There is only one rule about when to buy or when not to buy: if you will gain money, then buy. You can figure it out just now profitable a property might be with basic, elementary arithmetic.
To evaluate a property's profitability, you need to look at four areas:
Net Profit. The net profit is the amount of money you have left over after all your expenses are paid.
Appreciation. This is the amount of your property increases in value. There are two types of appreciation: natural, which is the amount of the market goes up; and forced, which is adding value with improvements or a higher and better use.
Equity Buildup. A portion of each mortgage payment you make is applied to reducing the principal balance of the mortgage. When rents are paying the mortgage, you can consider the equity buildup as part of your overall profit.
Tax Shelter. Real estate investing is a business, and you are therefore entitled to take a variety of business-related deductions on your income tax. Often this deduction will offset income earned from another source and reduce your overall tax liability. The deductions includes depreciation, interest, maintenance, and any other expenses related to managing your property, such as operational expenses and administrative expenses. The formula for calculating investment-property depreciation can change with revisions in the tax laws, so check with your accountant.
Profit
Calculate the return on your investment (ROI) by dividing your profit by the amount of cash it took you to achieve that profit.
For example, you bought a 5-unit building for $ 100,000. The owner is willing to hold mortgage and take 10% down payment or $10,000. The building is fully occupied, and each unit rented for $400 a month. This is how the computations work:
Here is an example of calculating your net profit.Calculating Net Profit:
Monthly gross rent (5 units @ $400 each) = $2,000
Annual gross rent (12 x $ 2,000) = $24,000
Monthly expenses = $ 1,000
Annual expenses (12 x $1,000) = $12,000
Gross annual operating profit = ($24,000-$12,000) = $12,000
Debt service (12 x $600, the monthly mortgage payment) = $7,200
Net overall operating profit = ($12,000-$7,200) = $ 4,800
Your first year ROI is the net profit divided by the cash out of pocket it took for you to buy the property, which is $4,800 divided by $10,000, or 48% return on investment.
Appreciation
Next is appreciation, if you know your market, you will be able to estimate how much specific improvements will increase the value of your property. Appreciation turns into a cash profit when you sell or refinance.
Cost of improvements $2,000
Revised appraised value of property $150,000
Forced appreciation $50,000
The appreciation ROI on this property was 500% ($50,000 divided by $10,000). This is just forced appreciation-that is forcing the value of the property to go up by improving it. When adding in natural market appreciation, contact a real estate agent for the figure that applies in your area.
As the rents pay down the mortgage balance, the equity increase is considered profit. It is a paper profit until you sell or refinance, but it is there for you to use when you need it.
Initial loan amount $90,000
Amount applied to principal $400
New principal balance $89,600
Equity buildup $400
Equity buildup ROI is 4% ($400 divided by $10,000).
Tax Shelter
With investment real estate, most of the time your expenses will offset most, if not all, of your income for tax purposes. You will make additional income gains by deducting depreciation and letting that offset the taxes on income from other sources. Generally you can count on 5 to 15 % ROI from tax shelter area.
Now lets take a look at the overall return on investment:
Return on cash invested 48%
Appreciation 500%
Equity buildup 4%
Tax shelter 10%
Total ROI 562%
Well, that's the reason why many great fortunes have been built through real estate. On any investment look a the first year anticipated net profit, and if you are not satisfied with the ROI, then don't go any further. The exception would be if there is a tremendous upside on the investment that you might predict to give greater return in the future. Don't put anything in concrete, but always have a sound basis for your decisions; be flexible and use logic and reason to make a good deal.
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