I bought my first rental property in 2008. It was a big two-story home on a cul-de-sac. Four beds, three baths, and three living areas. 2,600 sq ft. Corner lot with a huge backyard. Mountain views from the master balcony.
It was a great place to raise a family. And it was a complete loser for a newbie investor.
What did experienced investors know that I didn’t? For one, the best home doesn’t make the best rental. Perhaps most importantly, a rental property investment is all about the numbers. What you buy it for, what it will rent for, and all of the costs along the way.
I didn’t look at the numbers closely at all. I simply thought I was buying a good house at a good price, and that people would want to rent it from me.
I’ve learned a lot since then, applied it to my next 3 purchases, and am now a real estate millionaire!
Here’s what you need to know so that you only buy winning rental properties.
1 The keys to making money in real estate: Cap Rate and Return on Investment (ROI)
Any piece of real estate will make you money if the price is right. But what does that price need to be to make it worth the investment? That’s literally the million-dollar question.
The price I’m willing to pay is set by how much the property rents for and my estimate of all of the expenses that go into owning and operating it over many years.
There are several useful metrics that can be calculated from these numbers to estimate the property’s investment potential for a given price.
Enter your email below to get the simple rental property ROI calculator that I use!
First I have to narrow down the field.
1.1 The 1% Rule
The ‘1% Rule’ is the first test that I use to find properties I might invest in. It allows me to quickly filter properties and to invest with logic instead of emotion. I want to be thinking “Wow, those numbers look great!” rather than “OMG. That house is soooo cute!”
The 1% Rule says that the monthly rent needs to be at least 1% of the purchase price. A $250,000 house needs to rent for at least $2,500 per month, for example.
I estimate the rent using rent comps (comparisons) that my realtor finds on the MLS (Multiple Listing Service) or from a website like Zillow.
If the monthly rent is less than 1% of the purchase price, there would need to be something unique about the property where I can add value. For instance, there could be a basement that I can inexpensively convert to a separate unit. Or land that I can subdivide and build a second home on. I’ll talk more about ‘value add’ in a separate article in this series.
Usually, if the property doesn’t pass the 1% Rule it’s not worth my time and effort, and my money would be better off in the stock market.
The S&P 500 isn’t going to call me in the middle of the night to fix a toilet. So I’d better be sure that real estate deal is worth it!
1.1.1 What if nothing meets the 1% Rule?
My rentals are in Arizona, and I haven’t seen 1% there for years. This doesn’t mean no one is successfully investing in rentals there anymore, or that the situation won’t change as rents rise. But it makes it less worth my time.
If the 1% Rule doesn’t work currently in your area, consider other areas you know well. In the US, the highest rent-to-price ratios are usually found in the middle of the country.
OK. Now you’ve looked everywhere and can’t find properties that meet the 1% Rule. But you still want to get into the rental market. Consider this:
- There are creative ways to get higher profits. Many of them—such as borrowing more and putting less money down—also come with added risk. Others—like finding deals that aren’t on the market—require more work from you. Are you willing to take more risk or put in more work? Or do you really just want to sit back and let the stock market do the work? You can make outsized profits in real estate, but you need to put in the work and take some risk to make it happen.
- What are the highest rent-to-price ratios that you’re finding in your location? 0.75%? Maybe you’re willing take deals that meet the ‘0.7% Rule’ to the next stage.
1.2 Cap Rate
After a property has passed the 1% Rule, I’ll move to a more detailed metric called the cap rate (short for capitalization rate). A property has to pass my initial cap rate calculation before I visit in person. This step has saved me a ton of driving!
The cap rate takes the annual income of a property, regardless of the cost of financing, and divides by the purchase price.
Cap rate can be used before anyone knows how the property will be financed. This makes it the most common metric used by investors. And it’s frequently quoted in multi-family and commercial property listings, where the buyer and seller are both investors.
Basically, what the cap rate tells you is the expected return on your investment should you decide to purchase the property in cash—assuming the property doesn’t require substantial renovation.
Deals typically look good as long as the cap rate is above the mortgage interest rate. But my rule of thumb is to purchase properties with a cap rate of 7% or more.
Take care when trusting the quoted cap rate for a property listing. Cap rates can be very subjective, and are easily manipulated to suit the seller’s interests. You should always calculate it yourself and be conservative.
This is where I also look at how the cap rate changes if the seller accepts a lower purchase price. Is there a price that I would have to get down to in order to be interested?
Do my conservative estimates still produce a good cap rate at a purchase price I think the seller will accept? Yes? Then the property is most likely a good investment!
More on the 1% Rule here.
1.3 Return on Investment (ROI)
Now that I’ve used the cap rate to decide what properties to visit in person and what price I would need to pay, it’s time to project the overall return that I’d get on my investment.
ROI is the ultimate goal of investing. If it’s less than what you can get from a diversified portfolio of stocks and bonds, then why would you spend precious time on a real estate investment?
If you’re going to pay cash for the property, then Cap Rate equals ROI. But most of the time there will be financing involved. Let’s factor this in.
What interest rate can you get? How much will you put down? Will you get a 15-year or a 30-year loan?
There are two different ROI metrics that you can use to select the most suitable financing for your situation. They also help you understand, for instance, that a 15-year loan reduces cash flow over a 30-year. But it increases your total ROI if you aren’t counting on appreciation. This happens because you’ll have a lower interest rate and you’ll be paying the loan down faster.
Here are the two types of ROI that you should calculate:
- Cash-on-cash ROI: This is the total cash flow that you expect over the year divided by the amount of cash that you will invest in the property.
- My rule of thumb is to purchase properties with a cash-on-cash ROI of 7% or greater. This means that even if the value of the property goes down on a given year I will not be worried because I’m still making 7% cash on my investment! I’ll just wait longer before selling, allow the value to increase, and continue to make 7% every year on average.
- This is an extremely important aspect of my investment strategy because I will make better decisions and more money in the long run when I’m not forced to sell due to insufficient cash flow.
- Total ROI before capital appreciation: This takes the total cash flow that you expect in one year plus the amount of principal that you will pay on your loan that year (I use the first year of principal for simplicity and conservatism). Then it divides this number by the amount of cash that you will invest in the property up front—your down payment plus renovation costs. This gives you the total ROI from cash flow plus paying off your loan. Total ROI is always greater than cash-on-cash ROI.
- If this number is 10% or greater using conservative estimates of income and expenses, you’ve found a winner! At this point, appreciation of the property is just a bonus.
You’ll notice that none of my metrics account for appreciation. This is intentional.
I do not count on the property going up in price in order to make money. That type of speculation is how many people go bankrupt in real estate!
You’ll also notice that financing can be used to increase ROI. But it will also decrease cash flow. This is why I was happy getting loans in the beginning, but equally happy when I was able to pay them off.
I had high returns for the first 5-6 years. Then I turned them into great cash flow when income became more important to me!
1.4 Calculating rental property ROI and cap rate
I created a simple spreadsheet that I can use from my laptop or phone to quickly estimate all of the metrics that I need. I can do this from anywhere, whether I’m at home, in my realtor’s office, or standing in one of the properties. There are many more complex spreadsheets out there, but in my opinion simpler is better.
Enter your email below to receive a copy of the spreadsheet that I use to calculate rental property ROI.
A lot of assumptions go into the initial cap rate calculation. But they are refined as I learn more about the property, right up to the moment that I make a decision to buy.
Here’s where I get most of the numbers for the calculation:
- The MLS listing includes HOA fees, property taxes, and purchase price, which are entered directly into the spreadsheet.
- Based on knowledge from my other properties, I then conservatively estimate insurance, maintenance, utilities, and vacancies. If you don’t have knowledge in this area, partner with a realtor who does!
- My rule of thumb for vacancy is that a property will be empty 1.5 months/year. This is usually conservative enough.
- I then do my best to estimate the initial repairs and one-time costs required to purchase the property and get a tenant moved in.
- Repairs can’t be reasonably estimated until you’ve seen the property. And more will be found during the property inspection. So you should expect to make updates several times before the sale is complete.
- Again, consider partnering with a realtor who can help estimate these numbers. During the inspection stage, however, you can also get quotes from subcontractors on costs to fix and renovate.
- Finally, I calculate property management fees. This might be zero if you’re going to manage the rental yourself. But you might put it in there anyway in case you change your mind and to know how much you’re effectively paying yourself to do the work.
- 10% of rent plus a finder’s fee for every new tenant is typical
You can do this in a few minutes for each property that initially looks promising, once you have looked at enough of them. You can quickly refine it as more information comes in.
2 Summary
There are 4 numbers that I look at before making a decision to purchase a rental property:
- 1% Rule – this helps me immediately eliminate a bunch of properties that won’t be a good investment.
- Cap Rate – this tells me if the property will make money regardless of how I choose to finance it.
- Cash-on-Cash ROI – this metric is my favorite! It tells me what my actual cash flow should look like, and therefore how much margin there is if unexpected costs or vacancies occur.
- Total ROI – this tells me how much the property will earn in cash plus paying down the loan.
Knowing these 4 numbers will give you confidence as an investor, whether you’re buying your first or twenty-first property.
There will always be unknowns and incorrect assumptions. But these numbers will be your best friend if you do enough research and add a realistic level of conservatism. Then you can win at the rental property game!
Read the another article in the Rental Property series next:
- Part 1 How to Know if a Rental Property Is a Winner
- Part 2 What Makes the Best Cash Flow Rental Property
- Part 3 How to Know if You Should Invest in Rental Property
- Part 4 How to Find Good Rental Properties to Buy
- Part 5 8 Ways to Make Extra Money on Your Home and Land
And don’t forget to sign up for FREE at the bottom of the page to get much more value from PathwayToFI, and join me on the path to FI!
Join me on the path to FI!
