When it comes to investing your hard earned money, there is no shortage of options out there.
You will have plenty of acronyms thrown out at you when you are considering buying a rental property such as ROI, CAP, IRR, etc. The list goes on but you get the point!
The goal is to SIMPLIFY the entire process of buying rental properties. And it all starts out with understanding the numbers.
So how does one know if a rental property is a great investment or not?
Here are 3 calculations that you should ask for on every home you are considering purchasing:
1. CAP Rate: The Formula for CAP Rate is Equal to Net Operating Income (NOI) Divided by the Current Market Value of the Asset. In order to calculate your CAP rate you must first know your NOI. Net operating income is the annual income generated by the property after deducting all expenses that are incurred from operations including managing the property and paying taxes.
This calculation is one of our favorite calculations to use when deciding if a property makes sense to purchase because it factors in ALL of your expenses (some are assumed such as vacancy rate and repairs each year) against your purchase price.
Generally speaking anything above 7% is a great place to start. However, the answer to what cap rate you should look for is always begun with the phrase: “It Depends…”
This is why we look at the big picture by looking at not just ONE calculation but multiple factors that need to be taken under consideration.
2. Leveraged Cash on Cash. The cash-on-cash return formula is simple: Annual Net Cash Flow / Invested Equity = Cash on Cash Return.
You have a $40,000 downpayment (20%) on a $200,000 property.
The property makes $1,600 a month or $19,200 annually.
COC = $19,200 / $200,000 = 9.6% Year 1 cash on cash return
Most turnkey providers will provide you with years one, five, and ten, because as your mortgage gets paid off and appreciation occurs, your returns tend to go up in a normal market year after year.
Even if you keep up with the rate of inflation, one of the reasons why real estate can be such a great hedge against inflation is you have a fixed mortgage for 15 or 30 years typically while inflation goes up (in a healthy economy) around 2 to 3% year over year.
Bottom line: Your returns will be MUCH higher in year ten vs year one. Typically year one is the worst-case scenario, barring any unforeseen issues arising such as major repairs or vacancies, etc.
3. Cash Flow: Net Cash Flow = Total Cash Inflows-Total Cash Outflows. Why is this number so important? Because you need to be able to project how much money will be left in your pocket AFTER all of your debts and expenses have been paid each month.
How much cash flow is good?
The short answer to this question is that any amount of positive cash flow is good, and the bigger the better. But in reality, what makes cash flow “good” is subjective, and varies from one investor to another.
Some rental property investors look for a minimum return on investment (ROI) while others look for property that generates a sufficient net cash flow to meet targeted cash-on-cash returns:
As a rule of thumb, many investors aim for a minimum return of 10% on the cash they invest.
If you crunch the numbers on a rental property opportunity and you understand these 3 calculations, you will be able to make a wise investment decision.
Most important of all, make sure to follow Warren Buffett’s first two rules to investing your money.
“Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.”
If you run these calculations and the numbers pencil, then it is worth exploring further. Just keep in mind, you still have a lot of due diligence to take care of before you pull the trigger. Our goal is to help you along the entire process.