There’s nothing new about buying a house and renting it out to make some extra income, but the flood of foreclosures that began in 2007 sparked fresh interest in purchasing rental real estate for investment. Today, millions of individual investors, as well as huge Wall Street hedge funds, have invested billions of dollars into purchasing houses, fixing them up, and renting them out.

Rental real estate is one of the few investments that generate significant returns while you still own the asset. But how do you know you’re choosing the right property?

What constitutes a good rental property?

What makes a property a good investment? Local rental rates, which are a function of jobs generated by the local economy, are critical. But how do you know what rents will be like in 10 years? How can you anticipate management-related costs, including maintenance and repairs? What happens if you lose your tenant suddenly and can’t find a replacement?

A good way to measure current and potential profitability of a rental property is to compare its annual net operating income (the income after operating expenses are deducted) to either its capital cost (what you paid to buy the property) or its current market value. This is called the capitalization, or “cap,” rate.

(Real Estate Investing: How to Be a Good Landlord )

Calculating a cap rate

To figure out the cap rate, divide the annual net operating income by the capital cost or current market value. The higher the cap rate, the more profitable the rental property will be.

For example, assume that you purchase a home for \$150,000, and you charge \$1,200 a month, or \$14,400 a year, for rent. Then you hire a management company, which charges you 10 percent of the rent, or \$1,440. Your projected vacancy costs—the annual rent loss you can expect when the property is not being rented—will likely be between 5 percent and 10 percent of the annual rent, or between \$720 and \$1,440 each year. To calculate the cap rate, assume the higher vacancy costs.

Your other costs will vary significantly by locale. For the sake of this example, though, assume that each year you’ll spend \$750 in maintenance costs, \$710 in taxes, and \$650 for property insurance.

Subtract all of your expenses (which total \$4,990) from the annual rent (\$14,400) and divide the remainder by your acquisition costs (\$150,000). In this example, your cap rate—the annual return on your investment—is 6.3 percent. You should shoot for at least an 8 percent return, so the example property may not be a good investment.

Note that in the example, the buyer paid cash and did not finance the deal. Monthly finance charges change the math dramatically.

How to use cap rates

While cap rates offer the opportunity to make quick, easy comparisons between two or more pieces of property, they’re far from the only factors you should consider. At the very least, you’ll also want to consider the growth potential of your property’s income, as well as any likely changes in the value of the property itself, such as a highway, subway stop, or retail center going up nearby.

Finally, do your research on the local economy. At the end of the day, cities that offer jobs and opportunities are the locations that will provide you with tenants over the long haul.

Resources

You can find out a lot about markets around the country with a little time on the Internet. For research on the local economy, check out the Bureau of Labor Statistics, Forbes’s “The Best Places for Business and Careers,” and Projections Central.

Additionally, several real estate research companies occasionally publish market rankings based on cap rates and acquisition costs for foreclosures and investment properties. These include RealtyTrac, HomeVestors-Local Market Monitor, Clear Capital, CoreLogic, and PropertyRadar.

For information on local real estate markets, both purchase and rental, check out Realtor.com, Zillow, Trulia, DataQuest, the National Association of Realtors, and the U.S. Department of Housing and Urban Development (HUD).

Steve Cook is executive vice president of Reecon Advisors and covers government and industry news for the Reecon Advisory Report. He is a member of the National Press Club, the Public Relations Society of America, and the National Association of Real Estate Editors, where he served as second vice president. Twice he has been named one of the 100 most influential people in real estate. In addition to serving as managing editor of the Report, Cook provides public relations consulting services to real estate companies, financial services companies, and trade associations, including some of the leading companies in online residential real estate.