Despite the travails in the market in the 2020s, investing in real estate remains a solid strategy for building wealth, offering diverse avenues such as residential, commercial, rental properties, and real estate investment trusts. While it’s traditionally been a major way most Americans attain wealth over time, the market was rocked this decade by the pandemic, the near freeze-up of the commercial and residential real estate market, and interest rates at decades-long highs.
Given the higher interest rates and market uncertainties, the ability to analyze the key metrics of real estate investing is crucial for any success. Today’s best real estate investors are those who can look beyond a property’s facade and dig into the financials. The eight metrics below provide a foundation for that critical analysis, helping you potentially uncover hidden gems when the mantra is less “location, location, location” and more “calculation, calculation, calculation.”
For patient and savvy investors, the challenges of this decade are a reason to think there are many prospects to find that were previously left aside when demand was low. In this article, we’ll break down eight essential numbers to find these prospects, explain their significance in today’s market context, and show how to apply them to your advantage.
Key Takeaways
1. Your Mortgage Payment
For a standard owner-occupied home, lenders typically prefer a total debt-to-income ratio of 36%, depending on other qualifying factors, such as your credit score and cash reserves.
The debt-to-income ratio compares your total gross monthly income with your monthly debt payment obligations. For housing payments, lenders prefer a gross income-to-total housing payment of 31% to 33%, depending on other factors. For an investment property, Federal Home Loan Mortgage Corp. (Freddie Mac) guidelines put the maximum at 45%.
2. Down Payment Requirements
For investment properties, down payment requirements typically range from 15% to 25% of the purchase price, depending on the lender and property. This is higher than for owner-occupied properties, which can be as low as 3.5% for Federal Housing Administration loans.
Individual lenders will determine how much you need to put down to qualify for a loan depending on your debt-to-income ratios, credit score, property price, and likely rent. Paying a higher down payment isn’t all negative. With tighter lending standards in the mid-2020s and higher interest rates, larger down payments are needed to get some deals done. Here are some further considerations:
Impact on returns: A larger down payment reduces your mortgage but ties up more of your capital. Calculate how different down payment amounts affect your cash-on-cash return.Private mortgage insurance (PMI): For down payments of less than 20%, you may need to pay PMI, increasing your monthly costs.Leverage: While a smaller down payment increases your leverage potential, it also increases risk. In a fluctuating market, ensure you’re comfortable with the level of leverage you’re taking on.Liquidity: Consider how much liquidity you need to maintain for other investments or unexpected expenses.Source of funds: Investment property down payments can’t come from gift funds. You’ll need verifiable sources for your down payment.
The National Association of Realtors produces periodic reports on each major locality, broken down by state, that provide recent statistics for where you might be interested in purchasing property.
3. Rental Income to Qualify
While you may assume that, since your tenant’s rent payments will (hopefully) cover your mortgage, you shouldn’t need extra income to qualify for a home loan. However, for the rent to be considered income, you must have a two-year history of managing investment properties, purchase rent loss insurance coverage for at least six months of gross monthly rent, and any negative rental income from any rental properties must be considered debt in the debt-to-income ratio.
Lenders often consider potential rental income when qualifying for an investment property mortgage. However, they approach this cautiously to ensure the investment’s viability. Here are additional considerations:
Market research: Conduct thorough research on local rental markets to ensure your income projections are realistic and sustainable.Vacancy rates: Consider local vacancy rates when projecting your rental income. High vacancy rates might mean you need to budget for longer periods without rental income.Short-term vs. long-term rentals: If you’re considering short-term rentals, be aware that some lenders may be more hesitant to believe in this less predictable income stream.
4. Price-to-Income Ratio
The price-to-income ratio is valuable for assessing the overall affordability of a market, which can impact both property values and rental demand. It’s the median property price in an area divided by the median annual household income.
A high ratio indicates an overvalued market, while a low ratio might suggest potential for appreciation. Some historical context:
In 1988, the average U.S. price-to-income ratio was about 3.2During the 2006 housing bubble, it peaked at around 4.7As the housing crisis abated, it was 3.3In October 2020, during the pandemic, it was 3.2In 2023, it was at 4.9
Some further considerations:
Market stability: A ratio significantly higher than historical norms may indicate a market at risk of correction.Rental demand: High ratios often correlate with stronger rental markets, as fewer people can afford to buy.Regional variations: This ratio can vary significantly between different cities and neighborhoods. Always consider local market conditions.Income trends: Factor in projected income growth in the area, which could support higher ratios.Government policies: Be aware of local housing policies or initiatives that might affect this ratio.
In 2024, housing starts were nearing one million single-family units annualized, suggesting growing confidence in the single-family home market after the pandemic and high interest rates significantly slowed increases in new housing stock.
5. Price-to-Rent Ratio
The price-to-rent ratio compares the purchase price of a property to its annual rental income. To calculate it, divide the property price by the total annual rent it could generate.
For example, if a home costs $300,000 to buy and could rent for $2,000 per month ($24,000 annually), the price-to-rent ratio would be as follows: $300,000/$24,000 = 12.5
The price-to-rent ratio helps investors quickly assess whether a property’s price is justified by its rental income potential. Here’s a rough guide to interpreting the ratio:
15 or below: Potentially good investment opportunity16 to 20: Moderate investment potential21 or above: May be overpriced; exercise caution
In the case of higher ratios (21 or above), investors should be wary since these properties may be less likely to generate positive cash flow and could be riskier investments. However, “good” ratios can vary by location. In expensive urban markets, higher ratios may still be solid investments. Conversely, very low ratios in some areas could signal other issues, like a declining neighborhood.
6. Gross Rental Yield
Gross rental yield is a straightforward metric that gives a quick snapshot of a property’s income-generating potential. It’s calculated by dividing the annual rental income by the property’s purchase price, then multiplying by 100 to get the percentage.
For example, if a property costs $200,000 and generates $16,000 in annual rent:
Gross Rental Yield = ($16,000 / $200,000) x 100 = 8%
A higher gross rental yield generally indicates a better investment. However, it doesn’t account for expenses, so it should be used as an initial screening tool rather than a definitive measure of profitability.
Investors look for gross rental yields of 7% to 10% or higher, depending on the market. In addition, properties with higher gross yields may come with added risks or costs, so further analysis is crucial.
7. Capitalization Rate
The capitalization rate, or “cap rate,” is a property’s net operating income (NOI) divided by the property value, then multiplied by 100 to get the percentage.
The NOI is the annual rental income minus all operating expenses (excluding mortgage payments and income tax).
For instance, for a $500,000 property generating $50,000 in NOI, the cap rate would be as follows:
Cap Rate = ($50,000 / $500,000) x 100 = 10%
A higher cap rate suggests a better return on investment, but also higher risk. Here’s a rough guide:
4% to 5%: Lower risk but also lower returns (often seen in high-demand urban areas)6% to 8%: Balanced risk and return9% or higher: Greater potential returns but higher risk
Cap rates are forward-looking measures of investors’ return expectations, but realized returns can differ for these reasons:
Rent growth: Higher inflation can accelerate increases in rent, particularly for properties with short-term leases. This can offset higher interest rates, but an economic downturn could slow rent growth and increase the cap rate.
Economic indicators and the economic cycle: Gross domestic product and unemployment rates reflect overall economic health. Strong economic conditions typically lead to lower cap rates, while weaker conditions can increase investment risk and cap rates. During economic stress, cap rates may increase even as interest rates decrease, reflecting higher perceived risk.
Location: Properties in high-demand, stable areas generally have lower cap rates, while those in transitional or outlying areas often have higher cap rates because of greater volatility and the potential effects on cash flow.
In recent years, multifamily and industrial properties have shown the lowest cap rates. Economic factors may affect asset classes differently. For example, personal income heavily influences multifamily and retail.
8. Cash Flow
You are in good shape as a landlord if you can cover the mortgage principal, interest, taxes, and insurance with the monthly rent. For this reason, cash flow is one of the most critical metrics for real estate investors, representing the net amount of cash generated by a property after all expenses and mortgage payments have been made.
Positive cash flow means the property is generating more income than it costs to operate, while negative cash flow means the opposite. For example, a property that generates $2,000 in monthly rent, has $600 in operating expenses, and a $1,000 mortgage payment would have the following cash flow:
Cash Flow = $2,000 – ($600 + $1,000) = $400 per month
Your operating expenses typically include the following:
Property taxesInsuranceMaintenance and repairsProperty management feesUtilities (if not paid by tenants)Vacancy
Here are some key points about cash flow:
Positive cash flow provides a cushion for unexpected expenses and market downturns.Even properties with slightly negative cash flow might be worthwhile if there’s strong potential for appreciation or if the negative cash flow is tax-deductible.Cash flow can vary month to month due to unexpected repairs or vacancies, so it’s wise to maintain a reserve fund.Strategies to improve cash flow include increasing rent, reducing expenses, or refinancing to a lower mortgage payment.Cash-on-cash return, which measures annual cash flow against the initial investment, is a related metric that helps investors compare opportunities.
Remember, while positive cash flow is generally desirable, investors should consider other factors like potential appreciation, tax benefits, and long-term equity buildup when evaluating a property’s overall investment potential.
What Is Cash-on-Cash Return?
Cash-on-cash return measures the amount of cash flow in relation to the amount of cash you’ve put into a property. It’s calculated on a pretax basis. Cash-on-cash returns can be used to set a target for projected earnings and expenses.
What Considerations Should Investors Keep in Mind Regarding Equity and Fair Housing?
Historical practices like redlining, discriminatory lending, and exclusionary zoning have left lasting scars on American real estate markets. These policies denied minorities access to homeownership and specific neighborhoods, leaving persistent wealth gaps and disparities in property values in their wake.
Investors in the 2020s can contribute to more equitable communities by understanding local histories and considering the impact of their investments on longtime residents. Fair housing laws, awareness of unconscious bias, and pursuing prospects across diverse markets can help prioritize equitable development in a sector that has rarely practiced it.
How Is “Proptech” (Property Technology) Influencing Real Estate Investing?
Proptech is changing the real estate industry with smart building systems, virtual property tours, and advanced property management software, which comes after a decade of app-based shifts in how investors and consumers purchase real estate.
In recent years, the National Association of Realtors has made a big push in this area, wanting to get ahead of changes that could upend the livelihoods of the group’s members. As these changes come on board, investors need to consider how proptech adoption might affect property valuations, efficiency, and competitive advantage in the market.
What Are Housing Starts and Why Are They a Crucial Real Estate Metric?
Housing starts measure new residential construction projects that have begun during a specific period, with each “start” recorded when excavation begins for the foundation of single-family homes, apartments, and condominiums.
Housing starts are crucial because they serve as a leading economic indicator, help forecast future housing supply, provide insights for real estate investors, inform policy decisions, reflect consumer confidence, and indicate the construction industry’s health.
The Bottom Line
Given the volatility of the mid-2020s real estate market, success hinges on due diligence—that is, thorough financial analysis. These eight essential metrics—mortgage payment, down payment requirements, rental income qualification, price-to-income ratio, price-to-rent ratio, gross rental yield, capitalization rate, and cash flow—provide a comprehensive means for evaluating potential investments.
By mastering these calculations, investors can better navigate market uncertainties, identify prospects across various asset classes, and make data-driven decisions.
