Before purchasing any investment property, you should ask yourself: How much profit should you make on a rental property?
One of the first questions that you should ask yourself when you first start investing in real estate is: How much profit should you make on a rental property?
Rental properties are, generally, the most common entry-level investment in the real estate market.
Beginner real estate investors will typically start off by purchasing a rental property or by renting out a room in their own primary residence. Rental properties are considered to be the easiest type of investment properties for investing in real estate due to the simplicity of running and managing them.
If you’re opting out of hiring a professional property manager, then you should expect to spend a lot of time managing your rental property and tending to the tenants. Naturally, you will not want this effort to go to waste by not making enough rental income to cover for the time and effort that you’re putting towards the property, nor do you want your rental rate to be too high, resulting in your property being vacant most of the time and not generating any income for you.
So, when you’re considering the purchase of an investment property for the purpose of renting it out, either traditionally or through Airbnb, then you should always figure out how much profit should you make on a rental property before you commit your time and money to it.
How to determine how much profit should you make on a rental property?
In order to determine how much profit should you make on a rental property, you should consider a number of factors that all come together to help you decide the amount of rent that you should set on your property.
Determining the amount of profit that you will be making relies heavily on the property’s rental rate, its expenses, and the market in which it exists. Of course, it also helps to have access to the right tools, like rental market data or an Airbnb calculator, but you get the point.
We have broken down the different factors into three main ones:
- Property’s price and the market’s rental rates
- The expenses
- The projected returns of the property
So, without further ado, here is how you can determine how much profit should you make on a rental property.
Property’s price and the market’s rental rates
The first thing that you need to take into consideration is the property’s price and the average rental rate in the market that you want to invest in.
When choosing the market, you should make sure that it’s a good market for rental properties. Naturally, you should have an idea of the available budget that you have and focus on markets where the median price of properties fits within your price range.
After identifying a few markets that are affordable to you, you should collect data on those markets to see what the rental rates are in each one of them. Of course, the higher the rental rates are in the market, the higher you can set the rent on the property.
To do this, you can obtain the data from real estate agents in the area, the city’s municipality, property management companies, or through online sources and platforms.
Our suggestion would be to use Mashvisor as it will allow you to search for the perfect market using readily available data and calculations. Just type in the name of the city that you want to invest in, and then hover over the different neighborhoods (markets) to see the median price in each one, as well as the average rental rates for properties within that market.
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In this way, you can easily find the right neighborhood to invest in without having to spend too much time on finding a source and obtaining the required data for that market.
Accounting for the expenses
When trying to determine how much profit should you make on a rental property, it isn’t enough to learn about the rental rates in comparison to the property’s price in the market.
It is very possible to find properties that are affordable and have high rental rates, only to find out that the insurance and tax costs and the other expenses related to the property are too high and are resulting in a negative cash flow for you.
So, it is always a good idea to get a good understanding of the different expenses and how they differ from one market to another, and from one property to another.
For example, property’s that are aged 20+ years will typically be cheaper in price while still maintaining the average rental rates of their market. However, these properties will generally have much higher maintenance costs, which will in turn heavily affect the rental income that you make from the property, cutting short on the profits that you were hoping to make.
There are several expenses that need to be taken into consideration when trying to determine how much profit should you make on a rental property. These expenses include the following recurring expenses:
- Property management
- Property maintenance
- Property taxes
- HOA Fees
- Rental income tax
Accounting for all of these expenses will give you a better idea of the profits that you should expect from the property.
Using the different metrics and calculations, as you will see below, you should be able to project the amount of cash flow that the property will have before you even invest in it.
Calculating the returns
After determining the price of the property, its rental rate, and the expenses that will apply to it, you can finally use the data that you’ve gathered to determine how much profit should you make on a rental property that you want to purchase.
There are 3 important metrics that you should take into consideration at this point:
- Cash flow
- Cap rate
- Cash on cash return
The cash flow of a rental property is the amount of rental income minus the expenses.
Basically, if a property has a rental rate of $1,500/month ($18,000 annually), and $11,000 in annual expenses, then the investment property’s annual cash flow will be $7,000, which is a positive cash flow.
The cash flow can also be negative if the amount of annual expenses is higher than the annual rental income of the property, resulting in you losing money instead of making profits.
The cap rate of a rental property is one of the most commonly used metrics for calculating a property’s returns and determining the amount of profit that it will make once you invest in it.
This metric – the cap rate – uses the cash flow in its calculations to determine the amount of profit that the property will make as a percentage of its current market value.
Cap Rate = (Cash Flow/Property’s Value) x 100
Using this simple equation, you can determine how much profit should you make on a rental property based on the property’s price, regardless of whether you’re using borrowed money or your own money for purchasing the property.
The cash on cash return, on the other hand, is a similar metric to the cap rate, but it only takes into consideration the amount of actual cash that you’re investing in the property.
Cash on Cash Return = (Cash Flow/Cash Invested) x 100
This allows you to know how much profit the rental property will have as a percentage of the amount of cash you’ve invested in it.
Using these metrics, you can easily know the projected returns that a rental property will have based on the amount of rental income that it has. This will help you better understand how much profit should you make on a rental property and to adjust the rental rate accordingly in order to maximize your profits.
You can also use Mashvisor to gain insights on each investment property or neighborhood using these metrics. Mashvisor will give you the average cap rate and cash on cash return for each neighborhood, and it will give you readily calculated metrics for each property, with a powerful ROI calculator that allows you to modify and adjust the different values (cash invested, expenses, rental rate, etc.) to get the most relevant results in a matter of minutes.
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It is crucial for any real estate investor to be able to determine how much profit they will make on a rental property; otherwise, they would be risking their time and money while investing in properties without knowing whether they are profitable or not.
To save you a lot of valuable time and energy, Mashvisor has created a platform which will allow you to estimate the amount of profits that you can make from investing in any property and in any market in the US.
Using Mashvisor, the process that would typically take 3-4 months to finish can now be done in 15 minutes. You won’t need to use any spreadsheets or trouble yourself with the math; everything will be calculated and made available for you to help you make the wisest investment decisions at the least amount of effort.