This week the guys get nerdy about the numbers and chat about how to calculate cash on cash return to see if a property will be a smart investment.
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Is This a Good Investment?
If you’ve been talking about buying a rental property with friends and family, there was probably someone who told you some horror story about owning rental property. Before letting them scare you out of it, do the math.
It’s important not to make an emotional decision when buying a rental property. Instead look at the numbers and have systems in place to protect you.
Some of us are just not numbers people (including myself). Although real estate investment math isn’t calculus, there are a lot of calculations involved. Don’t worry; we’re here to help.
Cash On Cash Return
The cash on cash return is a simple way of measuring the performance of a potential investment property that is quick and easy. It can be a good starting point for quickly filtering potential investment properties.
Cash-on-cash return = annual pretax cash flow / total cash invested.
For example, if you put $100,000 cash into the purchase of property and the annual pretax cash flow is $10,000, then your cash-on-cash return is 10%.
Cash-on-cash return is the actual return you will get at the end of the year your rental property after all property specific expenses are paid out like mortgage, taxes, insurance, HOA, etc.
It’s a great metric to determine if a property will be a good investment right off the bat and a quick, easy way to compare different properties. Although cash on cash return is a useful back of the napkin evaluation, there are many other essential calculations to take into consideration. Yup, more math.
We’ll Do The Math For You
Unless you enjoy getting elbow deep in nerdy spreadsheets, we have something that will do all the math for you. Simple Wealth is a platform that will help you research, evaluate and track rental properties.
It not only will it calculate your cash on cash return, it will also help you understand your properties income, appreciation, and equity using our sexy graphs. Simple Wealth will help you calculate cap rate, NOI, gross yield, rent estimates, and vacancy rate. What does all that mean? Let us get into it.
Here are some of the key metrics we use to evaluate rental properties so you can get a better understanding of how all the math works.
Annual NOI (Net Operating Income) is income after property expenses. NOI is simply the annual revenue generated by an income-producing property after taking into account all income collected from operations and deducting all costs incurred from operations. NOI excludes any financing or tax expenses incurred by the owner/investor. In other words, the NOI is unique to the property, rather than the investor.
Cap Rate is the annual return on investment without financing. Return if you bought the property in full, in cash.
Gross yield shows the rate of return on investment. It is a good rule of thumb number you can use to compare properties quickly. It is an easy calculation which is the monthly rent times 12 then divided by purchase price. Not the amount you would invest but the full cost of the home.
The purchase price is the biggest lever you can pull to make a property a better investment. Even negotiating 1k lower can significantly improve your cash-on-cash return. Getting a good deal on the property itself is the biggest move you can make. We just bought a property for 110k, and if we negotiated down 1k, we would have gained .5% COC return.
The success of a rental property purchase is based on this number. Make no mistake, the easiest way to improve cash flow is to reduce how much the property costs. Unless you’re getting a great deal, this number should probably be lower than the Estimated Value provided by Zillow.
Acquisition Costs is the initial costs of purchasing the property. The cash required for financing up front. The down payment is the amount of money you contribute to a financing deal. The bank funds the remainder of the purchase price in the form of a mortgage.
Just like buying a home, you should put 20% down. PMI is like throwing away money. We went with a fixed rate mortgage for most investors because it allows you to have control of costs way into the future.
You would also account for the closing costs here. The cost of the transaction or closing costs are fees paid at the closing of a transaction. Often included in these expenses are the mortgage origination fee, appraisal, and escrowed property taxes. If you are paying for the property in all cash these costs will be less. You also want to count any major renovations costs as well.
Ongoing Costs should be next on your list when evaluation a rental property. Major ongoing costs would taxes, insurance or property management fees. Annual taxes records can be found online on sites like Zillow. Property management companies on average cost about 10% of the monthly rent.
Vacancy Rate is an estimation that landlords use to see the total amount of rental units that are unoccupied. There could be the time when your property could be vacant, and you will not be making your estimated monthly rent from a tenant. To keep the cash flow coming in even during a vacancy, you should put aside a percentage of your monthly income to save n a reserve account.
You can check the vacancy rate for the is your rental is in, but on average across the U.S., the vacancy rate is 5%. So let’s say you make $100 per month, 5% of that or $5 should automatically be skimmed off the top and saved.
Major/Minor CapX is money saved for break fixes. Instead of fearing what might happen to use statistics to protect yourself. I will get more into this in the following section.
Annual cash flow is your profit after all expenses. If this number isn’t positive, that means you’ll lose money every year on this property. If it’s positive, that’s how much you’ll earn. This doesn’t account for a vacancy, maintenance or things breaking. It does account for taxes, HOA, insurance, management and other known costs. The 1% Rule- Is your monthly rent at least 1% of the purchase price.
Medium-term cash flow is an estimation of what your cash flow will be accounting for Vacancy and minor/major repairs. Things break and need to replacing so be prepared. You need to be positive here. A rule of thumb would be saving 15% of your annual cash flow to account for bumps in the road. The formula is rent minus the Mortgage Payment minus Vacancy reserve minus CapEx reserve.
Long-term cash flow is like the 15%rule for medium term but more intense. In the very long term, you may need to replace a roof, renovate a kitchen and account for a vacancy. While not necessary, if you are positive here you can weather most any storm and still make money. Formula: 50% of monthly Rent minus the monthly Mortgage Payment.
The rule of 72 is a shortcut to estimate the number of years required to double your money at a given annual rate of return. The rule states that you divide the rate, expressed as a percentage, into 72: Years required to double investment = 72 ÷ compound annual interest rate.
Real estate investing for beginners can seem intimidating at first, but once you understand math, you will trust it. Investing in real estate is a number’s game. Do your homework and learn everything you can before diving in. Connect with other investors and as many questions as possible. Got to local meetups or talk to some experts in the LMM Community.
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