Humans have always sought shelter to protect themselves from the weather, predators, and discomfort. Today, the global real estate economy is worth $5.85 trillion and contributes 16.9% of the United State’s GDP. Real estate is a large piece of the pie that anyone can get a slice of through proper planning and management. Rental properties are one of the most proven ways to make money from real estate investment, thanks to their ability to hedge inflation and generally low-maintenance nature.
However, despite its highly profitable potential, real estate has still managed to spur several investors. Thus, it is only appropriate for entrepreneurs to ask, how do I invest in real estate successfully? What metrics should I observe? And is due diligence essential?
If any of these sounds like questions you have, stick around till the end of this post. Then, we’ll reveal 6 real estate investment rules every investor should know. Are you ready to up your investment game? Then, let’s get started.
6 Real Estate Investment Rules Every Investor Should Know
- Know Your LTV Ratio
Your LTV, short for Loan to Value ratio, is a crucial metric that lenders use when assessing your loan application. It is a tool that tells a lender how much risk they stand to incur by borrowing a specific amount of money.
Typically, the higher the LTV ratio, the riskier it is for the lender. Thus, most banks or private institutions would try to pass on that risk to the customer by increasing interest rates. But, of course, that is if they accept your proposal.
The formula for LTV is as follows:
LTV = Mortgage amount/Appraised Property Value
For example, if you want to buy a house worth $250,000 and you make a 20% downpayment of $50,000, you’ll have a deficit of $200,000.
LTV = $200,000/$250,000 = 80%
80% is a tolerable threshold for most lenders and will get you modest loan terms. The lower your percentage, the less risky it is to loan you money and the more leverage you have.
- Set Your Rent Using the 1% Rule
Setting the ideal price for your rental property can be tricky. If you charge too little, you stand to lose out on potential profits and could even run at a loss. On the other hand, if your prices are too high, you could drive away potential tenants and risk months of vacancy.
Thus to avoid either scenario, experts often recommend that landlords use the 1% rule to set their rental prices. The 1% rule is where property owners charge 1% of their total purchase price as their monthly due.
So if you bought a house for $200,000, your tenants should pay around $2000 per month for your business to remain profitable. While that amount isn’t fixed in stone, as other variables can determine your monthly charge, it is an excellent place to start.
- Estimate Your Profit and Expenses with the 50% rule
With so much cash flowing in and out, it can be hard to tell how profitable your real estate investment is. That’s why experts usually recommend that investors use the 50% rule to avoid overestimating their profits or underestimating their losses. Unfortunately, this mistake is prevalent among first-time property owners. Bay Property Management Group can help manage your first rental investment.
The 50% rule says that half of a property’s gross income should cover its operating expenses when calculating its profitability. For instance, if you have a single-family unit that generates $100,000 yearly as gross rent, $50,000 should go to its running costs. The running costs should include operating fees like taxes, insurance, repairs, wages, and utilities.
- Keep Your Cash Flow Positive
Cash flow is another metric system that indicates how well your business is doing monthly. It is the amount left over after deducting your total expenses from your income.
For instance, if your rent from a property is $2500, and all operating costs to run the building are $1400, your net cash flow is $1100. It’s simple enough to calculate, but some landlords might still have difficulty arriving at the correct figure. Your final figure will be skewed if you forget to consider specific fees like taxes, transportation costs, and HOA fees. Also, if you mix income from several properties or different investments, you might not spot when you have a negative cash flow.
Thus, monitoring your incoming and outgoing expenses would be in your best interest. After all, a negative cash flow would mean you’re running at a loss and could prevent you from paying your bills.
- Compare The Cap Rate
Cap rate, alternatively known as capitalization rate, is a metric that measures the potential income a property will produce to the original capital the investor makes. Some experts consider it a percentage value similar to that of stock returns.
For example, if you purchase a single-family unit worth $100,000 and your net income is $7,000;
The cap rate would be: NOI/Market Value = $7,000/$100,000 = 7% cap rate
Thus, a higher profit often means a higher reward. Comparing cap rates is often a good place to start if you want to learn how to search for investment properties.
However, that isn’t a hard-and-fast rule. For example, if the property you’re higher has a higher cap rate than comparable investments, it could be because the market value is lower. In addition, multiple repair needs and maintenance issues could make buyers offer a lower price than their competition since such properties come with more risk.
- Use Cash On Cash Return to Select the Right Investment
Cash on cash return is a ratio between how much money you earn against how much you’ve invested in a property. In other words, it is a financial metric that considers your leverage.
It differs from cash flow significantly because it also weighs measurables like your mortgage and other debts. The formula for cash on cash return would be:
Cash-on-cash return = Cash flow – Debt service
Debt service, in this instance, would refer to your loan repayments, closing costs, and other fees incurred during your property acquisition.
Savvy investors typically use cash on cash return to select the investment generating the highest return per dollar.
To be a successful investor you don’t have to start from scratch to be a successful investor. Savvy property owners build on existing wisdom to expand their portfolios, manage their businesses, and increase their financial power. With these 6 real estate investment rules every investor should know, you should be able to devise better financial strategies and make wiser decisions.
However, if you still need a hand in starting your journey, you should hire help. An expert property management company can help you make the best financial decisions for your business.
Nichole Shahverdi is the Director of Operations for Bay Property Management Group. Prior to taking over operations and marketing, Nichole worked as the Director of Leasing where she worked daily with investors and property owners to market and lease homes throughout Maryland, Pennsylvania, DC and Northern Virginia and ensure maximum ROI on their investments.