One of the biggest questions I’m asked is how I go about a property once I find it. What do I do, what do I look at, how do I know if it’s “the one”? There are several things I do and look at with any new property potential, but the most important is the numbers. If the numbers aren’t good, I walk. Save yourself some time and before you do anything else, run the numbers and see if they work. If they don’t, awesome, you didn’t waste time on other stuff.
What numbers do you run? Well, what should any investor care most about? Cash flow. What determines cash flow? Income and expenses. Simple. People make running numbers out to be so complicated sometimes it’s a no wonder more people aren’t involved in real estate. In fact, the numbers can be one of the easiest parts of shopping for a property. Unless you are a trained psychic on the crystal ball, then predicting appreciation may be easier for you than estimating cash flow.
Numbers for the Napkin
1. Figure out the Monthly Income (Gross Income): This will either be rent the current tenants are paying, the asking rent (confirm this number is realistic), or if you have neither of those you can talk to a local property manager or real estate agent who can give you a market rent value for the property.
2. Calculate the Monthly Expenses: These include property taxes, insurance, property management fee (if applicable), mortgage or financing (if applicable), homeowner’s association fee (HOA) (if applicable), vacancy and repairs. Don’t forget vacancy and repairs! They are a real part of any property investment and they can drastically affect the cash flow. Yet so many people don’t think to include them in the expenses.
- Property Taxes– Look on Zillow or another online source for the most recent annual tax amount and divide by 12.
- Insurance– Get a quote from an insurance provider.
- Property Management Fee– Usually around 10% of the monthly rent.
- Mortgage– Use an online mortgage calculator to calculate the monthly payment. Confirm with your lender what your down payment and interest on the loan will be to ensure you are using accurate numbers for your calculations.
- HOA– This can be tough to find sometimes. The seller or agent may know the number already, but if not you will have to call the HOA of the neighborhood. If you only know the annual fee, divide by 12.
Don’t skip out on finding out what the actual HOA is! The HOA can absolutely kill a property’s cash flow.
- Vacancy– I conservatively estimate 10% of the monthly rent towards vacancy expenses. In situations where you have a rockstar property manager or your tenants are under a lease option, the actual % should be much less. I still use 10% no matter what just to be sure I have a conservative margin.
- Repairs– Again an estimate but should not be left out. Just like with vacancy, I err on the side of conservative. If a house is a turnkey property or recently rehabbed and gets a good report from the inspector, I use 5% of the monthly rent. If the property is not in top shape, conservative could mean closer to 25%. Use your judgment on deciding what % to use for your estimate, but don’t overestimate the quality of your property and estimate too low.
3. Subtract the Monthly Expenses from the Monthly Rent (= Net Income): This is your monthly cash flow. Yay! Hopefully it’s positive. If it’s not positive, run.
4. Calculate the Returns: Two numbers I want to see on any property I evaluate are the Cap Rate and the Cash-on-Cash Return.
- Cap Rate– This gives you an idea if you are buying the property at a good deal. It basically compares the return on investment (ROI) to the purchase price.
The Cap Rate equation:
Net Annual Income / Purchase Price = Cap Rate
NOTE: I don’t include the mortgage payment in this calculation.
The lowest cap rate I would ever want to see for any property, whether residential or commercial I don’t care is 6%. The lowest I would want to see on a residential rental property in this market is 8% and even then, there better be a good reason it’s that low (property in a “sexy” market, highly desirable area, etc.). Anything over 8% and you are doing well in my opinion.
- Cash-on-Cash Return- This number is how much return you are getting on the money you invest. If you pay all cash for a property, this number will be the same as the Cap Rate. If you are financing, this number is the most accurate way to see the actual return you are getting on your cash-in and the leverage. Here is the equation, and remember to include the mortgage payment since this one is totally focused on financing:
Net Annual Income / Total Cash Invested = Cash-on-Cash Return
Understand the difference? One is a measure of how good of a deal you are getting on the purchase price and the other tells you the exact return on your money you are getting. They are the same for an all-cash buy but can be very different for a leveraged purchase.
If you compare the Cash-on-Cash Returns of an all-cash buy versus a financed buy. You may quickly see the benefit of leveraging! Way more bang for your buck! Try it out on a napkin sometime.
Practice Problem, on an Actual Napkin
Apply these steps to an actual property? On a real napkin? You got it. Even more fun, I’m going to use a property that I bought for myself just a few months ago in Atlanta.
What do you think? Good deal? Absolutely! I’m pocketing $358/month in cash flow (the actual number when there are no vacancies and repairs is $558!), the Cap Rate is 9.7% and the Cash-on-Cash Return is 17.97%. Not only are the returns great, but the tenants are under a 3-year lease and the property is in a great area. Score!