be considered attractive.
Gross Rent Multiplier (GRM) is another commonly used metric in real estate to evaluate the potential profitability of an investment property. The GRM is a ratio that measures the relationship between the property's purchase price and its rental income.
GRM = Property Value / Gross Annual Rental Income where:
For example, if a property has a market value of $500,000 and generates a total rental income of $60,000 per year, its Gross Rent Multiplier would be: $500,000 / $60,000 = 8.33
This means that it would take approximately 8.33 years of rental income to recoup the purchase price of the property.
The GRM is used to compare the relative value of different investment opportunities and to identify properties with higher potential returns. A lower GRM indicates a better value, while a higher GRM suggests that the property may be overpriced. But it's important to note that the GRM does not take into account expenses associated with owning and operating the property, such as property taxes, maintenance costs, and management fees, so it should be used in conjunction with other metrics, such as the cap rate, to make a well-informed investment decision.
Vacancy rates are an essential metric to evaluate when considering potential residential investment properties. The vacancy rate is the percentage of units that are vacant in a particular area. High vacancy rates indicate a weak rental market and indicate that it may be challenging to attract residents without discounting rent or adding amenities and other differentiated perks.
Location, location, location! Obviously local market dynamics are crucial indicators of potential returns. The fundamentals always matter: is the property located in a desirable neighborhood with good schools, close-by amenities, and public transportation or great walkability? Those factors tend to have broad bearing on the relative quality (and therefore long-term rental potential) of a particular property. But real estate investors should also look closely at the inventory and pricing trendlines for the area, which can suggest how a neighborhood is trending. Low or decreasing rental inventory in a quality location can indicate the ability to command higher rents. Similarly, sale and rental prices that are increasing in an area over time can indicate a locality that's in-demand or perhaps approaching a level of stability that may not yield as much long-term home price appreciation (HPA) upside.
Fixed and variable cost of property ownership are essential to consider when investing in residential properties. Properties with high fixed costs and maintenance costs can eat into the profits generated by the property and are ultimately one of the two major determinants of a property's investment potential (the other of course being the rent you can command).
Fixed costs are expenses that do not vary from month to month. These costs are typically predictable and recurring and include expenses such as property taxes, insurance premiums, and mortgage payments.
Variable costs, on the other hand, are expenses that can change from month to month based on rental activity and conditions in the home and include expenses such as maintenance and repairs, utilities, and advertising costs.
Fixed costs to consider:
Variable costs to consider:
Understanding the fixed and variable costs of owning and operating a rental property is important for calculating the property's net operating income and ultimately, its profitability.
Ultimately, investing in residential properties—particularly single-family rentals—can be a profitable way to build wealth and generate cashflow. But real estate investors need to evaluate the quantitative and qualitative fundamentals of any potential investment in advance to ensure the property will be profitable in the long run. Cash flow, cap rate, GRM, vacancy rates, market dynamics, and expenses are essential metrics consider when you analyze a potential residential investment property. By evaluating these metrics, real estate investors can make informed decisions and invest in properties that will generate the best returns. Fortunately, Picket is here to help. We do all the data and property analysis for you to provide these metrics (and many more) automatically so you can make decisions confidently and quickly knowing the best data and analysis has your back.
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