How to calculate rental properties made easy
One of the biggest questions I’m asked is how I go about a property once I find it. What do I do, what do I look at, how do I know if it’s “the one”? There are several things I do and look at with any new property potential, but the most important is the numbers. If the numbers aren’t good, I walk. Save yourself some time and before you do anything else, run the numbers and see if they work. If they don’t, awesome, you didn’t waste time on other stuff.
What numbers do you run? Well, what should any investor care most about? Cash flow. What determines cash flow? Income and expenses. Simple. People make running numbers out to be so complicated sometimes it’s a no wonder more people aren’t involved in real estate. In fact, the numbers can be one of the easiest parts of shopping for a property. Unless you are a trained psychic on the crystal ball, then predicting appreciation may be easier for you than estimating cash flow.
1. Figure out the Monthly Income (Gross Income): This will either be rent the current tenants are paying, the asking rent (confirm this number is realistic), or if you have neither of those you can talk to a local property manager or real estate agent who can give you a market rent value for the property.
2. Calculate the Monthly Expenses: These include property taxes, insurance, property management fee (if applicable), mortgage or financing (if applicable), homeowner’s association fee (HOA) (if applicable), vacancy and repairs. Don’t forget vacancy and repairs! They are a real part of any property investment and they can drastically affect the cash flow. Yet so many people don’t think to include them in the expenses.
Don’t skip out on finding out what the actual HOA is! The HOA can absolutely kill a property’s cash flow.
3. Subtract the Monthly Expenses from the Monthly Rent (= Net Income): This is your monthly cash flow. Yay! Hopefully it’s positive. If it’s not positive, run.
4. Calculate the Returns: Two numbers I want to see on any property I evaluate are the Cap Rate and the Cash-on-Cash Return.
If you are not on Cap rate, please see my other article, a detailed explanation.
The Cap Rate equation:
Net Annual Income / Purchase Price = Cap Rate
NOTE: I don’t include the mortgage payment in this calculation.
The lowest cap rate I would ever want to see for any property, whether residential or commercial is 6%. The lowest I would want to see on a residential rental property in this market is 8% and even then, there better be a good reason it’s that low (property in a “sexy” market, highly desirable area, etc.). Anything over 8% and you are doing well in my opinion.
Net Annual Income / Total Cash Invested = Cash-on-Cash Return
Understand the difference? One is a measure of how good of a deal you are getting on the purchase price and the other tells you the exact return on your money you are getting. They are the same for an all-cash buy but can be very different for a leveraged purchase.
If you compare the Cash-on-Cash Returns of an all-cash buy versus a financed buy. You may quickly see the benefit of leveraging! Way more bang for your buck! Try it out on a napkin sometime.
What do you think? Good deal? Absolutely! I’m pocketing $358/month in cash flow (the actual number when there are no vacancies and repairs is $558!), the Cap Rate is 9.7% and the Cash-on-Cash Return is 17.97%. Not only are the returns great, but the tenants are under a 3-year lease and the property is in a great area. Score!