Last Updated on February 17, 2022 by Kravelv
Today, more and more people are looking forward to investing their capital in rental properties. Locations like Los Angeles are already a booming market for real estate investors.
Real estate is one of the oldest industries in the world. And notably, also one of the most promising assets when it comes to capital investment.
A few decades ago, real estate trading only referred to the sale and purchase of realty. However, with changing times, trade has also evolved. Now people are looking towards rental properties in promising locations such as Los Angeles.
Of course, there are solid reasons for this trend.
For starters, real estate investments act as a hedge against inflation. In addition, record-low interest rates offered by bond markets and recent economic ripples have also triggered investments in rental realty.
Rental investments promise asset appreciation while also maintaining a regular cash flow.
It sounds pretty promising already. Right?
Real estate investments aren’t all whites and blacks, especially when it comes to rental properties.
Nonetheless, here’s a way to find out if an investment is worth it or not.
Calculating ROI On Rental Property
It should help if you learn how to calculate ROI on a rental property before investing your capital. According to a spokesperson from a los angeles property management company, calculating ROI on rental properties is quite easy. Generally speaking, there are two rules for calculating if it is worth investing in a rental property.
The Cap Rate
The “Cap” here refers to the capitalization of an asset, which, in this case, is the rental property.
Cap is the profits made on net income generated by a property.
Think of cap rate as the rate of return that you can expect on a house if you bought it with cash. Calculating the cap rate is quite easy. Read this formula:
Cap Rate = Net Income/Asset Cost
Now, consider this example if it is still not clear.
Let’s say you bought a home for $300,000. By renting it out at $2,250 per month, you’d make around $27,000 in a year. Let’s assume that your monthly expenses, including taxes, insurance, repairs, and maintenance, sum up to $750 per month.
In actuality, it brings down your property’s net operating income to $1,500 per month or $18,000 in a year.
According to the formula, your cap rate should be equal to:
$18,000/$300,000 = 0.06, or 6%.
Note: Nicer neighborhoods tend to fetch lower rentals, so the cap rate might also be lower.
The One Percent Rule
It’s more like a rule of thumb – If the gross monthly rent before expenses equals at least 1% of the purchase price, the property investment can be profitable.
Now reconsider the example mentioned above. Under the One Percent Rule, a property worth $300,000 should rent out at $3,000 per month.
If the rule is followed, a property can generate around 12% gross revenue on the purchase price each year. After paying out the expenses, the property can easily earn a net gain of around 6%-8% on the purchase price.
Deciding on the profitability of a rental property is as essential as it is challenging. At times there could be zero-tenancy, while on others, there could be maintenance dues. From purchasing to managing a property, there are several things to take care of, especially regarding rental properties.
However, amidst all these challenges, the ROI is the only thing that can make it worth the pain. So, if you’re considering investing in rental properties, consider the rules mentioned above.