Everyone likes to say you can get wealthy off real estate through acquiring investment property. However I beg to differ. You can also lose your ass too. There are a lot of definitions of what a “good” investment property in Chicago is. The premise of a “flip” property is pretty easy to understand – buy low, sell high.
But let’s talk about long term investment property in Chicago and what you may want to look for.
There are 2 numbers you should look at when determining if this is the right investment property in Chicago to buy. Those are Cap Rates & Cash on Cash return.
No piece of real estate is worth buying that does not meet a certain criteria. Buying real estate is great, but making smart real estate investments is way better.
So, what the hell is a Cap Rate?
(Net Annual Income / Purchase Price) x 100 = Cap Rate
According to www.investopedia.com, “cap rate” is defined as, The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on his or her investment.
This is a simple formula many real estate investors use to initially check if a property meets their minimum criteria. When you buy investment property in Chicago, your first step should be to determine your desired returns. There is no emotion involved so don’t fall in love with any property and focus on the numbers. You may set a desired cap rate up front and only really dig into properties that meet this initial criteria.
I want to define what I mean by net income so it is not overlooked. The Net income is the money left over after all bills and expenses are paid. Gross is the total amount of rent you receive.
For example, let’s say you buy an investment property for $100k, and you’re able to pocket $500/month after all bills & expenses are paid, which is your Net monthly income. $500/month Net x 12 months in a year = $6000 Net Annual Income
($6000/ $100,000) x 100 = 6% Cap Rate
Simple enough, right? Now some will argue that a “6 Cap” isn’t worth the investment and wouldn’t touch it with a ten-foot pole. Surprisingly enough, in most cases, they’d be 100% justified. Other investors may look at Cash on Cash Return and think differently.
The first thing I would recommend is finding out what cap rates most other investors shoot for. For example, in the south and west sides of Chicago, many investors see properties with higher cap rates since the sales prices are lower. These properties may also have more management duties required.
If you were to look at a true armchair investment property in a very desirable area, you may see a lower cap rate, but it would be more of an arm chair investment. Units typically rent themselves when you put up for lease.
When you begin narrowing down your area and strategy, you want to take in the cap rates of different areas and see if you can find some trends.
Cash on Cash Return
(Net Annual Income / Cash Invested) = Cash on Cash Return
According to Wikipedia the definition is as follows;
Let’s use that same $100k property in our Cash On Cash calculation. Assume we got a loan for 80% of the purchase price or $80,000 on a $100k property. In this example the buyer would put down 20% or $20,000.
$6000/ $20,000 = 30%
If they were to net $6,000 a year on that investment property, they would see an annual return of 30% based on the money invested.
I don’t know about you, but if I could find a Mutual fund paying 30% annually, I’d be richer than Ken Griffin.
It’s up to you to determine which metric is more important when considering buying an investment property in Chicago, but why not use both?
One could argue that Cap rates only matter when you’re buying or selling a property. It’s one of the quicker and more popular metrics showing a property’s value based on the income it generates.
One important note – any financing or mortgage costs ARE NOT considered in Cap Rate calculation while the Cash On Cash return metric is entirely dependent on financing, and IS ALWAYS taken into consideration. The interest rates won’t affect it much, but the down payment amounts will change the number the most. So if you only can use one of the two, use the Cash On Cash return, unless you pay cash for the property – then they’ll be the same anyway.
I really hope tis article spelled out some of the basic metrics that many real estate investors use when determining if an investment property is worth it or not, but now that you’re a shrewd real estate investor, let’s start looking for your next investment!