This is going to be a short, simple, down-and-dirty tutorial to help you look for or make offers on rental properties.
Going from simple to complicated, the first thing to understand is the 1% rule, which is easy to do in your head, and can save you the trouble of breaking out the calculator for properties that are overpriced.
The 1% rule is quick and easy. Monthly rent should be at least 1% of the acquisition price. The acquisition price may be a higher number than the purchase price. It’s purchase price plus the money to get the house ready to rent.
$80,000 to purchase house plus
$20,000 remodeling equals
$100,000 acquisition cost.
$100,000 home should rent out for at least $1,000 a month, or it would not be a good investment.
What is the logic behind the 1% rule?
If a house will give you 1% of the purchase price each month in rent, then it gives you 12% of the purchase price each year. That apparently means the investment makes 12% a year!!!!
WOW, THAT’S AWESOME! I’M RICH (ON MONEY!!)
Not so fast!!! It’s not 12%.
Here’s where things can get tricky. We haven’t deducted our expenses from the rent yet!
We’ll use another shortcut to simplify it.
The 50% Rule
According to this rule, approximately 50% of your rent will go to expenses:
Generically, these expenses are: maintenance, taxes, insurance, property manager, and vacancy losses
This means that in our now fictional example of a house that should rent for $1,000 a month, approximately $6,000 of the $12,000 you collect in rent annually is actually profit. The other $6,000 is expenses.
Which means that if a house meets the 1% rule, it doesn’t actually make 12%. Half of that (50% rule) is eaten up in costs and the house is actually making you 6%.
Houses that meet the 1% rule will give you a return on investment of 6%.
Houses also appreciate in value, typically at the rate of inflation. It is generally agreed that inflation averages at 3% a year.
You can add another 3% a year (appreciation) to the 6% (cash flow).
So, all said and done, a house that meets the 1% rule will make roughly 6% cash flow and 3% appreciation, for a total of 9%. This puts it on par with what the S&P 500 will supposedly earn you historically.
So up until now, we’ve used the 1% and 50% rule, which are so easy, you can do it in your head.
But when you are about to actually buy an investment property, it is worth it to break out and dust off that calculator, do the more complicated math, and calculate your estimated capitalization rate or cap rate.
The cap rate is your return on investment on a cash real estate deal. I know many of you will not be able to do a cash deal, but I recommend you calculate your investment this way first.
You should have the goal of paying off your mortgage ASAP.
Evaluate each house as if it were a cash deal. That way you can separate the quality of the house investment from the quality of the loan you are getting.
Two VERY different things.
If the deal makes sense to do in cash, it’ll also make sense to do with a mortgage. You’ll just have some added costs.
Sometimes there is confusion about the difference between cap rate and return on investment (ROI) on a real estate deal. Cap rate calculates your return on investment assuming a cash deal (no mortgage).
ROI calculates your return on investment including mortgage related expenses.
Both are useful numbers. My advice, if the house has a good cap rate and is a good purchase as a cash deal, then it’s worth buying.
At this point, you find the best way to finance the property that you can.
That way you consider the property and the loan separately.
Here is how you figure the cap rate.
- Gross income from the rental property (add up how much rent you get in a year)
- Subtract operating expenses (this is tricky, but worth the time. Taxes, insurance, maintenance, property manager, vacancy losses)
- Divide the net income (after subtracting expenses) by the property’s acquisition price (ready to rent condition).
The number you get is a percentage. 2-3% would be low. 15% or higher would be awesome!
Rich on Money’s Real Numbers
Let’s use the 1% and 50% rule, and calculate the cap rate from my second rental property in Alabama.
I bought this property for $45,000 cash.
It was a 4 bedroom, 2 bath home that was move-in ready. This was a huge reversal from the fixer-upper/money pit that was my first property!
Read about that here.
1% Rule on my property
According to the 1% rule, this house should rent out for $450 a month to be “worth it”. That would mean it would be an investment that cash flows about 6% a year.
Supposedly, my house was going to rent for about $900. Double.
50% Rule on my property
If this house rents for $900 a month, I’ll get $10,800 a year (not bad, if you consider the purchase price of the house!)
With the 50% rule, half of that gets eaten up in expenses of one kind or another. I am left with $5,400 cash flow a year.
If you divides cash flow / purchase price, you will get my approximate cap rate or ROI without doing all the heavy math.
$5,400 / $45,000 = 12%
It’s an investment that returns 12% from cash flow.
This 12% is an estimate of what the cap rate would be. You’ll get the actual cap rate by calculating more accurately your operating expenses instead of just assuming it’s half of rent.
Remember, the house should also appreciate at approximately 3% per year, just keeping up with inflation.
That makes it an estimated 15% investment. That’s quite a bit better than the typical S&P 500 rate that people love to compare investments to, and with much less volatility.
Capitalization Rate on my property
Even though this house was bought move-in ready (I didn’t even have to vacuum!), there are expenses that go into the acquisition cost.
Purchase price $45,000
Closing costs $488
Acquisition cost $46,798
We need to calculate gross income. The property rents for $925 a month. A little bit better than I originally estimated.
$925 X 12 $11,000
Next we subtract operational expenses from the gross rent.
Maintenance (10% of rent) $1100
Property manager (10% of rent) $1100
Vacancy losses (estimate 10%) $1100
Total operating expenses $4,245
Gross rents minus $11,000
operating expenses $4,245
Net yearly income $6,755
Now divide this number by the acquisition cost for Cap rate
$6,755 / $46,798 14.4% Cap rate
Add 3% for appreciation (only realized when you sell the house)
Not bad at all!
Let’s see how accurate the 50% rule was in calculating what my expenses would be
I’ll divide my operational expenses by the yearly gross rents and get a percentage (hopefully close to 50%)
Operating expenses $4,245
Yearly gross rents $11,000
Percentage of rent going to expenses 38.6%
In this particular case, using the 50% rule is an overestimate.
Nothing wrong with overestimating expenses when deciding to buy real estate!
I could calculate this value on a few more properties, and then come up with a percentage more suitable for my market and situation. Maybe it’ll be closer to 40%.
As you can see, I used 10% of rents for vacancy costs. You will be able to get a good idea of what the vacancy rates are from talking to a management company or other investors in the area you are buying.
I used 10% of rents for maintenance costs. It’s probably in the 10-15% range. If the house is newer and/or newly renovated, it could be lower.
Conversely, if the house is old, or in need up much remodeling, it could be higher.
How’d you like this posts? Your thought on evaluating properties? Leave a comment.
Rich on Money
So know you calculate how much you will make. But here’s the problem.
Is it better to buy or rent?