Rental real estate can be a great way to generate income and build wealth, but few new investors know how to evaluate and select properties. Purchasing your first rental property is a major financial decision and shouldn’t be taken lightly, so it's important to understand what you’re doing.
Here’s an overview of what aspiring landlords should know about cash flow, equity appreciation, and a few other factors. Smart analysis can be the difference between years of strong income and lots of accumulated equity versus so-so returns.
How your rental properties (could) make you money
There are two basic ways you can make money with a rental property. It can generate current income (cash flow) or it can build equity. As your mortgage balance declines and the property becomes worth more over time, equity rises.
Many experts tell real estate investors to focus on cash flow. There's good reason for this. Equity appreciation can be extremely difficult to project, especially over shorter time periods. And mortgage principal reduction can be depressingly low during the first few years of ownership. I often say that looking at my loan’s amortization schedule was the most depressing memory I have of closing on my first rental property.
To be clear, both are extremely important to your long-term returns. In fact, if you hold a rental property for decades, equity appreciation could easily become the larger of the two components.
Over long periods of time, real estate prices have grown slightly faster than inflation. So, if you plan to hold a rental property for 25 years, it’s reasonable to expect its value to grow at this rate if it’s properly maintained. However, property value fluctuations are impossible to predict over short periods of time with any level of accuracy.
Even though appreciation is important and potentially lucrative, cash flow is the more important part of your analysis. Here’s why:
- Property values in geographical areas tend to rise and fall at roughly the same rates. If you’re looking at 10 potential duplexes in your local market, their values should rise at about the same rates over time.
- Mortgage repayment occurs at roughly the same rate for each property, assuming you get the same type of loan with the same interest rate. Say you buy two properties with 30-year fixed rate mortgages at 6% interest and 20% down. The proportion of each loan you've paid off will be the same after five, 10, and 20 years.
While equity is important, cash flow is the main differentiator. It's the factor that generally makes one rental property investment better than another.
Analyzing your property’s cash flow
Cash flow is a simple concept to understand. Your property’s cash flow is the income it brings in minus the expenses associated with owning, managing, and maintaining the property.
While it’s a simple concept, the calculation of rental property cash flow can be complex. Many inexperienced investors have trouble with it. Specifically, many of them dramatically underestimate the costs of owning a rental property. Things you need to account for in your cash flow analysis include the following:
- Your mortgage payment: Most lenders require property taxes and insurance payments with the mortgage payment. Be sure to include that in your calculations. If you don’t pay them with the mortgage, account for them separately.
- Any utilities you pay: Tenants usually pay their own electric bills, but landlords often pay for water, cable, sewer, and trash collection. This is especially true if the property is a multi-unit building. If the property you’re considering is already rented, find out what utilities the landlord pays. Then conservatively estimate how much they’ll cost.
- Property management: If you plan to hire a property manager, account for the expense. The industry standard is 10% of collected rent.
- HOA fees: If the property is part of a homeowners’ association, budget for this expense as well. Find out what's included with the HOA fee. For example, in some condominiums, the HOA dues include basic cable.
- Other expenses: Account for anything else you’ll pay for on an ongoing basis. Examples could include pest control or lawn maintenance. Don’t count on your tenants doing either of these things on their own. Plan on paying for them yourself or making it the tenants’ responsibility as part of the lease.
- Vacancy: This gets tricky. At some point, your rental property will likely sit vacant for at least a little while. In a perfect world, you or your property manager will have a new tenant lined up before the old one moves out. But it doesn’t always work out that way. Depending on the nature of your property and current market conditions, it’s smart to assume a 5–10% vacancy rate and set aside this portion of the rent to offset the cost. After all, you still have to pay the mortgage and other expenses when your property is vacant.
- Maintenance: At some point, things will need to be repaired or replaced. The property’s HVAC unit is going to die. You'll need to pay for a new roof. Winter means you'll have to hire a snow removal company. Set aside part of the rent so you’ll have reserves when you need them. I use 10% for a maintenance allowance and 5% for a vacancy allowance and adjust as necessary. For example, a 5% maintenance allowance could be plenty for a new construction, but you may need more for an older home.
An example of cash flow analysis
To illustrate this, I’ll use a real-world example of a rental property I recently bought.
Here are the details: The property is a triplex (three units) with total rent of $2,425 per month. I pay taxes and insurance as part of my mortgage payment each month, I pay for water service, and the property isn't part of an HOA.
Because of the age of the property (about 50 years), I use a 10% maintenance allowance. But I use a lower 5% vacancy allowance because it's located in a strong rental market.
With all of that in mind, here’s how I analyzed the cash flow of the property:
|Mortgage payment (PITI)||($1,600)|
|Landlord-paid utilities (water)||($50)|
|Cash flow||$168.75 per month|
My only strict requirement is that after a thorough and exhaustive cash flow calculation, the property produces positive cash flow from day one. Ideally, the cash flow I get from a rental property will be more than I could get from a savings account, CD, or other risk-free place to park my cash. We’ll get into that later.
As I mentioned earlier, comparing the cash flow situations of different properties can be a great way to analyze deals.
Also remember that this is immediate cash flow and that it should rise over time. Historically, rental rates have increased in line with inflation over long time periods. Your rental income will probably increase while your mortgage payment remains the same. The bottom line is that if you start with positive cash flow, you’ll set yourself up nicely for the future. And you still won't lose money if the real estate market has a slow year and rent doesn’t rise as expected.
How much rental income will the property generate?
For your cash flow analysis to be accurate, you need to know how much rental income a property will generate.
If the property is already rented, this is easy. This was the case with the property I used for the example -- all three units were already rented when I bought the triplex, so there wasn’t any guesswork involved. Better yet, if the property is occupied, ask the current owner for a detailed rental history. This not only lets you know how much rent has been generated by the property but can also give you good insights into vacancy trends.
On the other hand, things can get tricky if the property is vacant or owner-occupied. A rental history is a good indicator for a property that’s vacant but had previously been used as a rental. If no rental history is available for that property, check rental listings for comparable properties in the area, ask a local property manager for their opinion, or get a rental appraisal done. Appraisals can be expensive, but many investment property lenders require one.
Err on the side of caution and be conservative when estimating rent in your analysis. If the property ends up renting for more than you think, great. But remember that as a responsible investor, you want to know what the property’s cash flow will be if things don’t work out perfectly.
An important thing to know about property taxes
For the most part, I don't look at taxes when I evaluate a rental property. After all, property tax rates tend to be roughly the same within the same geographical market. And your rental income will be treated the same from the IRS regardless of which property it came from. Sure, higher cash flow might translate to a higher tax bill at the end of the year, but that’s a good problem to have.
However, there’s one potential tax issue that is worth mentioning. Many jurisdictions give special tax treatment to owner-occupied properties. That means investors pay higher tax rates than owner-occupants for the same home. The difference can be dramatic.
For example, I live in South Carolina, where property taxes are notoriously low. One of the reasons they're low for owner-occupants is that rates given to investors are dramatically higher. An investor would pay three or four times what an owner-occupant would pay.
Here’s the point. If you’re thinking of buying a rental property, find out if it’s currently used as a rental or if it’s occupied by the homeowner.
If the latter is true, your tax bill could be much higher than public records indicate. Your real estate agent should be able to give you a good idea of how property taxes for investors versus homeowners work in your target market. It's an important factor to include in your analysis.
Other important metrics and analytical concepts to know
When I analyze a rental property, cash flow is the number one factor I consider. If a potential property has negative cash flow, I don’t pursue it any further or conduct any further analysis.
However, if a property has an acceptable level of cash flow, I use a few other metrics and concepts to evaluate them:
This is the annualized return you generate relative to the amount of money you pay to acquire the property. To calculate your cash-on-cash return, divide the property’s annual cash flow by the amount of money you paid to acquire it. That includes closing costs, property improvements you paid for, and other expenses incurred when purchasing the property.
For example, I paid a total of about $60,000 out of pocket to acquire the triplex in my example, including my down payment and all other costs. Dividing the annual cash flow of $2,025 by $60,000 shows that I’m getting a cash-on-cash return of about 3.4%. This isn’t great by any means, but it’s more than I could get from a savings account. Plus, keep in mind that this doesn’t account for future rent growth or any accumulation of equity over time.
One of my favorite ways to use cash-on-cash return is to compare properties where you need to put different amounts of money down. For example, let’s say you're comparing two $100,000 properties. The first one should net about $300 per month while the other should only produce cash flow of $100 after expenses.
Imagine your lender wants a 20% down payment for the second property, while the first is in poor condition and has to be an all-cash deal. Cash-on-cash return helps show which property provides the better annualized return. (It’s the property with the lower cash flow in this case.)
Capitalization (cap) rate
This metric is a property’s pre-tax annual cash flow -- excluding mortgage payments -- divided by its acquisition cost. For example, a property that generates cash flow of $7,000 per year and costs $100,000 would have a 7% cap rate. Higher is better.
Cap rate is a widely used real estate metric. It's especially handy for rental property investors if you don’t know the details of your financing yet. If you don’t know how much you’ll need to put down or what interest rate you’ll be paying, it’s impossible to know for sure how much your monthly mortgage payment will be.
For our purposes, when you’re examining a particular property’s cap rate, calculate its cash flow exactly as we did earlier. But this time, exclude the monthly mortgage payment (include property taxes and insurance). Then divide by your expected acquisition cost, including closing expenses and property repairs or improvements you’ll need to make right away.
Narrowing down your search
There’s a lot of information to consider before buying a rental property. Why would you make a six-figure financial decision without understanding what you’re getting into?
However, if you live in a market where there are dozens or hundreds of properties that meet your criteria, it's too time-consuming to conduct a complete cash flow analysis for all of them.
One smart way to narrow down your list is by looking at each property’s gross rent multiplier. This is a property’s price expressed as a multiple of its monthly rent. For example, a property that costs $100,000 and generates $1,000 in monthly rent would have a gross rent multiplier of 100. Lower numbers are better.
There are differing opinions on how to use the gross rent multiplier to narrow your search. Many investors won’t even look at a property with a gross rent multiplier of more than 100 or some other fixed number.
I use a different approach, as gross rent multipliers vary by market and can change with economic conditions. If I have a long list of potential properties, I’ll narrow down my list to those whose gross rent multipliers are in the lowest 10–20% of the market.
When you do it this way, the gross rent multipliers are based on each property’s asking price, not on the price you could actually purchase the property for. Some sellers will be significantly more flexible than others when it comes to negotiating, so this is an imperfect way to assess properties. Even so, it’s a good way to narrow down your search. Then you can conduct more intensive analysis on each property.
There’s more than one way to evaluate and choose rental properties
Keep in mind that there’s no one right way to apply these methods to your own rental property analysis. The best method for you depends on your priorities, risk tolerance, and investment goals.
For example, there are many income-oriented real estate investors who would consider the cash flow of the triplex I recently purchased as too low. A friend of mine who also invests in rental properties insists that all of his properties produce at least a 6% cash-on-cash return.
Neither of us is necessarily wrong. He relies on his rental portfolio for income to pay his bills and other living expenses. It makes sense that he wants more cash flow. I take a more long-term view and focus on the potential for future equity appreciation and an income stream that grows over time. Since I don’t need current income from my portfolio, I’m willing to take on a bit more debt to maximize long-term appreciation and returns.
The analytical methods discussed here are pretty universal. But it’s up to you when it comes to cash flow, cash-on-cash return, or cap rate standards. Make sure that a deal makes sense for you, and that it’s better than the alternatives available in your target market, and you should be just fine.