Today’s letter comes from David, who says:
“How do you determine the water, taxes, trash, etc. costs in determining if (an income property) will produce cash flow?”
Forget calculus – the most important math is the multiplication you learned in fourth grade.
To evaluate a property’s income potential, 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. (Mine rents for $3,100 per month).
One percent is the minimum level of return I’d accept. But 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
Mortgage, Insurance, Taxes, Water, Trash, Repairs, etc. = $950 per month
“Net income” (your income after expenses) = $1,200 – $950 = $250 per month.
$3,000 / $200,000 = 0.015
Multiply your answer by 100 to convert it into a percentage. The $3,000 in cash flow you’re receiving translates to a 1.5 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.
$3,000/$100,000 = 0.03, or 3 percent.
Much better! At that rate, it will take you 33 years to “pocket” the price of the house (100/3).
(P.S. Notice that if you bought the house for $200,000, and rented it for $1,200 per month, it wouldn’t pass the One Percent Test. But if you bought it for $100,000, and rented it for $1,200 per month, it passes the One Percent Test with flying colors.)
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.
Don’t misunderstand me: Real estate is still risky. But unless you’re Warren Buffet, leveraging your money for other investments – like buying stocks “on margin” (with borrowed money) – is much riskier, in my humble opinion.
No equation paints a total picture.
The cash-on-cash return equation rewards taking out the biggest possible mortgage. This shrinks the denominator, which makes the formula spit out a higher number.
The cap rate equation rewards having no mortgage. This boosts the numerator, which makes the formula spit out a higher number.
Neither equation is perfect. That’s why it’s important to run both. You’ll get a more balanced idea.