In the world of purchasing income producing properties, looking at financial statements can be a daunting task.
Here are 2 rules to consider whether a property could be profitable for you…simple guidelines to consider when deciding to purchase or not.
1. The 1% Rule
When purchasing a property for investment purposes, it requires a thorough analysis of future rents compared to cost of owning the property. Property owners want to maintain a cash greater than it’s costs
The 1% rule is a quick calculation that can help determine if the property you are considering investing in could be profitable.
eg. Investor looking to purchase $200,000 property with 20% down payment leaving a mortgage of $160,000. The 1% rule says that the home would have to be rented for no less than $1600/month.
If the property can not generate somewhere in the neighbourhood of this amount, chances are the property will not be profitable.
This rule is used for a quick estimate, it is a starting point to determining the profitability of the property.
2. Debt Coverage Ratio (DCR)
This is used to determine the ability of the property to cover payments on its debts. It also provides lenders information on the extent the income properties net operating income (NOI) covers the debt service. It helps the lender determine whether the property generates enough cash to cover debts.
For every dollar ($) paid out in expenses, the lender likes to see a minimum of a $1.20 generated in income or DCR minimum of 1.2. Showing the current rental property is showing a profit. The higher the DCR, the more profitable the investment will be.
eg. Determine Net Operating Income (gross income minus all operating expenses = NOI)
Rental income of $150,000 minus $72,500 (expenses) = $77,500 $77,500 divided by 12 months = $6458/month NOI Monthly income of $6458 divided by 1.2 (DCR) = $5382
This example indicates that based on these numbers, the monthly mortgage payment can not exceed $5382 per month in order to have the DCR at 1.2.
Every property is different and has its pros and cons to determine profitability. These are quick references to help you in your search for a profitable investment property.
If you have any questions on how one of these items may affect you, please call us. It is important to get it right!