In this industry, you’ll want to learn to love the numbers. Love them like they are part of you. For good or for bad, ‘til death do you part, never leave the numbers.
One of the biggest questions I’m asked is how I analyze 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 , but the first thing I look at is the numbers. If the numbers aren’t good, I move on to the next property.
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 analyzing other aspects of the property.
What numbers do you run? First things first–cash flow. What determines cash flow? Income and expenses. These numbers are simple. So simple that they can literally be scratched out on a napkin.
So what numbers do you need to look at?
Numbers for the Napkin
- Figure out the Monthly Income (Gross Income): Either the property will already have paying tenants in it, so you can use their rent amount for this, or if the property is vacant, you’ll need to figure out what the current market rent is for the property.
- Calculate the Monthly Expenses: These include property taxes, insurance, a property management fee (if applicable), mortgage or financing (if applicable), homeowner’s association (HOA) fee (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. You’ll just use estimates for those since you won’t have actual numbers.
- Property Taxes– Check the county’s tax assessor’s website.
- Insurance– Get a quote from an insurance provider.
- Property Management Fee– Usually around 10% of the monthly rent, but you can confirm with the property management company you plan to use.
- 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– Not all properties have an HOA, and this could also be seen as a “Condo Fee”. Check with the seller of the property, or an agent you’re working with, for this number.
- 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.
- Repairs– 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.
- 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.
- 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- The Cap Rate shows the relationship between how much cash flow a property is getting and the purchase price you buy the property for. This number is more typically used in commercial real estate, but oftentimes you will see it used for residential, as well. The Cap Rate can give you a basic idea of how good the cash flow return will be on a property compared to what you’re paying for it.
Cap Rate = Net Annual Income (no mortgage) / Purchase Price
Note that you do NOT add in the mortgage payment into this equation!
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’re financing, this number is the most accurate way to see the actual return you are getting on your cash.
Cash-on-Cash Return = Net Annual Income (with mortgage) / Total Cash Invested
Note that you DO add in the mortgage payment into this equation!
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 in Atlanta (it was years ago! Don’t expect to see these numbers on properties today…).
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!
Update: Since I wrote this article in the earlier years of owning this property, the rent has increased from $1300/month to $1430/month, and we’re on track to get it up to $1800/month this year!
Running the numbers on a potential rental property purchase is easy. If you can remember what numbers you need to know it will take you no time at all to do this for every property you look at. Jot down the list of expenses on a scrap sheet of paper, fill in the numbers, and calculate your cash flow.
The only trick to this version of running numbers is that it doesn’t include any expenses for rehabs or any work that may have to be put into a property once you purchase it. I usually only deal with turnkey rental properties, which are fully rehabbed when I buy them, so this formula works great because there’s no work required on the houses.
Grab yourself a few spare napkins and try running numbers on some properties! If you’re having trouble getting accurate numbers, hit us up on our Contact Page.
Running numbers on a property is only the first step in determining the worth of the property as a rental property investment. Remember that the numbers you run are only projected numbers. There are no guarantees they’ll hold up! So it’s important to identify risk factors with any property to help determine how sustainable those numbers should be, and help you identify ways to mitigate those risks to help ensure your property continues to be profitable for the life of the investment. Not sure how to do that? Let us know! We’re happy to help.