Summary: How do you know if a rental property is a good investment or not? One way is to have the right metric to help you analyze the deal. Problem is, there are so many different metrics out there, it can quickly get overwhelming for the new investor. Part of the issue may be that some investors buy properties without a clear strategy. If you have a clear strategy, then it’s easier to identify the metric that will help you achieve your goals.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
One of the most common questions we hear is: Is this rental property a good investment?
This is typically followed by a confusing discussion about the different metrics used to evaluate real estate investments: return on investment, gross rent multiplier, internal rate of return, cap rate, equity multiple, return on equity, cash-on-cash, 1% rule. It’s enough to make your head spin.
Often the confusion is driven by not having a clear investing strategy. Some pursue appreciation; others pursue cashflow. And still, others just want to get in the game because everyone seems to be doing it.
We believe that if you are clear about your investing strategy, the metrics you should use to evaluate potential properties narrows significantly.
We invest in cashflowing rentals using the buy and hold strategy and maximizing cash flow. You can read about the buy and hold strategy by clicking here.
Using this strategy, we spend a majority of our time working with only two real estate investing metrics: the 1% rule and cash-on-cash return. This post covers the definition and application of each metric in detail.
The first real estate investing metric we use (pretty much every day) is the 1% rule.
The formula is the monthly rent divided by the purchase price.
For example, if you see a duplex listed for $150,000 and the monthly rent is $1,500, then the calculation is $1,500/$150,000 = 1%.
You are aiming for a property that has a monthly rent of more than 1% of the purchase price.
We only use this metric to screen potential properties. In other words, we don’t make the decision to buy based solely on the 1% rule. That’s because the 1% rule reflects an incomplete view of a property because it doesn’t take into account expenses, for one thing.
The Importance of the 1% Rule
The strength of the 1% rule is its ease of use. Because you can literally glance at two numbers (the price of the property, and the monthly rent) and determine if a property is close to meeting the rule. This allows you to quickly screen hundreds of properties and avoid having to delve into the details of a property that isn’t going to be profitable.
It’s important to note that if a property does not meet the 1% rule, but is CLOSE, it’s reasonable to look into the details of that property to see if you can make it work. For example, a property running at 0.7% may have below-market rents or may be over-priced. In these types of cases, you would need to purchase the property for considerably less. You will also need to be certain that the property can rent for more than it is currently.
We all know it’s not a perfect world (or market) out there. So sometimes it’s worth looking at a property that is not quite meeting the 1% rule a little closer.
Once we find a property that meets the 1% rule (plus whatever other non-financial criteria we might have such as good schools, low crime, etc.), we then do a more detailed analysis using a metric called cash-on-cash return.
Cash-on-cash (COC) return is a more detailed calculation that requires numerous inputs and formulas. We recommend using a calculator for this purpose. We have created a free calculator that you can download below.
In brief, COC return is the amount of cashflow the property will generate annually divided by the total amount of cash you spend to purchase the property (including closing costs). As well as any repairs (if any) you have to make for the property to be ready to rent.
For example, using the same $150,000 property described above, if you were to put down 30% ($45,000), pay $5,000 in closing costs and minor repairs, your total investment in the property would be $50,000. This is the denominator for the COC calculation.
For the numerator, you have to calculate the annual cashflow. You start with the annual rent ($1500 x 12) and then subtract all of the costs of managing the property. Which are: mortgage payment, taxes, insurance, property management, utilities, as well as reasonable assumptions about vacancy and repair costs.
Let’s say that you calculate the annual cashflow to be $6,000. Then, using the annual cashflow divided by the total investment ($6,000/$50,000), you get a COC return of 12%.
In our investing, we aim for at least a 10% COC return. We say “at least” because this is an initial target. Over time, we aim to increase COC return by continuing to search for ways to increase income and decrease expenses. We’re not satisfied with a 10% COC return.
Why COC Return Is Necessary For a Good Rental Investment
The reason we aim for a certain amount of cashflow is that we want to be sure that we have a financial cushion in case our properties have unexpected vacancies or repairs. What we never want to do is to be in a situation where we are having to come out of pocket to maintain our properties. We want our properties to put money in our pockets month after month.
You might be saying to yourself, 10% doesn’t sound that great. It’s close to what index funds do over the long-term. However, the true return from a property investment is actually much higher than just the COC return.
The true return from cashflowing rentals include a number of other sources including tax savings. Which would be even higher if you are a Real Estate Professional. The amount of debt your renters pay down each year and something called forced appreciation (the amount a property increases in value when you increase the net income). When you add in these three additional elements of return, your overall return is considerably higher than 10%.
You might also be asking yourself, why don’t we include these three additional elements of return in the COC calculator? One reason is for simplicity. Adding in these elements would make the return calculation more difficult. We believe in keeping things simple because “complexity is the enemy of execution.” Second, we’re intentionally prioritizing cashflow over the other three elements. You want to buy something cashflows, otherwise, you have a liability. I made that mistake in my past investing and paid dearly for it.
While cashflow is critically important, we wanted to note that we don’t buy just for cashflow. We’re also buying for forced appreciation. The equity you can build up from forced appreciation is one of the major reasons you can achieve financial freedom in years, not decades.
So there you have it. The only two real estate investing metrics you need to determine whether a rental property is a good investment or not.
Note: These are the metrics we use for determining whether or not a rental property is a good investment. We do use some of the other real estate investing metrics, but for completely different purposes. One in particular, return on equity (ROE), is something you might use well after you’ve purchased a property. You can read about return on equity by clicking here.
What real estate investing metrics do you use to analyze rental properties?
Do you use the 1% rule or a higher cut-off when screening properties?
What is your cut-off for COC return?
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