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.

Note: Whenever I say “purchase price,” I’m referring to total acquisition cost — which includes property price, closing costs, and any upfront repairs to get the unit rent-ready. It wouldn’t make sense to just count the “sticker price” of the home, because you might buy a $10,000 home that needs $80,000 in upfront repairs. Run calculations based on total acquisition price.

Just FYI, there are some investors who believe that One Percent is too lenient. These investors shoot for the “2 Percent Rule,” which means they collect $2,000 per month in gross rent for every $100,000 of house. However, I don’t (necessarily) advocate for those types of properties, since those tend to exist in high-risk neighborhoods. 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 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 operating income divided by the acquisition 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 operating income” (also known as “NOI”) = $1,200 – $700 = $500 per month.

Multiply by 12 to find your Annual NOI: $500 * 12 = $6,000
does this property produce good income ?
To find the cap rate, divide $6,000 (Annual NOI) by the total acquisition 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).

(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.)

**Important Note: Notice that we’re calculating “net operating income,” not “net revenue.” This sounds like an inconsequential distinction, but it carries one important implication: We subtract operating expenses, but not debt servicing or equity-building expenses.

What does that mean? Mortgages consist of four parts: Principal, Interest, Taxes and Insurance. These are collectively called PITI. When you calculate NOI, you subtract the cost of TI (taxes and insurance), because they’re part of your operating overhead. You don’t subtract the cost of PI (principal and interest), because these build equity and service debt, respectively. They’re not an operating expense.

“Okay, I understand not subtracting for principal repayments. But why wouldn’t you subtract the interest?”

We’re trying to evaluate the asset itself — the property — not the attractiveness of the loan. Let’s exaggerate this for the sake of illustration: ALL properties will look terrible with a 99% interest rate, and MANY properties will look awesome with a 0% interest rate. That doesn’t necessarily make those properties inherently good or bad rental candidates. We want to remove the financing arrangement from clouding our judgment about the property itself.

In other words: First, evaluate the property. If you like it, THEN find good financing. Don’t mix the two.

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 NOI 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 NOI 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.

Gigantic Freakin’ Disclaimer:
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.) Frankly, that gives this the potential to be a dangerous equation. You don’t want to get led into thinking that more leverage is always the better option.

The bigger your mortgage, the bigger your risk. Be cautious about using the cash-on-cash formula.

Here’s a safe way to use this formula: Try using this equation ONLY to compare the performance of properties you’d buy in cash. That way, you’re looking at “pure cash return,” absent of leverage risk.

If you can’t literally buy a property in cash, run the numbers through this equation anyway. You’ll at least gain an understanding of what type of return this property will create once the mortgage is paid in full. In other words, you’ll develop stronger knowledge about the strength of the property itself — absent any financing considerations.

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.

Note: This article was updated in February 2015 to clarify FAQ’s around this topic.

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

Comments

  1. says

    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.

  2. says

    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!

      • says

        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 :)

  3. says

    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..

    • says

      @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.

      • says

        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.

        • says

          @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?

          • says

            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

            • says

              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.

  4. says

    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.

    • says

      @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.

      • says

        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!

  5. says

    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!

  6. says

    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.

  7. says

    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.

  8. says

    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.

  9. says

    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.

  10. says

    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!

  11. says

    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!

  12. says

    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

  13. says

    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!

    • says

      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.

  14. says

    Thank you so much for writing this article! :-) I’m gathering knowledge to buy my first rental property, and some websites really confused me, but you’ve made the math really easy for a beginner to grasp. (Why can’t other investor writers explain things in conversational, plain English?) I’ll be using your tips in my journey, for sure.

  15. says

    Great article and I like the simplicity. Do you still recommend the same equations for cities such as NYC or Boston? The housing market is very expensive…you can not buy a 2 bed condo for less than $400k, but the rent for that same place is only $2k a month. Should you not invest then, even though the prices are going up at least 10% in some areas?

    • says

      @Ellie — Yes, I recommend ONLY buying a rental property that meets the 1 Percent Rule, regardless of where you’re investing. Buy-and-hold investors buy for cash flow, not for appreciation. Appreciation is icing on the cake (and a hedge against inflation), but it’s not the purpose of the investment.

      If you’re negatively-geared on an investment property, meaning that you’ll pay out-of-pocket for the operating costs, you’re stuck. You’re necessarily limited in how many properties you can buy, you’re tied to a job that you may not want because you need to pay the bills for the property, and you hold significant risk of losing the property in the event of a vacancy or major repair. If your property produces strong cash flow, which can only come from a 1 Percent Rule property (or better), you’ll have better protection from all of those downsides, and you can reinvest the cash flow into growing your real estate empire.

  16. says

    Great blog post… Very interesting 1% theory. In the UK, it’s practically impossible to achieve that kind of yield now as property prices are off the charts.

    But it’s certainly an adaptable rule of thumb.

  17. says

    Hello,

    these rules applied to Europe (i.e. France and Swiss) don’t work,

    in Switzerland for exemple an apartment of 500 000 CHF is rented @ 1600 CHF, far from the 5000 CHF you suppose.

    … any other calculation available?

    • says

      @Lorenzo — I’d recommend investing ONLY in areas where the One Percent Rule works. My knowledge and experience is entirely U.S.-based, so I cannot comment on Europe — I simply have no investment experience on that side of the ocean. However, I know that in the U.S., there are some cities/areas/neighborhoods where it’s almost impossible to find a One Percent property, and other cities/neighborhoods where it’s much easier. If you’re in a location where there aren’t One Percent properties, look elsewhere. Yes, this means you’ll need to invest the upfront time into learning a new area, but that upfront investment of time and research will yield dividends that pay off in the long-term.

  18. says

    Thanks for laying it all out. You didn’t mention it here, but one cost that I always put into my cap rate (and other) calculations on investment property is vacancy. When you look at investment returns long-term (e.g., what it will make over a year, three years, etc.), vacancy becomes a cost. I have seen you account for vacancy in your projections of your own properties, but I think it can be handy for cap rates too. This is particularly true if you are comparing multiple properties and have a good sense of the market. Not all properties will have a similar vacancy rate. I’ve been investing in real estate for about 10 years and when I go to look at a potential property, I try estimate what vacancy will be. An APOD from previous managers/owners can be helpful, but not always trustworthy. I almost always start at 10% and go up from there, just to be safe. (I’ve got some properties that have had 0% for years, but it’s not something you want to count on). Some high-risk properties here (Albuquerque) can have vacancy rates of 25% or more. There’s good money to be made on those, but a lot more time/effort/management has to go into it. So, if you are evaluating properties in the same neighborhood in the same condition, it doesn’t matter whether you add in vacancy as a cost. But if you are looking at diverse properties, it’s a must. Something that looks like a great deal (1.5-2% rent to cost) might actually be a bad investment once you have deal with high vacancy (which means more cleaning, advertising, unpaid rent, etc.).

    • says

      Yes, I completely agree!

      I didn’t go into detail about everything that gets piled into the expense category (since there are so many items to list), but expenses should include:

      – Property tax
      – Homeowner’s insurance
      – Umbrella liability insurance
      – Any other insurances (e.g. flood insurance)
      – Vacancy
      – Management (even if you manage it yourself, run the calculations as if you don’t — so you can later step away and the equation doesn’t change)
      – Repairs (rule-of-thumb: 1 percent of purchase price annually.)
      – Maintenance (pest control, gutter cleaning, lawn care, etc.)
      – Advertising (depending on the neighborhood, paid ads might be effective)
      – Cleaning and turnover-related costs
      – Unpaid rent and collection-related / eviction-related fees
      – Landlord-paid utilities and services (trash, water, sewer, and if applicable, electric, gas, internet, security)

      The list can be quite extensive. :-)

      I’ve seen that my properties in high-risk areas (House #2 and House #5) tend to have the highest vacancy rates but lower turnover. In other words — it’s harder to find a tenant, but once you find one, those tenants stay for awhile. My properties in low-risk areas (Houses #1, #3 and #4) have low vacancy and are much easier to fill, but tend to experience high turnover, since many of these are rented by young professionals who get job opportunities out-of-state, enroll in grad school, get married, buy their own house, etc.

  19. says

    Great post on how to work the numbers on a deal!

    Like all things, I think many people get confused with the terminology. It irks me when experienced investors use it to explain things to non-experienced ones. No wonder people get confused!

    Enjoying the blog, thanks for sharing! :)

    • says

      @MobileHomeGurl — Yes, I hesitated to use the term “Net Operating Income,” because it sounds technical and confusing, and I worried that it might scare away the beginners. But I also want to teach readers the difference between Operating Income and other types of income (such as equity income). So my approach is to use the correct terminology, and also spend a few paragraphs explaining these terms. It bothers me when I read articles that simply reference “NOI” or “PITI” without explaining what those terms mean. :-)

  20. says

    Hey Paula! I LOVE your blog and I am so fired up to buy a rental property (I’m hoping to be able to get one next year). I’ve struggled my entire adult life with work and feeling restless and aimless. You’ve inspired me and helped me find direction with where I want to take my life!

    Please forgive me if my question is really basic, but how do you know what the rent is going to be in order to calculate the one percent? How do you decide what a house is worth? What if you overshoot or grossly under charge? Thanks so much, you have inspired me!

    Melissa

    • says

      Hi Melissa! I’m SUPER happy to hear that this blog has made such a positive impact on you!! Rock on!!

      To determine the rent: I pretend (inside my head) that I’m a renter who wants to live in a particular neighborhood, and then I’ll search online for rental properties in that area. I’ll check Craigslist, PadMapper, Zillow, Trulia and Postlets, narrowing the search based on the number of bedrooms and the type of property (example: high-rise condo vs. single-family home). I don’t actually make any viewing appointments, since I want to respect the other landlords’ time, but if anyone is hosting an “Open House,” I’ll swing by to check out the condition and size.

      Just for kicks, I’ll also check websites like RentOMeter.com, but you should take their recommendations with a grain of salt. If the rent you see on RentoMeter is aligned with that you’re finding independently (when you’re researching online), then cool — they’ve corroborated what you already know. If the results you find on RentoMeter are drastically different, through, give priority to the prices that you’ve found firsthand by searching online.

      My pricing philosophy is to compete on quality, rather than price. If I start undercutting the other houses in the area, then I’m starting a chain reaction that will cause the whole neighborhood to fall in price. (Plus, I’m depriving money from my own bank account). Instead, I’ll price my units at the same rate as everyone else, but offer a nicer place to live: fresh paint, updated cabinets and countertops, new windows, professional cleaning before move-in. The tenants get a higher-quality space at the same price.

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