Is This House a Good Investment?

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income propertyForget fancy-pants calculus.

The most important math is the stuff you learned in fourth grade.

How do you know if an income property (rental property) is a good investment?

Start with The One Percent Rule: Does the monthly rent equal one percent of the purchase price or more?

Example:
Purchase Price: $100,000

$100,000 x 0.01 = $1,000

Is the monthly rent greater than, or less than, $1,000? If the monthly rent is greater than $1,000, this property merits further consideration. Otherwise, ignore the property and move on.

In other words: for every $100,000 in price, I look for $1,000 in rental income. If a house costs $225,000 – as mine does – it needs to rent for $2,250 per month or more.

One percent is the bare minimum level of return I’d accept.

Some people shoot for the “2 Percent Rule” (get $2,000 per month in gross rent for every $100,000 of house), but those tend to exist in higher-risk, less-stable areas. Keep in mind, there’s usually a tradeoff between risk and reward.

Example:
Midtown, Atlanta is a stable neighborhood with high rental demand. Tenants are highly likely to be college-educated, and many will hold graduate degrees. Tenants are likely to have perfect credit. Many are saving for their own home.

The tenant risk is lower, so your returns will also be lower. One percent is probably the best you’ll find in an area like this. (I got lucky.)

Hypothetical Town, in contrast, is an area with a high crime rate. Tenants are likely to have bad credit and bankruptcies. The tenant risk is higher, so your returns should also be higher. I’d demand at least 2 percent in a place like this.

The Cap Rate

If a house passes the One Percent Test, I look at a measure called the capitalization rate.

The capitalization rate, or “cap rate,” measures the return on the property value. Cap rate equals annual net income divided by the home price.

“Uh, what?” – Don’t worry, that sounds like gibberish to me, too (and I wrote it!) Let’s walk through an example.

Rent = $1,200 per month
Insurance, Taxes, Water, Trash, Repairs, etc. = $700 per month
“Net income” (your income after expenses) = $1,200 – $700 = $500 per month.

Multiply by 12 to find your annual net income: $500 * 12 = $6,000
does this property produce good income ?
To find the cap rate, divide $6,000 (annual net income) by the price of the house. Let’s assume your house cost $200,000.

$6,000 / $200,000 = 0.03

Multiply your answer by 100 to convert it into a percentage. The $6,000 in cash flow you’re receiving translates to a 3 percent return on your property value.

Meh. Yawn.

I’m not excited about that.

Let’s change one variable: Let’s assume you bought the house for only $100,000.

$6,000/$100,000 = 0.06, or 6 percent.

Much better! At that rate, it will take you 16 years to “pocket” the price of the house (100/6).

(P.S. Notice that if you bought the house for $200,000 and rented it for $1,200 per month, it wouldn’t meet the One Percent Rule. But if you bought it for $100,000 and rented it for $1,200 per month, it totally hits the One Percent Rule.)

Cash-on-Cash Return

Finally, I scope out my cash-on-cash return: An equation that shows how far my cash will carry me.

The formula for this is annual net income divided by down payment.
is this income property a good investment?
Using the same example as above:

I buy a house for $100,000. I put 20 percent down, or $20,000. The annual net income is $3,000.

$3,000 / $20,000 = 0.15, or 15 percent! Holy moly!

This illustrates why real estate is so powerful: it’s probably the safest way to leverage your dollars.

Let me be clear: Real estate is still risky. But leveraging your money for other investments – like buying stocks “on margin” (with borrowed money) – is much riskier.

The cash-on-cash return needs to be taken with a grain of salt. (Actually, take it with a whole damn salt shaker.) This equation rewards people who take out the biggest possible mortgage. (This shrinks the denominator, which makes the formula spit out a higher number.)

But the bigger your mortgage, the bigger your risk. So be cautious about using the cash-on-cash formula.

I know some people who use this equation ONLY to compare properties that they’d buy in cash. That way, you’re looking at “pure cash return,” absent of leverage risk.

Final Thoughts

Of all these formulas, the One Percent Rule is the easiest and most intuitive.

Cap rate is the most comprehensive.

Cash-on-cash is a nice finishing touch.

Use them all. Your success (or failure) as a real estate investor happens before you buy.

 



Thanks to Jeremy Levine Design and Images of Money for today’s photos.

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45 Responses to “Is This House a Good Investment?”

  1. Money Beagle
    25. Jan, 2012 at 10:11 am #

    Those are awesome tests. I especially like the one percent rule of thumb. I’m not in the market to do any rental stuff but if I did, I would for sure use this post.

  2. Monica
    25. Jan, 2012 at 10:13 am #

    Real estate investing is very tricky indeed, but you did a fabulous job of demonstrating what to look for as far as ROI, and it was easy to understand. I like the real life examples, they really brought your point home.

  3. DollarDisciple
    25. Jan, 2012 at 12:05 pm #

    This is a fantastic write-up! I love reading about other’s investment strategies.

    I’ve only seen cap-rate applied to commercial/multi-family properties but it makes a fine rule of thumb in this case too. However, I think strictly speaking, cap-rate doesn’t include your mortgage payments but it does include all of your other operating costs (including management, even if you do it yourself). This makes it easier to have an “apples to apples” comparison of properties while taking stuff like mortgage rates and credit scores out of the equation.

    Another rule of thumb you have probably heard of is the 50% rule: in long-term studies of residential real estate, they found that expenses approach 50% over a long time horizon. Many will say that if you can make $100/mo after the 50% and your mortgage, then it’s a good deal. Personally, I’m skeptical of this rule but many investors swear by it.

    I’m looking forward to more posts like this!

    • AffordAnything.org
      25. Jan, 2012 at 3:40 pm #

      @DollarDisciple — Thanks!

      I’m 100% skeptical of the 50% Rule (haha — that’s my weak attempt at a nerdy real estate joke). :-)

      The reason I’m so skeptical is because rental income and operating expenses are “independent variables” — you can adjust one without affecting the other. Here’s a post I wrote about why I’m dubious of that rule — http://afford-anything.com/2011/10/24/how-i-make-70-per-hour-working-from-home/

      • DollarDisciple
        26. Jan, 2012 at 7:04 pm #

        Haha, love the real estate humor! :)

        You make an excellent point in that linked article. And I completely agree that rent and expenses are not correlated. They increase (or decrease) independently for different reasons. But they do have one common factor: inflation.

        I think the 50% rule was established for apartment complexes anyway. I like to think of it as a *really* conservative rule of thumb. Though, I don’t really use it either :)

  4. YFS
    25. Jan, 2012 at 12:52 pm #

    Great job on the write up. I use the same 3 metrics when deciding if a home is a good investment. Do you use any other metrics beside the three listed?

    To breakdown my 1st rental property.

    1 percent rule: I get 3%

    Cap rate: 14.36%

    Cash on Cash return: This number is over 1000% Why? I bought for 30k (price+repairs) the appraisal came back high so I took out 33k. So technically I got paid 3k to do this deal. At this point I do not have any of my own cash invested in property 1

    With the 33k in hand I bough property two for 30k (purchase + repairs).. the cycle goes on and on and on..

    • AffordAnything.org
      25. Jan, 2012 at 3:27 pm #

      @YFS — Wow, congratulations on that cash-on-cash return!! That’s impressive!!

      Those are the three main metrics I use, and of those three, the 1 Percent Rule is my favorite, since it’s so easy to do in my head. The minute I hear the stats on a property, I know if it’s a good deal or not. If some says, “this will cost $50K (purchase plus repairs) and will rent for $1,000,” I’m like, “wow, I’m in!”

      I’m looking at a house now that’s on the market for $30K, and needs probably another $20-$30K in repairs, and it’ll rent for about $700 – $800. I’m feeling ambivalent. It’s an alright deal … not awful, but not great.

      • YFS
        27. Jan, 2012 at 3:14 am #

        The property you’re buying is gonna pass your 1% rule. Is there any possible appreciation? That might make the deal a really good one in the long run.

        In the area I invest the most I will pay for a property + repairs is 30k. I typically get 800-1000 depending on how many bedrooms the place has. I am to get section 8 tenants so of course the more bedrooms the better. I’m currently in the process of buying a place for 16.5k and it will only require 7k in repairs with the estimate rent being 850.

        I expect this property to appraise and allow me to pull 33k out. Meaning another cash on cash victory. Then on to the next deal.

        • AffordAnything.org
          27. Jan, 2012 at 11:12 am #

          @YFS — You’re brave; I haven’t ventured into Section 8 territory yet. Many people love Section 8 because the gov’t guarantees a rent payment, but what about all the potential damage they can do to a place?

          • Dale P @ poyserdk
            07. Nov, 2013 at 1:47 am #

            I have heard similar stories about section 8 tenants trashing your property. I did a bit of digging and found two interesting things
            1 – The damage is mainly due to wear and tear from the tenants being in the property longer than say someone with a 9-5 job. This extra time causes more

            2 – The selection criteria for someone to get on section 8 is actually pretty tight. Section 8 tenants may actually be better tenants than non section 8 in a few ways.

            If a section 8 tenant causes issues you (as a landlord) can report them and have them removed from section 8. So it does not benefit them to screw you as it screws them in the long run.

            I tried my hand in real estate but did not apply the 1 percent rule and had to walk away from the deal. My main thing right now is the stock market and peer to peer lending.

            I do plan to get back into real estate though.

            Great article!

            Dale

            • Afford Anything
              07. Nov, 2013 at 2:19 am #

              Thanks Dale!

              Those are excellent points, and in the intervening time since my original writing, I’m warmed up to the notion of Section 8 tenants, in part because I’ve met many other real estate investors who have success with renting their properties to Section 8 tenants.

              My advice to anyone who wants to pursue Section 8 renting is the following:

              Make it your niche. If you’re a beginner real estate investor (e.g. fewer than 5 properties), you’re best served by focusing on just one niche and one strategy, as outlined in this post. Master that niche, dominate it, and learn everything that you can. Expand into other niches only after you’ve freed up enough time and mental space to dominate two spheres of the real estate world.

  5. AverageJoe
    25. Jan, 2012 at 4:05 pm #

    The engineer in me likes this type of post…great How To tips. …and I agree with leverage in the real estate market being less risky than the stock market for one other reason: the chance of having your risk “called” because of a couple bad days are nearly nonexistent in the real estate arena. In stocks, because they’re revalued so often, the chance your leverage turns against you is much, much greater.

    • AffordAnything.org
      25. Jan, 2012 at 11:32 pm #

      @AverageJoe — I figured this post would appeal to engineers, accountants and all other math-types.

      You know, it’s funny. I never liked math as a child. I never, ever (EVER) would have imagined myself writing a math-centric article like this one.

      But the more I invest, the more I realize that many people make decisions based on speculation. “Oh, I think the price will go up.” “Oh, I think that’s a good deal.” There needs to be a standard, a metric, to evaluate houses — and math / formulas are a good one.

      And I agree — leveraging stocks is RISKY business!! You (as an individual) have zero control over the stock price, and leverage can really accelerate your loss.

      • DollarDisciple
        26. Jan, 2012 at 7:07 pm #

        The fact the real estate is just a pure “numbers game” is one reason I was attracted to it in the first place. Of course, I’m an engineer too… :)

        I love that I can run all the numbers and pretty much know exactly how much money I’m going to make before I even buy the property!

  6. Dr Dean
    25. Jan, 2012 at 7:04 pm #

    The one percent rule is a nice, simple way to begin the decision making process. Takes the emotion out of the equation.

  7. PKamp3
    26. Jan, 2012 at 11:51 am #

    Engineer here! At work while we’re coding we like to discuss real estate (we’re pretty hardcore…) and the 100x Rule and its variants (50x, 75x) and some of the things we talk about. We get into heated battles about how to predict maintenance and what to do about HOA (if a condo is poorly run? HOA will increase and eat directly into CoC return). Also beware the special HOA assessments!

    Nice article!

    • AffordAnything.org
      27. Jan, 2012 at 11:13 am #

      @PKamp3 — LOL! It sounds like I’d love your workplace (well, besides the engineering part!)

  8. Mayur Gudka
    27. Jan, 2012 at 3:30 pm #

    Wonderful Article. I love the break down process.

    Just a thought on the cap rate where I am buying the property for 100% cash. If I had a $100,000 in cash, I’d leverage it by buying 5 properties worth $100,000 each with $20,000 down payment on each property.

    Now, I could collect rent as long as I wanted to on these 5 properties or if the prices went up in a few years, I could sell them for a profit. Say for example, after 5 years of ownership, real estate market jumps and all 5 properties are now worth $115,000 each … That’s a $75,000 profit on capital gains alone. The rent you pocketed in these 5 years is ON TOP of the capital gains. This could result into well over a 100% return altogether in just a few years time.

    There ain’t no game like real estate in town.

    Thanks Paula for the wonderful article.

  9. Carol
    02. Feb, 2012 at 10:06 am #

    This was a great and useful post. Could you provide a post on how to protect yourself from legal liability? My family is looking at purchasing a rental, but is concerned about getting sued if something goes wrong. It’s not clear if the property itself needs to be held in a LLC. Thanks if you can address this soon.

    • AffordAnything.org
      02. Feb, 2012 at 10:49 am #

      @Carol — I’m not a legal expert, but I can tell you what I do personally: First, I file a quick-claim deed which transfers the property into an LLC. Then, I use a seperate LLC / a seperate entity for the property management. Finally, I buy an “umbrella policy” to insure against claims — this policy is cheap (less than $10 per month).

  10. Laurie Woolner
    18. Feb, 2012 at 5:35 am #

    This is a nice article or information. I like this.Your one percant rule is a very good rule and also the real estate strategy is very nice..Your post is really a very nice post.

  11. Luis@wealth-steps
    10. Mar, 2012 at 9:25 am #

    I would not call it the 1% “rule” but more like the 1% suggestion. 3 years ago in Atlanta it was close to impossible to make that 1%. Now its more like the 1.2-1.3% or even higher. It’s a guideline and just a quick check but it really has no mathematical backing.

    • AffordAnything.org
      12. Mar, 2012 at 12:32 pm #

      @Luis – It’s a “rule of thumb.” Rules of thumb are just meant to be general guidelines.

  12. Red Brick
    25. Feb, 2013 at 9:23 am #

    The formula explained to evaluate a property’s income potential was an excellent way to select some property. I was just passing by this article and it has suddenly helped me in home purchasing. These rules of thumb are now my bookmark as for every property I will definitely calculate my margin like this. Thanks a lot!

  13. Sam
    09. Apr, 2013 at 7:24 am #

    Great post! I would love to know if you think this applies to places like Seattle, where the cost of real estate is much higher. I could see this definitely working in some parts of the country, but does this also apply to high cost areas? How would you adjust for that? Or does this article imply that you would not invest in this kind of area? Is this about finding the miracle deal? I have been told many times that the miracle deal does not actually exist.

    We bought a duplex for 575,000 which we get 3500/month for between both units. And I always thought that was pretty good until I read this article! It’s in a highly desirable area and it is rented to stable professionals with perfect credit. On the other hand, my parents own a house in a very sketchy neighborhood in Arkansas that is maybe worth $50,000 which they rent for $500/month. They always have problems with that house.

    Thanks again for a great new perspective on gauging these investments!

  14. Manny
    21. Oct, 2013 at 3:00 pm #

    Where is everyone getting these figures from and which cities are you buying property. In Canada you need 20% downpayment for rental properties. So can someone please xplain how they getting to buy houeses with 20-30k downpayment. That would mean the house purchased is 150k
    which i have never seen a home like this.
    When I look for rental properties i look in major cities like toronto, and close to the downtown core.
    I purchases a rental property with cap rate of 5.15%
    cash on cash return of 25.7%
    the 1% rule really doesnt make any sense to me and dont expect to be buying houses close to major city downtown cores and expect 1% rule to work out

    • Afford Anything
      21. Oct, 2013 at 6:22 pm #

      @Manny — Then look for houses away from downtown cores. Go where the good deals are.

  15. John
    19. Feb, 2014 at 3:15 pm #

    Does the cap rate method take into account the expense of a monthly mortgage payment? In addition to monthly maintenance and utilities, would you include your mortgage payment as an expense? Or are these strategies for investors who are purchasing properties with 100% cash? I want to make sure I could calculate an accurate ROI if I were to take out a mortgage loan with 20% down.

    Thanks!

    • Afford Anything
      20. Feb, 2014 at 1:18 pm #

      Great question, John.

      Anytime you’re calculating the return on a property, you should always — intentionally — remove the principal + interest portion of the mortgage payment, but include the taxes + insurance portion.

      Why? Because you want to make an apples-to-apples standardized comparison of how the properties perform, regardless of the financing structure that you establish. Your first tasks is to evaluate each property on its own merits, to see if it’s viable. Once you find the property that gives you the best returns, you then look for the best financing arrangement possible.

      Taxes and insurance are part of the operational expense, so you include those in your Cap Rate calculation. But debt servicing is the second step, and it’s unrelated to the underlying performance of the house itself.

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