- - Thursday, November 3, 2011

Q. I’ve been watching interest rates fall and property values collapse over the past several years. It seems to me that this might be a good time to purchase an investment property.

I’ve read that the rental market is as strong as ever. This, coupled with low rates and depressed values might make the timing perfect for such an investment.

I read your column, and you appear to keep on top of these events. Thoughts?

A. I also have read that the rental market nationally is very strong, and your logic certainly makes sense. The problem is that no one really knows for sure when the housing market will revive and values will start to appreciate. But I agree with you that the combination of a strong rental market, low interest rates and depressed property values paves the way for a good opportunity.

Such a decision should never be made without crunching some numbers. Before investing in real estate, you need to determine the asset’s capitalization rate, or “cap rate.” This is simply the rate of return an asset makes based on its value. Let’s illustrate.

Suppose you find a property and purchase it for \$200,000. Your research concludes that you are able to rent out the unit for \$1,500 per month, or \$18,000 annually. You determine that the annual expenses include real estate taxes of \$2,000, insurance of \$800 and estimated maintenance of \$500. What’s the cap rate?

First, subtract the annual expenses from the gross rent, and we have a net income of \$14,700. Because the property is worth \$200,000, divide the net income by the value and you see that the cap rate is 7.35 percent.

Think of a cap rate as a stock dividend and the purchase of the property as an investment in a particular stock. The property is paying you an annual return on your \$200,000 investment of 7.35 percent. At the same time, you are hoping the value of your investment will rise over time, just as investors in the stock market are betting the stock price will increase.

Now let’s talk about financing the property with a mortgage. The picture changes significantly. Let’s assume you put 20 percent down and finance \$160,000 at 4.75 percent on a 30-year fixed-rate mortgage. The monthly principal-and-interest payment is \$835, or \$10,020 annually.

Your annual expense suddenly rises from \$3,300 to \$13,320. But your cash investment drops from \$200,000 to a cash down payment of \$40,000, plus closing costs of, say, \$5,000.

Now you have \$45,000 cash invested in the deal, \$18,000 in gross revenue and \$13,320 in total expenses. Let’s divide your net income of \$4,680 into the \$45,000 cash investment, and your annual return jumps to 10.4 percent.

This is the beauty of superlow interest rates. If the mortgage rate were 6.75 percent, for example, the annual mortgage cost would jump to \$12,453 and your net revenue would drop to \$2,247, resulting in an annual return of just 4.99 percent.

There are other things you need to consider, however, such as a “vacancy factor.” While the rental market may be strong, there’s no guarantee the unit will be rented 100 percent of the time.

One last caution: I just pulled these numbers out of my head while writing this column. Keep in mind the saying, “Garbage in, garbage out.” You can crunch the numbers all day long, but if the assumptions and the numbers are inaccurate, your conclusion as to whether the investment is sound will be wrong.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.