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