Most people grossly overestimate the cash flow they are actually getting on their rental property.
At the same time, the people trying to sell you investment properties also have a habit of fudging the numbers on cash flow and return on investment.
I’m here to make sure you can spot these inflated numbers a mile away.
The mistake most people make is believing that your money left over after paying a mortgage each month is your cash flow.
You need to subtract your mortgage from rent, then subtract all other expenses to arrive at your actual cash flow.
In many people’s case, this is a negative number.
That means you are not cash flowing, you are paying money to own this investment.
Make sure this doesn’t happen to you.
It is helpful to understand two simple concepts for this all to make sense.
Those two things are the 1% rule and 50 % rule, which are easy to do in your head, and can save you the trouble of breaking out the calculator for rental properties that clearly won’t make money.
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 is 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 understanding the 50% rule can help.
We haven’t deducted our expenses or mortgage costs from the rent yet!
The 50% Rule
According to this rule, approximately 50% of your rent will go to expenses.
If you are self managing, it’s fair to assume 40% expenses. (You save 10%)
Generically, these expenses are: maintenance, capital improvements, taxes, insurance, property management, and vacancy losses.
Note: Capital improvements are big, expensive updates to the property like replacing the roof, windows, HVAC, etc. These are expensive items that don’t occur often, but need to be budgeted for.
IMPORTANT NOTE: This 50% expense rule does not include your mortgage. If you want to calculate your cash flow, you need to deduct all the expenses listed above and then subtract your mortgage as well.
In some cases, your mortgage may already include property tax and fire insurance.
This means in our 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 profit.
The other $6,000 is expenses.
Which means that if a house meets the 1% rule, it doesn’t actually make 12%. Approximately half of that (50% rule) is eaten up in costs and the house is actually making you 6% without counting the mortgage expense.
Rental property that meet the 1% rule will give you a return on investment of approximately 6% on a cash purchase.
This puts it on par with what the S&P 500 index 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 calculate what you will make on a real estate investment, it is worth it to break out the calculator, do the complicated math, and find your actual cash flow accounting for all expenses including mortgage.
Calculate your Cash Flow with a Mortgage
It’s unusually common for new investors to calculate their cash flow after the mortgage is paid and ignore the rest of their expenses.
Here’s something I heard once about paying a mortgage vs. paying rent that illustrates this point beautifully;
When you pay rent each month, that’s the most you’ll pay for staying there.
When you pay the mortgage each month, that’s the least you’ll pay for staying there.
I spent 20 years in the military, and lots of people bought houses during their one to three year assignments, and then turned them into rentals when they left.
It was common for people to tell me they were cash flowing $200 a month on their rental.
I asked them how they calculated this.
They told me their mortgage is $1,400 a month, and the rent was $1,600.
$200 cash flow!
Remember, approximately 50% of rent gets taken up by expenses (other than mortgage).
Let’s be more conservative. It’s safe to assume 40% expenses if you manage it yourself.
40% of $1,600 is $640.
$640 of your $1600 in rent is expenses.
$1600 – $640 = $960 is your cash flow before mortgage.
$960 cash flow – $1400 mortgage payment = -$440
It is more accurate to say you are losing $440 a month than it is to incorrectly claim you are cash flowing $200 a month!
Even if you think 40% expenses is a little high, you still lose money with a very conservative 30% expenses.
30% of $1,600 is $480
$480 of your $1,600 in rent is expenses.
$1600 – $480 = $1,120 is your cash flow before mortgage.
$1,120 cash flow – $1,400 mortgage payment = -$280
Still negative cash flowing $280 a month.
That’s no way to build wealth!
Note: 30% expenses on a rental property is low, and typically not possible unless you are self managing. Things that could make this low of a rate possible are a combination of the following factors:
- newer property with recent updates
- low property taxes
- low vacancy rates
I wouldn’t bother trying to convince yourself or anyone else your expenses will be much lower than 30% on average over several years.
You’ll have the most accurate expense estimate if you use as many real numbers as you can to come up with your expenses.
The 50% rule is meant to give you an idea, but not good enough for a purchase decision.
In addition to cash flow, you’ll hear real estate investors talk about return on investment (ROI).
This can be a tricky term.
I want to give you the confidence to know what people mean when they say ROI on a rental property.
The truth is, many people that use it don’t know themselves.
Return on Investment
First of all, a return on investment, often abbreviated ROI, is a financial term. It is by no means limited to real estate.
It is a measure to evaluate the gain on an investment. It’s a ratio of the:
Profit on any investment to the cost of the investment
The answer to this can be used to evaluate investments against each other.
The answer will be a percentage.
If you invest $1,000 dollars and your profit is $100…
$100 (profit) / $1,000 (cost of investment) = .10 or 10%
You have a 10% return on investment based on your cost.
We already talked about how to calculate cash flow in an earlier section. After you calculate it as outlined above, just divide it by the price of the house.
To calculate cash flow (or profit) on a rental property, you take:
Rental income minus expenses minus mortgage payment.
That’s your cash flow or profit. Then you divide your profit by the cost of the property.
Let’s say you bought a house for $50,000.
The rent is $900/mo
Your expenses altogether are $315/mo
Your mortgage is $250/mo
Monthly rent $900 – expenses $315 – mortgage $250 = $335 cash flow
If we want a yearly ROI, $335/mo X 12 mo = $4020 cash flow per year.
Your cash flow is your profit.
Profit on any investment / cost of the investment
$4,020 yearly cash flow / $50,000 cost of investment = .08
An 8% return on investment per year.
Now here’s the trick with ROI on rental properties.
I’ve given you an ROI based on expenses and a mortgage being taken out. This is the most accurate way to do it. The ROI represents your true cash flow.
That’s not always the case. Sometimes the ROI you are given by someone selling a property has not factored in all expenses, or even mortgage cost.
It’s also common to grossly understate the actual expenses you will incur. An example of this is assuming you won’t have any vacancy and hardly any repairs.
So you might see a great ROI of 15% on a property, only to find out that’s a before expenses and mortgage number.
It’s not the whole story.
The real ROI will likely be much lower.
A great example of low-balling expenses to sucker you into buying overpriced properties is a turnkey real estate company.
They sell houses fully rehabbed, often with renters in them and property management in place, and claim you’ll make a good ROI.
Read more about this – Should I Buy a Turnkey Property?
Cash on Cash Return
As I’ve stated a few times now, the formula for ROI is:
Profit on any investment / cost of the investment
You’ll hear real estate investors use the term cash on cash return.
This is simply a different type of ROI calculation. It gives you the ROI based on a different cost.
The cost of investment in this case is not the the price of the property, but how much money you have in the deal.
Usually, this would mean a downpayment, and any other cash costs you had to incur to make this investment.
With my $50,000 house example, we will assume I put 20% or $10,000 down on this property.
My cost wasn’t $50,000. It was $10,000.
So what return on investment am I getting on my downpayment?
$4,020 yearly cash flow / $10,000 downpayment = .40
It’s a 8% ROI based on the purchase price, but a whopping 40% return on investment based on the money I put into the deal.
That’s the power of leverage. You only have $10,000 tied up in this property, and it’s paying you back $4,020 per year. In less than three years, you’ve got all your investment money back!
Let’s go do it again!
So you can see now when somebody tells you what the ROI is on a property, you still have several questions you need to ask.
- Is the ROI based on the property price or your investment into the deal?
- Is it based on all expenses including mortgage?
- Are the projected mortgage expenses realistic?
- Is this a one year ROI? One month? 5 years?
We are clear on what an ROI is now, but lots of investors keep throwing around the term Cap rate!?
Read my in-depth post on cap rates and how to calculate it
A capitalization rate, often abbreviated as cap rate, is essentially an ROI including expenses, but not mortgage.
The cap rate is your return on investment (ROI) as if you were doing a real estate deal in cash.
It allows you to compare it to other similar investments disregarding a mortgage. That way you can separate the quality of the property investment from the quality of the loan you are getting.
The formula is:
Net Operating Income / Current Market Value
A net operating income is all you rent and other income (called Gross Operating Income) minus your operating expenses.
Keep in mind, this is slightly different than expenses in general. Operating expenses are things you do to keep the property running and repaired.
It does not include capital expenditures, which are large expenses like replacing a roof, remodeling a kitchen, or putting in new windows. These aren’t viewed as repairs but as improvements.
This is kind of like reinvesting in your property vs. just fixing it so it’ll keep running.
So while you subtract capital expenses to get your ROI or a cash flow, you don’t for cap rate! For that reason, your cap rate may be a little higher than what you see in cash flow.
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, landlord paid utilities, property management, 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. 8-9% is considered pretty good!
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Rich on Money’s Real Numbers for Cap Rate
Let’s 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!
By the way, did you know the key to my success was finding a great property management company for my 20 houses while I was overseas?
Don’t get ripped off by bad property managers!
Click here to get my tips on finding the best property managers.
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.
Note that capital improvements matter for cash flow, but are not factored in for cap rate. You will not see capital improvements as an expense for cap rates below, but it still costs you money.
Purchase price $45,000
Closing costs $488
Total purchase price $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 yearly operational expenses from the gross rent. (Remember, capital improvements are not included here)
Average Maintenance $900
Property manager (10% of rent) $1100
Vacancy losses (estimate 10%) $1100
Total operating expenses $4,045
Gross rents $11,000 minus
operating expenses $4,045 equals
Net yearly income $6,955
Now divide this number by the acquisition cost for Cap rate
$6,955 / $46,798 14.9% Cap rate
Not bad at all!
I think it’s all too common to underestimate what expenses are and overestimate ROI, cash on cash return, and cap rates.
Regardless of information that you get from someone trying to sell you a property, run those numbers yourself and make sure the expenses are all included and as close to accurate as possible.
This way, when you buy an investment property, you’ll know what you’re getting yourself into.
What have been your experiences with ROI’s that you get from investors or family?
How much are you really making from your rental property?
Rich on Money
Check out my Complete Guide to Real Estate Investing