When it comes to making a smart investment in the single-family rental sector, a lot of it boils down to math. The good news? It’s not calculus. The better news? Modern solutions can significantly streamline the process and help eliminate projection errors.
“Wealth creation through real estate starts with correct math.” —Brandon Turner, author of “The Book on Rental Property Investing”
In this two-part blog series, we’ll explore the process of evaluating investment property ROI, and break down some of the questions you might have as a first-time rental home investor.
1. The One and 50 Percent Rules
It's easy to fall down an Internet rabbit hole of percentage-based rules—and varying opinions on them—when researching how much to spend on an investment property or how to calculate ROI.
Just remember: These rules aren’t hard and fast. They’re rules of thumb, or quick techniques to perform a first-pass when determining if a rental property might be worth examining more. Think of them as screening tools or benchmarks in a multi-step process that also takes property quality, location and tenants into consideration (we explore this more in Part II).
Here’s a look at two common “rules of thumb” in the world of rental property investing, and what they mean:
a. The one percent rule
The aim of the one percent rule is for rent to be close to one percent of the purchase price of the home (this includes the cost of urgent repairs or improvements). By this standard, rent will generally be greater or equal to the mortgage payment. Buyers use the one percent rule to immediately ascertain how a property will cash flow.
Here’s an example of the one percent rule from Zillow:
- Scenario 1: If you can collect $1,600 per month in rent and you paid $200,000 for the property, you are collecting rent that is 0.8 percent of the purchase price. This checks one item on the list of things to examine.
- Scenario 2: If you can collect $1,600 per month in rent and you paid $400,000 for the property, you are collecting rent that is 0.4 percent of the purchase price. This is farther away from the one percent benchmark and might not be a very good deal.
The one percent metric is not, however, a guarantee of cash flow. Nor should it be the primary metric used in making investment decisions. For example, an investment property might have good cash flow, but come with higher investment risk due to other factors like the neighborhood quality or area occupancy rates.
b. The 50 percent rule
This rule of thumb states that the total cost of owning a rental property, excluding the mortgage and interest payment, should be about 50 percent of the gross rent.
While this is a quick and easy way to estimate cash flow, it’s not as accurate as using actual expected numbers and shouldn’t replace a more thorough property analysis.
2. Calculating Expenses
Above: Roofstock provides a lease and tenant summary upfront for all of its properties, which makes it easy to see at-a-glance what expenses the tenants are responsible for covering.
Having a realistic understanding of ongoing operational costs is critical when calculating investment property ROI. While the tenant will pay the mortgage and typically the utilities (trash, water, electricity, etc.), other expenses are your responsibility. This includes:
- City taxes
- Property taxes
- Property insurance
- Property management fees
- HOA fees (if applicable)
- Landscaping (if applicable)
- Capital expenditures (bigger renovations, additions, etc.)
- Vacancy costs (this is typically calculated as a percentage and factored into your projected expenses as a conservative oversight, in case the home sits empty between tenants)
Be sure to review carefully the property’s financial pro forma, or cash flow projection that includes forecasted expenditures and returns. Knowing true costs will help guide your purchase decision.
3. Crunching the Numbers
“ROI changes depending on whether you pay cash or finance the purchase of property. As a general rule, the less cash you put into a real estate deal and the more you mortgage, the greater your ROI will be. Conversely, the more cash you put into a deal and the less you borrow, the less your ROI will be (but the greater your net income).”—Investopedia
Wondering what kind of return metrics you should be looking at when evaluating investment property ROI? Here’s a list of key figures we believe are important:
- Monthly gross income: Total current monthly rent, excluding operating costs
- Monthly cash flow, or net income: Monthly rent - monthly expenses (including your mortgage costs)
- Yearly cash flow, or net annual net income: Monthly net income x 12
- Net yield, or cap rate: Net annual operating income/purchase price. Cap rate does not factor in mortgage and interest payments.
- Cash-on-cash return: Your annual pre-tax cash flow/invested equity (aka, cash income earned on the cash invested in a property). This doesn’t take into consideration some of the other benefits of rental property ownership, including appreciation, loan paydown, depreciation and other tax benefits. Whereas calculations based on standard ROI take into account the total return of an investment, cash-on-cash return only measures the return on the actual cash invested.
- Gross Yield: (Monthly rent x 12)/purchase price
- Appreciation: An increase in the value of an asset over time
4. Or...Let Someone Else do the Number Crunching for You
To see this tool in action, visit our marketplace and click into any property.
Understanding the variables that go into evaluating potential ROI of a single-family home is an important part of becoming a savvy rental property investor. That said, you can also take advantage of modern tools and platforms that help streamline the process and reduce projection errors.
For example: At Roofstock—an online marketplace for buying investment properties—we put all the numbers at your fingertips. By using our interactive tool to manage assumptions, you can create a customized, comprehensive pro forma with conservative five-year projections including estimated revenue, operating expenses, total return and more.
Unlike a basic math problem, there’s no one answer to the question of “How much should I spend on a rental property?” But with the right information and tools, you can invest with confidence knowing the answer is right for you.
The above is for informational purposes only and is not intended to be investment or real estate advice. You should always consult with your professional financial advisor prior to purchasing an investment property.