How To Analyze Your First Rental Property

Real estate investing is an amazing form of investing that offers infinite possibilities to quickly generate wealth.  That being the case, why isn’t everyone doing it?  I believe the answer is fairly simple.  

Firstly, and most commonly, there is the automatic response of “But I really don’t care to fix toilets at one in the morning!”.  Well, you’ve heard of property management companies, right? Believe it or not, their sole purpose of existing is to do the managing for you.  Even then, they aren’t out there fixing toilets in the middle of the night. But they can and will manage all aspects of owning a rental that you don’t want to be involved in.  Like repairs, showing the property, getting tenants in place and collecting rents.

Secondly, it involves some math and enough education to confidently crunch the numbers.  I understand that not everyone out there loves number crunching as much as I do! It is very intimidating to imagine all the factors that must go into the process of evaluating a property for it’s investment worthiness.  But honestly ask yourself, if a little number crunching earned you an early retirement and financial independence, would you do it?

The reality is that maybe only 3 properties evaluated out of 50 or even 100 will make sense as an investment.  But once you learn how to run those numbers, the process is quick and easy. You just need to keep running the numbers until it makes sense.  The more you run the numbers, the easier it is and the better you will be at quickly spotting a great deal. Once you know a property has the potential of being a great investment, you can confidently make an offer to purchase.

How to analyze your first rental property

Know the Area

Before you even start analyzing properties, you need an understanding of the area and the market.  Here are some factors to consider:

• Unemployment rate
• Population growth
• Industry – How is the job market?
• Neighborhoods – Properties in excellent school districts attract long term family tenants, college towns attract student tenants every year, making vacancy low
• Appreciation – Is the market continuing to grow and home value increasing over time?
• Time on market – Are homes selling at, above or below asking price?
• Typical selling prices
• Rental market – Are there more rentals available than people looking to rent or vice versa?
• Gentrification – Are neighborhoods being rehabbed, built-up or repurposed into a popular up-and-coming areas?

Once you feel confident in the area, and specifically the neighborhoods, you want to own property in, it’s time to start crunching some numbers.

There are three main calculations you want to run that will give you a good idea of whether this property will be a great investment or not.  I will break them down into three steps.

Step 1: Calculate the Cash Flow

This is the amount of money that you will collect every month, after all of your expenses.  Think of this as passive income, it comes in every month whether you put any effort or time into it or not.

Hint:  Once your passive income exceeds your monthly expenses, you are financially independent and can do whatever the heck you want with your life.

Cash Flow = Income – Expenses

Income:

Your income is usually just your rent coming in.

• Current rent
• A real estate agent or property management company can confirm current market value

Expenses:

• Repairs
  • If the property was recently renovated, I estimate around 5% to be conservative.  If the property needs some work, factor up to 25%, depending on the age and condition of the basic components that will need to be repaired throughout the property.  Examples include leaking pipes, faulty electrical work, appliance issues, etc.. 
• CapEx
  • These are the big ticket expenses you expect to see over the years.  Appliances need to be replaced every 5-10 years, HVAC every 20 years, roof every 25 years, water heater every 10 years, etc.  You don’t want the shock of replacing an $5k roof just 3 years into owning the property, therefore you reserve a percentage of your collected rental income specifically to cover these expenses as needed.
• P&I
  • This is the principal and interest payments that you make on your mortgage.  The easiest way to estimate this is to use online mortgage calculator and research current interest rates.  Remember that interest rates on rental property is usually higher than when you borrow money for a personal residence.  
• Vacancy
  • This is the amount of time, expressed as a percentage, that a unit is vacant.  High turnover when renters don’t stay in the unit very long, the length of time between renters due to market or cleaning/repairs, and the time it takes to re-rent with an approved renter effect the vacancy rate.   Overall, this rate depends on the area and the rental market.  Markets that are in demand and have rental shortages can be as low as 1%, slow markets with plenty of rentals available can be much higher.  For a conservative calculation, allow for 5-10% of your rental income to be reserved every month.
• Taxes
  • The most recent tax information can be quickly estimated by using a real estate app such as Redfin or Zillow.  
• Insurance
  • It is best to request a quote from an insurance company based on the area and type of property that you are interested in.
• Utilities
  • Some utilities are covered by the tenant, such as water and electricity.  Some utilities should be covered by the owner, typically garbage.  This will depend on the area.  To estimate utilities, look into local providers online or call and ask for an estimate.
• Management
  • Typical management fee is 10% of the rent and includes many other services.  Call a couple local companies to get a feel for what they offer and at what rate.  Typically 9-10% will include showing the property, dealing with all aspects of lease signing, managing minor repairs and collecting rents.  Sometimes the property management companies even offer to oversee major rehab projects.  
• Closing costs
  • There are added expenses associated with the process of purchasing a property, such as all the filing fees.  These can be estimated with online real estate app such as Zillow of Redfin, or contact a local real estate agent for an estimate.

Step 2: Calculate the Cap Rate

The Cap Rate represents whether the purchase price is a good deal or not.

Cap Rate = Net Annual Income / Purchase Price

The Cap Rate will vary by area and market.

An ideal value is greater than 6%.

Net Annual Income is the total income (rent) for the year, factoring in the expenses.  This is your total Cash Flow that you calculated in Step 1.

Easily refer back to this post by saving it to your favorite Pinterest board!

Step 3: Cash on Cash Return

This represents how much return on your money you earn based on the money you put into the investment.

When you purchase a property outright with all cash (called a cash purchase), this will be the same as the Cap Rate.

However, when you finance the property by obtaining a loan from a bank, this number will factor in the monetary leverage.  When you utilize a loan, you have 75% more purchasing power.  The Cash on Cash Return tells you what your financial return actually is. (This is explained further by the example below)

Cash on Cash Return = Net Annual Income / Total cash invested

Total cash will include the down payment, mortgage and agent fees, repairs and other expenses necessary to get your property rented.

Spoiler alert: Look out for how much Cash on Cash Return you can see when you utilize leverage over an all cash purchase.

One thing to keep in mind as you run all of these numbers: Numbers are just numbers and they rely on correct estimates and calculations.  While running the numbers may look amazing on paper, the reality might be very different.  If you are buying in an area with class C properties, meaning the quality of tenant is poor, quality of the house is poor, there is high turnover, high likelihood of missed rent payments and tenant evictions, etc., no matter what the numbers look like on paper, you won’t want the headache of owning the property.  

Now let’s look at an example to see how these calculations actually work:

Example:

Let’s first assume that you cash buy this rental outright.

Step 1: Calculate monthly cash flow

Cash Flow = Income – Expenses

Expenses:

Cash Flow = $2,100 – $1,436 = $664

Step 2:  Cap Rate

Cap Rate = Net Annual Income / Purchase Price

Cap Rate = ($664 x 12) / $200,000 = $7,968 / $200,000 = 0.040 or 4.0%

Step 3: Cash on Cash Return

Cash on Cash Return = Net Annual Income / Total cash invested

Cash on Cash Return = Same as Cap Rate when cash purchase

Now, let’s assume we take out a mortgage to purchase the property:

Step 4: Calculate monthly cash flow

Cash Flow = Income – Expenses

Expenses:

Cash Flow with mortgage: $2,100 – $2,311 = $-211

Yes, that’s negative $211.  Meaning, you will have to pay $211 out of pocket every month in order to own this rental.  In order to cash flow you need to purchase at a lower price or evaluate whether rent could be raised.  If for instance $1000/unit is a reasonable market rent, the cash flow would then be:

Cash Flow = $3000 – $2,311 = $689

It is not uncommon to purchase a property with low rents.  If the tenants have been in place for a very long time, they will be paying below market rent.  If the property hasn’t been updated in a very long time and you repaint, install new flooring and make minor repairs, you will be able to bring rents back up to market value.  This would be a reasonable example of how you could raise rents by $300/month and still find tenants to sign a lease.

Step 2:  Cap Rate

This calculation specifically doesn’t account for mortgage and is an estimate of how good the deal is based on the full purchase price.  

Cap Rate = 4.0%

Step 3: Cash on Cash Return

Cash on Cash Return = Net Annual Income / Total cash invested

Cash on Cash Return = (Monthly cash flow x 12) / Cash to close (Down payment + closing costs)

Cash on Cash Return = $8,268 / $55,000 = 0.15 or 15%

The return on your investment dramatically improves when you leverage with a mortgage.  It requires much less dollar investment, allows you to buy more house, and greatly improves return on investment, ROI.  While cash flow is greatly decreased, since you have to cover the mortgage every month, your tenants are going to cover this and if you have enough saved for another down payment, you can buy more rental properties and continue to add to your overall cash flow.

Recap

I love real estate investing.  It is by far my favorite form of wealth generation.  

What other investment offers you a reliable 15% return?  Perhaps the stock market will periodically perform better, but averaged out over good years and bad, you won’t see this consistent rate of return.  And remember, the tenant continues to pay down your mortgage, meaning your ROI only increases over time as that mortgage gets paid down.

Also, this is assuming you pay the traditional 25% down payment.  What if instead you use private money lending or other forms of creative financing such that you purchase with little or no money out of pocket.  Your cash on cash return can be infinite.

There are so many other reasons to love REI.  Take a look at Real Estate Investing: 6 Pivotal Reasons To Get Started Today to learn about a few REI techniques.

The calculations to evaluate a property are simple.  

1. Cash flow
2. Cap Rate
3. Cash on Cash Return

These numbers will give you a good idea of whether a property is worth your time or not.  If the numbers work out, great!  Contact your realtor and put in an offer.  Of note, your offer is not necessarily what the asking price is.  Keep in mind, the asking price is what the owner is hoping to receive.  It may not be what the property is worth or what the market requires.  Make your offer confidently with the numbers you have. If ultimately the owner wants more, then it just doesn’t make sense and you can walk away and find one that does make sense.  You never know, if the property doesn’t sell you could come back with your original offer and make the deal anyway.

The most important thing to keep in mind: Numbers don’t lie.  Emotions do. An investment is not an emotional attachment. Don’t get steered astray by cuteness or location factors.  I recently purchased my first duplex almost 9 months ago and I’ve still haven’t even seen it yet.  I have a team that I trust and the numbers made sense before purchasing and continue to make sense now.  

The key is learn to analyze rental properties as investments that accomplish your financial goals.  

Action Steps

I encourage you to check out one of the many real estate apps available, such as Zillow, Redfin, Trulia, or good old MLS.com. Then:

1. Check out your area
   1. What are the market stats?  Refer back to the “know the area” section of this post.
   2. If you aren’t sure, contact one or two realtors in your area.  When picking a realtor to work with, check if they have experience working with investors.  This is important! Many agents don’t know how to analyze a rental purchase and don’t think in the same terms that an investor needs to.
2. Find a duplex to analyze first.
   1. In the listing, check if they provide rental details.
   2. If you don’t know what rent would be, ask your realtor or a local property management company.  In particular, property managers have no problem providing this information. It means you may be a potential client in the future.
3. Using the asking price and rental estimate, calculate cash flow.
4. Next, calculate Cap Rate.
5. Finally, calculate Cash on Cash Return.
6. If the numbers are terrible, like negative cash flow or below 6% Cap Rate or ROI less than what you’d want from a savings account or long term retirement account, take a look at the factors involved in why this is.  Is the asking price too high? Is the rent too low?
7. Move on to the next and continue crunching numbers until they make sense as an investment.
8. When you come across a property that makes sense on paper, do a happy dance!
9. Then, contact your realtor to find out more information and make an offer based on the numbers that work for you.
10. Making an offer is not as scary as you may think.  You are not committing to purchase. You are learning whether the owner will be willing to sell for your asking price and starting the process of due diligence.  This is where you can dig deep and analyze further.
11. This is the first step to owning your first rental property!  Congrats!