Are you thinking about investing in real estate to earn rental property income? Whether you invest in a residential or commercial building, there are several things to consider to make sure the property will generate a profit. Here’s what you need to take into account to determine how profitable an income property will be.
What factors determine how profitable rental property is?
Figuring out how much profit you can expect after buying a rental property with no more than four units or a building with five or more units involves much more than just subtracting expenses from income. Since this is a long-term investment, several factors will influence (positively, we hope) your building’s market value over time:
- Is the building in a good location? Is it in a popular, safe neighbourhood?
- Does the area have strong development potential or is it in decline? For example, property near a planned metro extension might increase in value.
- Is the property near a number of amenities, public transportation, a hospital, or a school?
- Is the type of property you’re looking at in demand in that neighbourhood? For example, if there’s a commercial space on the building’s ground floor, make sure the building is on a commercial street and there are other stores nearby.
- What is the building’s occupancy rate?
- How much rent do the tenants pay? A building with apartments rented below market price isn’t worth as much as one with higher monthly rents.
- Do all the tenants pay their rent on time?
- If there’s a commercial tenant, what business are they in? How long have they been there? Some financial institutions find certain business sectors to be risky.
- Are the leases evenly distributed? If one of the businesses occupies 80% of the leased units and its lease will soon be up, you may find yourself with a number of vacant units. Sometimes it’s better to have several small commercial tenants rather than one big one.
- Do the leases have short or long terms? Read them. If any of the leases will expire soon, you may end up with a vacant unit.
Condition of the building:
- To avoid any unpleasant surprises and possibly negotiate a lower price, have a certified building inspector inspect the property.
- Determine how well the building has been maintained. If the owner has hired a building manager and you want to keep them, this will be an additional cost that may lower your profit.
How do you calculate the profit on rental property?
There are several ways to determine your profit on income property.
Debt-service coverage ratio (DSCR)
This is the simplest way to determine how profitable a building is. Just subtract all your annual expenses, such as mortgage payments, utilities, municipal and property taxes, maintenance costs, and insurance, from the total annual rent.
If income equals 125% of expenses, meaning you earn $125 in income for every $100 of expenses, the profit will be acceptable.
Bear in mind that this is merely a guide. Talk with an expert to make sure the building will generate enough profit.
Gross income multiplier (GIM)
The gross income multiplier (GIM) is a quick way to calculate rental property income.
The formula is simple: divide the building’s purchase price by annual gross income.
While simple, this ratio is not the most accurate because it doesn’t take all of your building-related expenses into account. However, it’s an easy way to compare similar buildings in different areas.
We recommend using the discount rate for commercial buildings and buildings with 12 or more residential units.
This is another simple calculation: divide the net income generated by the building by its market value.
The discount rate is used a lot for comparison purposes. For example, you can compare your desired building’s discount rate with market discount rates by building type and location.
How can I make my rental property more profitable?
To make a rental property more profitable, you have to analyze your costs and operations first, and all the available options second. For example:
Raise the rent
Let’s talk first about raising the rent. This might be an option, but it might make some of your long-term tenants move out. In addition, rent increases must comply with applicable law, be reasonable, and must respect tenants’ rights. Rent increases are warranted and easier to justify if you’ve renovated the units and maintain the building properly.
Improve the building’s energy efficiency
Doing work to improve the building’s energy efficiency, such as replacing doors and windows, might reduce your energy bills. That can help you increase your net income from the building.
Streamline your costs
Reducing your administrative costs can be another way to increase profitability. Review all your expenses, such as snow clearing, landscaping, and concierge or building manager costs. You may find budget items where you can cut costs and increase revenues.
Upgrade the units
By adding services or making the units more luxurious, such as by providing Internet, a garage, or even a carport, you might be able to raise rents.
What other factors affect rental property profits?
- The down payment you make on the building is a profitability factor. The bigger it is, the lower your mortgage payments will be and the more income you’ll earn from your building.
- The tax impact of the capital gain can also affect the profits you realize when you sell. When you sell your rental property you’ll be able to recoup the amortization expense, which is considered 100% taxable income. In addition, 50% of the capital gain is taxable. You’ll want to consider all this and expected profits when selling a property. That’s why it’s very important to understand how capital gain works. Talk to a tax lawyer or accountant about it.
- Tax exemptions for certain investments can also increase your income by reducing your taxes. For example, costs such as building renovation costs are tax deductible. That’s another factor that can make a building more profitable.
Taking the long view will also help you generate rental property income. For this type of property, supply, demand, and sales remain constant over time. Year after year your building should increase in value, giving you a return on investment when you sell.