A smart investor knows it would be financially foolish to jump into a property purchase without first doing a few essential calculations to see if it’s even a good deal or not. Many of these investors will at least calculate the rent to price ratio (RTP), which offers a good gauge of a property’s potential yield and affordability. In other words, this metric provides useful insights to those interested in moving forward with a deal, letting them know if a property is capable of providing a good return on investment.
Using a metric tool such as this is important because shelling out thousands of dollars to buy a rental property before even knowing its potential could possibly place an investor in the red. With that said, let’s dive in to learn more so you can be on top of your game when searching for your next investment property.
What is Rent to Price Ratio?
The rent to price ratio is a financial metric used to evaluate the relationship between the income generated by a rental and its purchase price. Simply put, it’s a math equation that divides the annual rental income by the purchase price, and the final result is often expressed as a percentage. It’s commonly used to compare or evaluate rental properties, where a higher rent to price ratio typically means that a property can produce a substantial amount of rental income compared to its cost, which can possibly make it a wise investment. The bottom line is that it enables the investor to get a better idea of the profitability factor of a rental so they can use that knowledge in deciding if they should move forward with pursuing the property further.
How to Calculate Rent to Price Ratio
When considering a rental property, it’s important to understand how much rental income it can generate compared to its purchase price. To calculate this, you’ll need the rent to price formula, which I’ll use in the following example that can give you a good idea of how to move forward by plugging in your own numbers to evaluate a property.
Standard Rent to Price Formula:
RTP = Monthly Rental Income x 12 ÷ The Purchase Price
I’ll put this formula into action with the following example of an investor considering a property that rents for $2,000 per month and has a purchase price of $400,000.
Using the formula, they would calculate the annual rental income, which would be $2,000 a month multiplied by 12 months, which comes to $24,000 a year. They would then take the yearly rent of $24,000 and divide it by the purchase price of $400,000, and that comes to 0.06. This number can be multiplied by 100 to get a percentage point, which equals 6%.
6% is a good number, as most investors consider anything above 5% to be profitable as a rough estimate. Using this calculation is a good idea because it’s important to assess a rental property before moving forward if your goal is to build wealth and become a successful investor. For instance, when you own a rental property that reels in a profit and also increases in value each year, you can use the property’s equity to buy an additional piece of real estate. Take a moment to read more about this in my article Harnessing the Power of Home Equity to Buy a Rental Property. Keep in mind that if you invest in a rental that lands you in the red, this scenario may not be possible.
Calculating Your Expenses into the Equation
When you calculate the RTP ratio for a property you’re interested in, it’s essential to ensure that the final number is high enough to cover all your expenses. These might include the typical costs such as your mortgage, property or landlord insurance, taxes, repairs, and so on. When it comes to taxes, I’ve always been able to increase my ROI by putting a good tax strategy in place. This is really important, and I advise you to watch the following video that can teach you how to lower your tax burden and, in some cases, pay zero.
Significance of Rent-to-Price Ratio in Real Estate Investing
As discussed, analyzing the rent to price ratio is a helpful calculation used to take a closer look at individual investment properties, compare rentals and even housing markets. It can set an investor on the right path when it comes to achieving a high ROI, building wealth, and growing their portfolio – so, as you can see, it’s a pretty essential metric. To drive this point home, I’ll provide another example of how useful and essential the rent to price ratio formula is, and in this case, I’ll compare two housing markets:
You’re interested in purchasing two similar 4-bedroom single-family rental properties that are located in two different markets: Market A and Market B.
Specs for Market A:
The annual rent is $30,000, and the purchase price is $350,000. Based on this, the calculation would be as follows:
$30,000 ÷ $350,000 = 0.0857 or (8.57%)
Specs for Market B:
The annual rent is $24,000, and the purchase price is $200,000. Based on this, the calculation would be as follows:
$24,000 ÷ $200,000 = 0.12 or (12%)
Before doing any calculations, at first glance, seeing that the Market A property will pull in $30,000 compared to the $24,000 that the rental in Market B will generate, an investor might feel that the higher annual rental income is the more profitable deal. However, as seen in the rent to price ratio calculation, the property that sports the lower rent actually has a higher RTP ratio and, therefore, offers a more lucrative return. THIS is why it’s so important to do the math.
Benchmark RTP Percentages to Shoot For
Although investors may have benchmark numbers that vary, a good scale to go by would be an RTP Ratio of 8% or higher. This can be deemed a great number because it points to a potentially profitable rental yield. In contrast, anything under 5% would be considered an unsure deal given the fact that it may not provide enough income to be profitable, and may not even cover expenses.
The bottom line is that a higher rent to price ratio indicates it may reel in more income relative to the property’s purchase price and therefore, provide a higher return on investment.
RTP Ratio vs The 1% Rule
Just in case there are some investors out there who are using what’s called the 1% rule, I’d like to provide a little information so there’s no confusion. In real estate investing, the rent to price ratio and the 1% rule are related concepts but they’re not exactly the same thing.
As you’ve learned, the rent to price ratio is a calculation used to compare the monthly rental income of a property to its purchase price, and this ratio helps investors determine if a rental property can generate enough income relative to its cost. On the other hand, the 1% rule is a guideline used by investors to quickly figure out if a rental property could be a sound investment.
How it works is that the monthly rent that a property produces should be at least 1% of its purchase price to be considered potentially profitable. While both metrics aim to evaluate if a property is a wise investment or not, the 1% rule is more of a benchmark for a very quick evaluation that tells an investor if the property is worthy of evaluating further to ensure it’s, in fact, a good deal. In comparison, the rent to price ratio provides a more comprehensive view of the property’s investment potential.
You can get a full overview and compare the differences by heading over to my post titled The 1% Rule for Real Estate Investing.
Utilize the RTP Ratio Formula to Safeguard Your Wealth
I speak from personal experience when I say using the rent to price ratio calculation is a smart way to evaluate a property to know if it’s worth your time and your money. This metric has given me great insight on specific rental homes more than a few times, letting me know if they would offer a good return on my investment or not, so I wasn’t blindly moving forward with a deal, risking losing out financially.
I’d like to offer a bit of advice, though – when considering a rental property, definitely calculate the RTP ratio, but don’t depend on it. Why? Because when it comes to investing in real estate, there are many moving parts and so you’ll want to ensure all your bases are covered. That said, if you’re not experienced in buying real estate, you’ll also want to run your numbers and specs by a seasoned real estate investor. This means having them not only take a look at your RTP calculations, but also evaluate the neighborhood or housing market the rental sits in, the condition of the property, and your projected expenses. In addition to this, you’ll want to read the following article I put together on rent comparables and gross rent multipliers, which are additional key tools for evaluating an investment property’s revenue potential.
Buying Turnkey Rental Properties Through a Full-Service Investment Company
If you’d like to invest in real estate but are unsure how to move forward and don’t want to deal with all the steps needed to locate and analyze a potential rental, I suggest buying a turnkey property from a full-service investment company. If you go down this path, every step of the process will be taken care of for you, and you’ll then have a cash flowing rental property in your portfolio.
Morris Invest is actually more than a turnkey company though, because we offer so much more on a personal level. As Justin French, CEO of SDIRA Wealth, the company we partnered with, explains: “From the moment an investor joins us, we guide them through every step—from providing exclusive access to our new construction properties with bulk pricing and benefits, to connecting with preferred lenders for financing, partnering with top property management teams, and offering ongoing education.” If you’re curious about SDIRA Wealth, head over to this page we just put together: More Than Just Turnkey—Experience Full-Service Build-to-Rent Real Estate with SDIRA Wealth.
Morris Invest and SDIRA Wealth provide investor support for the life of the property, and even place a tenant in your rental for you. We also offer exceptional resources and programs, which you can check out below:
- Freedom Number Cheat Sheet
- 90-Day Financial Empowerment Bootcamp
- Morris Invest & SDIRA Program Overview
Those who would like to hear about our new construction turnkey properties or have questions regarding how it all works, feel free to book a call with us. The team at Morris Invest looks forward to connecting with you and helping you jump on the path to financial freedom through rental real estate investments.
In the meantime, grab your favorite drink and dive into the following video for some inspiration:
