I've had several conversations recently with new investor clients trying to find their first rental, and the first question most people ask is "how do I know if it will make a good investment?" My go-to calculation for evaluating a property is the simple Cash on Cash return.
I see many people using or trying to use the "1% rule" which states that 1 month's rent must equal or exceed 1% of the purchase price. I.E. a $100,000 property should rent for $1,000/mo or more. If you can find this, great... but for many markets this type of property is almost non-existent or it's the type of property that you don't want to own. The truth is you can find cash flowing properties without meeting this rule, and in may cases the over all return on investment may be greater in the long term. It all depends on what mix of cash flow vs appreciation you would like. Keep that in mind as you evaluate investments.
The Cash on Cash return calculation is almost as simple at the 1% rule. You just need a couple of additional pieces on information to run the numbers. 1) You need to know the total cash investment to purchase. I keep it simple and just use [downpayment + closing costs + repair costs]. 2) You'll need to know the expected monthly rents. Find rental comps in the area and then ballpark a little low to protect yourself. 3) You'll need to know the expected monthly expenses. This will include debt service (if you have a loan), taxes, insurance, maintenance / capital expenditures, and management costs. I like to use an average of about 19% for maintenance, CapEx, and other, but this will vary from property to property depending on the condition and age of the major mechanicals. If you plan to self manage, you can factor in a cost to pay yourself or you can just consider the monthly profits and long term gains as your compensation. Oh, and don't forget to consider vacancy and leasing expenses. Here is the basic calculation:
CoC = [(monthly rents - monthly expenses) x 12] / total cash investment
I.E. [($1,595 - $1,224) x 12 ] / $35,000 = 12.72% Cash on Cash return
- Mortgage (PITI): $849 / mo
- Maintenance/CapEx/Other: $375 / mo
- Cash investment: [$40,000 (down pmt and closing costs) + $20,000 repair costs] - $25,000 cash out refi = $35,000 total investment
In short, the cash on cash return is calculating how much money you will earn on your invested cash in the first 12 months. It is assumed that you will continue to make that much or more return each year after.
Now that you know how to calculate it, how will you know what return is a "good investment" ?? That's a tougher question, because it depends completely on the individual investor and their goals. I like to use a rule of thumb of 10% to 12% or higher. I use this number because if I were to put my money with a financial advisor I would expect to get a 6% to 8% return on average. I know that real estate investing involves more work, so I don't just want to equal an average stock return, I want to exceed it by at least a few percentage points or more. Don't forget, real estate tends to provide other forms of ROI with things like appreciation, debt pay down, and tax deductions. Those items can be factored into other calculations, but just know that you're most likely getting a lot more than just the monthly cash flow.
By the way, another great thing about the Cash on Cash return calculation is that you can use this calculation equally if you are paying cash or getting a loan, and/or doing a cash out refi to recoup some of your original investment after the value goes up.