How to Calculate Rental Yield So You Can Make a Smart Investment
- Written by Laura Fiebert
This week we will continue our journey in real estate investing. The last episode the guys gave an overview of what a real estate deal would look like and how it can be a profitable investment if done right. This week Thomas and Andrew get nerdy about the numbers and chat about how to calculate rental yield to see if a property will be a smart investment.
Owning a profitable rental property is all about the math. You might know someone who is going to tell you a horror story about being a landlord, but 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 and although the math isn’t calculus there are a lot of calculations involved. Andrew has spent the last month working on a tool to help you do all the math. LMM Pro now features an Investment Property Evaluation Tool that can help research, evaluate and track rental properties. It will determine if a potential property is going to be a sound investment and how to calculate rental yield. The tool pulls in data for you, so you don’t have to punch a ton of numbers and formulas into a spreadsheet.
We are also working on a property management feature where you can keep track of all your rentals, paperwork, and other relevant information. Check it out and let us know what you think. If you don’t have rental property in mind, play around with your parents or neighbors home.
Ok, let’s get into the numbers.
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 is your return on investments using leverage.
For example, if you put $100,000 cash into the purchase of property and the annual pre-tax cash flow $10,000, then their cash-on-cash return is 10%.
Cash-on-cash return = annual pre-tax cash flow / total cash invested.
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 largely 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 upfront. 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 like 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 are 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 should be 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 meet ups or talk to some experts in the LMM Community.
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