Buying rental property remains one of the best classes of investment available. Properties offer the combined benefits of capital growth, ongoing cash flow and significant tax benefits. However, it is just as easy to buy rental properties the wrong way, causing significant financial damage.
People often buy rental property for appreciation. If you buy a $300,000 property and it increases in value to $400,000, you have made $100,000 or a 25 percent return. The returns are heightened when you “leverage” (borrow money). For instance, if you put $100,000 down and borrowed $400,000 to buy a property, and it sold for $800,000, and use the proceeds to pay off your loan, you would get $300,000. That’s why real estate is an attractive investment.
While certain investors buy properties for their appreciation potential alone, other rental properties provide cash flow. If you have money left over from your rent after paying your operating expenses, you have a “net operating income (NOI).” If you have money after paying your mortgage, you have net cash flow.
Real estate benefits from a number of tax advantages. While owning real estate, equity builds without needing to pay tax on it. At the same time, you can write off numerous expenses, including depreciation – which shield a large portion of your income from taxes.
The Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) is the metric that commercial real estate lenders use when they are deciding whether to lend on a property. To calculate, they divide a year’s worth of mortgage payments into the property’s annual NOI. Having a positive DSCR means that you will have a positive cash flow and that the property can be self-sustaining.