I own a couple investment properties; and also am a mortgage loan officer in NH. If you need any help, feel free to contact me. Thanks and good luck,
While rules-of-thumb are often tossed around when discussing investment property such as gross rent multipliers, cash-on-cash yields, etc., the only surefire way to understand what you are getting into, how it affects your personal financial situation, the affect of possible risks and to avoid pitfalls is to do a detailed analysis of the revenues and expenses and consider the after tax consequences.
I will be happy to screen candidate properties with you. This will put all of them on a baseline for your financial decision making. My practice is real estate. If you need financial, legal or tax advice, you will be able to take what I do to your advisors in these areas for further guidance.
Chuck Braxton, REALTOR GRI
First: No magic ratio. Just an iron law: Income exceeds expenses. Is the house bringing in more in income than it's costing you? You may want to involve an accountant, since there are various factors to consider such as depreciation (it really doesn't cost you anything, but can reduce your taxable income) and your income tax bracket.
Second: Return on investment. The point here is that you're going to take a chunk of money and invest it. Maybe you'd invest it in the stock market. Maybe in CDs. Maybe somewhere else. Or maybe in real estate. So let's say you have $60,000 to invest and there's a house worth $300,000. That's 20% down. And suppose you have a positive cash flow every month of $500. Is that a good use of your money? Well, you're earning $6,000 a year on a $60,000 investment. That's 10%, and in today's market that's pretty good.
Third: Return on equity. And that's kind of what Ellen and Doc were getting at when they referred to a decline in effective return. When you start out, using the example above, you'll have $60,000 in equity in that $300,000 property. (OK, CPAs, I know I'm oversimplifying a bit.) So initially your ROE is 10%. And let's assume that you're happy with that. But fast forward a few years. The value of the property has gone up, increasing the equity. You've paid down the mortgage some, also increasing the equity. Let's say the property is now worth $400,000 and the mortgage is paid down to $200,000. You now have $200,000 equity in the property, but you're still only getting $6,000 a year. That's only a 3% return. Now, realistically, you'll probably have raised the rent some. To get back to return to that initial 10% ROE, you'd need to be bringing in $20,000 a year, or $1,667 a month. That's not very likely. So at some point--let's say when your REO drops to 5% or 6%--you might want to do as Ellen and Doc suggest.
So, check with an accountant.
Hope that helps.
Also, most rentals reach a point where they start to decline in effective return, at which point, it is advisable to consider trading up. You can do that with a 1031 Exchange, or if you own the property in your IRA, you can trade at will without tax consequences. One caveat - if you do that, don't plan on using it for a personal residence, or you could lose all the benefits due to self-dealing.
I've included a link to a site that gives a more thorough explanation of the process. As is true of all investments, you have to know the numbers and know what makes sense in your market (or have an agent who does).