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**.

**Wrong**.

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.**

**1% Rule**

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.

Example.

**$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!

**You wish!**

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

**minus**

*expenses*

**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.

You won’t.

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!?

**Capitalization 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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*I offer a FREE 6-Day Video Mini-Course showing methods to buy real estate at a HUGE discount.*

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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**

**Repairs $1,060 **

**Inspection $250**

**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)

**Taxes $301**

**Insurance $644**

**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!

**Conclusion**

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?

Accurate?

*How much are you really making from your rental property?*

Comment below.

*Rich on Money*

Check out my Complete Guide to Real Estate Investing

This post is really helpful for beginning RE investors like myself. I have always been confused by the definition of a cap rate, but your explanation about it being the ROI for an all-cash deal is very helpful.

Excellent post Rich! I love how you tied the 1% Rule, 50% Rule, ROI, and inflation concept all together. I don’t think I’ve seen anyone describe these concepts so clearly. Great work!

That’s high praise! I appreciate it. I enjoy your website as well. Good luck!

I just checked out your site OB and am looking forward to reading more.

Rich, would you still have considered the acquisition a success if you had only been able to rent for 1% of the house’s acquisition cost (say $450 for ease of calculation)? That would have provided you with $5,400 of gross income. After subtracting expenses of $2,835 ($301 for taxes, $644 for insurance and $540 each for prop mgt, vacancy and maintenance), your net yearly income would be $2,565. This would equate to a pre-appreciation cap rate of 5.5%, and a post-appreciation cap rate of 8.5%.

Personally, I’m shooting for at least 1.5% to be happy. 5.5% post appreciation, i feel like I should leave my money in the s&p500 and take my chances. Real estate is more work (but not a lot more) than leaving your money in index funds, so I want a higher rate of return.

Hey there, love the formula, been years since deaed in real estate but it all came back and I must say your way is a lot easier than the old way! My wife is much more settled on going into the rental business, of course she is leaving everything up to me! But your articles have put her at ease!! Thanks for the refresher course!!

Jump back into it. There is money to be made in any point in the cycle. I don’t wait for dips or crashes, you might wait forever.

Rich, great blog! I came here via WCI.

I’m wondering if you can comment on the calculus for converting your current home into a rental. If there is no acquisition cost, can you calculate a cap rate, and if so would you use purchase price or current mortgage balance?

Here is an example: purchase price 400k. Current balance 280k on a 15-yr fixed. Could probably get 3k in monthly rent, and the place is turnkey. Would manage independently in the same town.

Arguably, cap rate could be near zero and 1% rule doesn’t check out based on purchase price. But it is in a desireable location (high demand for both onwerhship and renting), where appreciation is solid and vacancies low.

Curious to know whether you think it could still be worthwhile as an income property, even if cash flow is marginal. Thanks

You didn’t tell me what the house is worth now. I think it’s important to know how much equity you have in the property and then find out what your return on equity will be if you rent it out. If it’s too low, you are better off selling the property, pulling the equity out, and finding a better way to put that equity to work. If you’ve lived in the property 2 of the last 5 years, this will likely be a capital gains free sale.

How do you know if the return on equity is too low? Compare it to other options you have to make money. I have to do better than 8% personally, because I feel like I can beat 8% on average by just leaving money in index funds.

Anyway, if you are telling me cap rate is near 0 and 1% rule doesn’t check out, doubt it’ll be a good rental. You’re better off selling and doing something else with your money. Your equity is being wasted sitting there doing nothing, and your cash flow sucks!

Incredibly informative post Rich! I just listened to the Bigger Pockets podcast where you were introduced. It’s great to learn from someone who is willing to be real and breakdown the reality of the situation and actual costs. What would you say is the lifetime of a home in its prime state before it starts to deteriorate so much that it wouldn’t make sense to keep it anymore?

Homes can last a long time. I’m not so concerned about age. You can always remodel if it’s in a good location making good rents. I’m concerned about cash flow first, expenses, and maybe potential for appreciation. If you have several properties, you sell your worst performing ones.

I, too, just listened to your Bigger Pockets podcast. I love your story–I hope to get there. We have a couple rentals and own our own home. We hope to get more going forward. We finance ours. In reply to Sam: While I agree with Rich that a home can last a long time, one of our 2 rentals is a 1950s home, and when the last renter moved out, there was a LOT of repair to do. Our newer one (2000s) has much lower maintenance/repairs. That being said, we’re still cashflowing positive, when you take the whole year in review.

Thanks for this comment. Good luck with the rentals. Let me know if I can help.

As I emailed, I am analyzing a coupe of properties. One meets the 1% rue and one does not but they are two completely different products.

1. 2/1 1950’s build in a mmm, C- neighborhood in South Augusta, GA. Weird old set up with washing machine in kitchen and dryer out back. Was rehabbed by m cousin in 2014 after buying at auction. Will need an new roof in 5 years (approx 3k). Will rent for $650 easy.

2. A brand new townhouse in an are south of Nashville, TN. Nashville is exploding and has a very diversified housing market. PITI + management would be $1200 and rent around $1400. Barely cash flowing but a managed town home with little to no cap ex outside of appliances, especially being new. Nashville has a lot more appreciation potential and the it strategy here is more promising. I can also have family manage this one giving me another $100+ a month in my pocket.

I have been looking for over a year (sometimes actively and sometimes I retreat and focus on other things). It is hard to find a deal right now if you’re trying to break into the market.

On the brand new townhouse, you do understand that if your rent barely covers your mortgage, then you are losing LOTS of money. Half of rent goes to expenses. So take that half out, then subtract your mortgage, and you are upside down in a big way. Bad investment. Do NOT invest in an upside down cashflowing property telling yourself you are doing it because you think it will appreciate. That’s a losing strategy. On the first property, you didn’t say what you bought it for, so I don’t have an idea if it’s a good deal or not.

How would you calculate this on a home that WAS your primary residence. We own several rental properties but they were all our primary residence at one time. For example I bought a home 13 years ago for $229,000. I lived there for 9 years then moved into a new home and started renting the old one out. I owed $150,000 on the property when we moved out. Would I run numbers on it from what was owed when I moved out to calculate my return on investment?

No, you run the numbers based on your initial investment. What did you buy it for? That way you know if it was a good use of your money at the initial investment. You also might have a lot of equity in this property, in which case if you sold, you could get the equity tax free as long as you’ve lived in the property 2 of the last 5 years, because there would be no taxes on the capital gains. You have to consider that. Some people want to make sure there equity is working for them. That’s not so important for me, I like having paid off properties.

I’m curious if the $45000 purchase price in your example includes the real estate agent’s commission? Also, what year was this purchase made?

Thanks for providing so much great info! It’s difficult to find resources that aren’t devoted to maximizing leverage to invest. I understand the benefits on paper, but it’s not something I’m willing to risk.

$45000 includes the commission. That’s normal for the price to include the commission, and it comes out of the seller’s proceeds. Thanks for the comment.

Thanks for the info Rich. I am based out of Canada, hardly will get deals like these here

Also, if we need to jump into real estate in US, how do we start the process? I mean who do we contact, can we go via you?

No, it’s not me. It’s a relative, friend, business partner, or someone you trust in a city in the U.S. where the numbers will work. I’ll admit, without any of these, it can be tricky. You’ll have to go there yourself and make all the connections, but that takes some time.

That’s good to know that you could keep about 50% of the rent. I would think that would still be a good amount of money. I’ll have to consider getting a house to rent out so that I could start earning that money.

Are you buying mobile homes? I can’t buy anything less than $200k anywhere on the west coast that’s not basically a landfill or crime ridden area

Ha! It can be frustrating if your in a high cost of living area, but that doesn’t mean it’s impossible everywhere!

Looking at a 3 unit for $270,000.

Total rent is currently $2650.

Is it worth getting a mortgage?

Would end up with $550 monthly after expenses.

This is a start, but I would need so much more info to help you answer this question.

You need to sit down with someone who is experienced in investing in your area, and then define what the minimum roi on an investment in that area would be for you. Then you crunch the numbers and it either passes or doesn’t pass.

You said above, you’ll get $550 after expenses. Do you mean after paying the mortgage $550 is left over, or after ALL expenses, including vacancy rate, capital improvements, and money alloted for repairs? Big difference.

My initial take is that it doesn’t quite meet the 1% rule as a multi-family. In that case, it better be in great condition, in a great neighborhood with projection growth and inflation in that area.

Do you specifically have a feature or things you look for in a long term rental property? For example, it has to be 3bed 2bath or the property has a specific type of damage you find very easy to fix. It will be very helpful if you made videos of actually going through the process of looking at houses. Thank you for the useful info on the site.

Yeah I have that, but it’s definitely market specific. At least 3 bed 2 baths is important to me. If the damage is too easy to fix, then hard to get a good deal on it. Great idea for a video, thanks.

I learned about you via Paula Pant’s podcast! Thank you for making these concepts come to life with your real-world examples!

You are welcome. Any friend of Paula’s is a friend of mine.

Rich,

I am trying to determine how you would approach a potential investment property that has a good cap rate, but has a lower ROI due to the mortgage expenses, if a mortgage was used.

The mortgage will lower the ROI and it may cash flow poorly due to that additional mortgage expense. BUT as a cash purchase it may have a better ROI and cash flow as a result of not having that mortgage payment.

How would you handle a property where the numbers make sense on a cash deal but not so much with a mortgage? Would you pass, unless you can buy in cash?

Does your cash flow rule apply to properties whether or not they are financed and is there a cash flow range that you aim for?

Thanks for all the informative articles!

Gino

Yes, I would pass on that. The price of money is important. The cap rate is helpful in comparing deals to eachother, but you still have to judge off of the financing you can get on that particular deal. About to update this article. Look out for it. Thanks!

Rich,

As a someone doing research on rentals and trying to understand it all before I take a leap this was informative! Thank you.

One question though… when calculating your ROI I saw you used a few methods to determine your yearly ROI. I’m curious if I could also use the deprecation perk on the tax bill as an added ROI while using the 1% , 50% and appreciation guides.

No, I wouldn’t. Depreciation is recaptured someday when you sell the property. it’s a temporary benefit.