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.
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.
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.
$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).
(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.
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 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.
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.