How To Analyze A Rental Property
“Men lie, women lie, numbers don’t.”
Jay Z (Rapper & Entrepreneur)
Numbers Don’t Lie
You’ve decided that you want to jump into the world of real estate investing. Congrats! Before you start putting in offers on potential investment properties, however, you need to know how to run the numbers. The reality is, a vast majority of properties you find listed on sites like Zillow or Redfin, wouldn’t make great investments. Having the ability to analyze the numbers will help you identify which opportunities to pass on and which ones to pursue. While “Deal Analysis” might sound complicated, it really isn’t. If you can understand third grade math, (addition, subtraction, division) you can absolutely analyze a real estate deal. Better yet, there are tools that will automatically do all the calculations for you (more on those later). With some education and practice, you’ll be a deal analysis expert in no time. Let’s dive right in!
The Basic Formula
At its core, breaking down rental property profitability comes down to a very simple formula:
Income - Expenses = Cash Flow
Your job when analyzing a deal (also referred to as “underwriting”) is to determine 1) How much money will this property make (“Income”) and 2) How much will this property cost to operate (“Expenses”). The difference between income and expenses will be your net cash flow (ideally this number is positive). This formula is not specific to real estate, it’s a general formula that applies to understanding the health of any business. A coffee shop owner, for example, estimated the income potential vs. the expenses before starting their coffee shop, and every month they are recording how the coffee shop is actually performing against expectations. Real estate is no different than the coffee shop in this regard. Each rental property is a business, and before acquiring that business, we need to run the numbers to make sure it will be a profitable venture for us.
Let’s double click into each of the following elements of the formula (Income, Expenses, and Cash Flow).
Income 💰
This one is pretty straightforward. The income that a rental property can generate is how much the property will rent for. There are a couple of ways you can determine the rental rate for a particular property:
Zillow.com (Free)
You can look up the zip code/neighborhood that the property is located in and see what the average rent for the surrounding properties.
Rentometer.com (Paid)
You can plug the address in and this site will aggregate all the relevant comparable properties to determine average rent.
⚠️ Be Conservative: You want to be realistic when estimating the income potential of a property. When looking at comparable properties, you want to make sure that they are similar to the one you are thinking about acquiring (neighborhood, bed/bath count, square feet, entire house vs. apartment, condition). Properties that command higher rent do so for good reason. If your property has those same attributes, great! Otherwise you are better off being conservative. I typically estimate the average (or lower).
🤑 Other Income: It’s possible that your property might be able generate income in addition to the rental income. You might have storage space that you charge tenants to use, you might have washers/dryers that you charge, pet rent, parking, etc. If that is the case (and you are confident that you will continue to see that income), you can factor those numbers into the analysis.
The 1% Rule 💡
As a real estate investor, you’ll be analyzing tons and tons of deals. In order to save time, we can leverage helpful rules of thumb to identify which takes warrant a closer look vs. deals that we move on from. The 1% rule can help us do just that!
According to the 1% rule, if a property can rent out for at least 1% of it’s purchase price, it has the potential to be a good deal.
For example, if a $100,000 house rents for at least $1,000/month, that property has a good chance of having positive cash flow.
A $1,000,000 property that only rents for $5,000/month on the other hand, will probably be negative cash flow.
While it’s a helpful screening mechanism, the 1% rule is no substitute for doing a full analysis on a rental property. There are some properties that don’t meet the 1% rule that still cash flow and vice versa. Always run your numbers!
Operating Expenses 💸
Now that we’ve reasonably estimated income, it’s time to determine what our expenses will be to operate the rental property. As with income, we want to be extremely conservative and realistic when outlining our expenses. If we underestimate expenses, what we thought was a good deal, might end up having negative cash flow. Here is a breakdown of major expense categories for a rental property:
Property Management: A property manager will typically charge you 8% to 10% of the gross monthly rents to manage the day to day operations of your property. Some property managers might have additional fees/costs, so take note of these when interviewing different companies, and factor this into your analysis accordingly. Good property managers are well worth the cost, and it’s what allows real estate investing to be a more passive activity for you, the investor.
Property Taxes: Property taxes can vary widely depending on your location. While websites like Redfin and Zillow often provide current property tax figures, it's crucial to understand how property taxes work in your local market. Some areas reassess property taxes immediately upon sale, while others do so every few years. As a conservative estimate, assume that property taxes will increase over time, and factor this into your calculations. You can use online resources like smartasset.com to research property taxes for specific zip codes and property values.
Insurance: Protecting your investment is non-negotiable, and insurance is a fundamental expense. Insurance costs can fluctuate based on your property's location, with regions prone to natural disasters typically incurring higher premiums. To get an accurate estimate, seek quotes from multiple insurance providers or use websites like Zillow and Redfin as starting points.
Gas & Electric: If there is a separate gas & electric meter for each tenant, then your tenants are typically responsible to pay this bill and you wouldn’t incur any cost as the landlord. If there are some shared utilities, however, you might be responsible so it’s important to conduct your due diligence.
Water & Sewer: Similar to gas & electric, cost of water & sewer can be passed onto to the tenant if there is a separate water meter for each unit. In a single family rental, for example, all utility costs would be passed onto the tenant. In multifamily (duplex, triplex, etc), however, it’s pretty common to have a “master meter”. In this case, the water & sewer will fall on you, the landlord.
Landscaping: Most properties will require some form of ongoing landscaping (lawn mowing, snow removal, etc). Unless you have some sort of agreement with your tenants, this cost will be the landlord’s responsibility.
Garbage: As a landlord, you’ll likely be responsible for garbage/trash removal.
There will be some legwork in determining what are the appropriate figures to input for all these expenses. Over time, however, as you become more familiar with your market, you’ll have a good sense of what the costs should look like for each property.
Reserves ☔
One mistake new real estate investors make, is not budgeting for reserves. What are reserves? They are amounts you set aside each month for a rainy day. Things happen in real estate, and when they do, you want to make sure you have cash reserves to cover those unexpected expenses.
Vacancy: There will come a time when a tenant will move out and your property will be vacant. At this time, the unit will not be generating revenue, but you still need to pay expenses like the mortgage. It's important to set aside reserves for this eventuality. If you set aside profit each month to cover costs when you have a vacancy, you'll be in a much better spot. 5% to 8% of the gross rental income is is what most investors budget for this line item.
Maintenance: It's inevitable that things will need repair or things will need routine maintenance. Similar to vacancy, it's better to set aside reserves each month so you have the funds to cover the expense when they do happen. 5% to 8% of rental income each month is normal to budget for this line item. Older properties will usually warrant a higher percentage.
Capital Expenditures: Capital Expenditures (CapEx) are the replacement of the big ticket items - roofs, flooring, appliances, etc. Similar to vacancy and maintenance, if we set aside reserves each month - we are more prepared to cover these replacements in the future! Standard input here is 5% to 8% of rental income each month. If you know a property is going to need major items replaced, input a higher percentage here.
Owning rental properties is expensive, and it’s not a matter of if something goes wrong, it’s when. If we analyze our deals, and budget for reserves, and we still cashflow every single month, then we feel much better about riding the roller coaster of real estate investing because we gave ourselves that cushion.
Net Operating Income (NOI): NOI is the amount of income a property would generate if the property had no debt on it. It’s calculated as Income - Operating Expenses (incl. reserves). NOI in combination with the capitalization rate (“cap” rate) is how commercial real estate is valued, but they are helpful metrics in residential real estate as well (more on commercial vs. residential in a future blog post).
50% Rule: Another helpful rule of thumb is that your operating expenses (including reserves), should roughly be 50% of the gross rental revenue. If it’s under 50%, great! If it’s too low, however, there is a chance expenses are being underestimated. If it’s way above 50%, I would be concerned. That would indicate that the property is too expensive to operate relative to the income it’s generating.
Debt Service 🏦
One of the biggest expense categories that we haven’t touched on yet is debt service. If you took out a loan to purchase the investment property, we’ll need to pay the bank back every month (mortgage + interest). It’s important to note that debt service isn’t considered to be an “Operating Expense”. Why? Because this can vary greatly from property to property. One property might have a 3% interest rate while another property has a 7% interest rate. Another property might be completely paid off and not have any debt on it at all. The point being, debt doesn’t speak to the operating performance of the property.
In order to calculate potential cash flow, however, we absolutely need to factor in debt service as an expense. We want to make sure that the rental income is enough to cover the operating expenses, reserves, and debt service. Here are some key terms related to real estate debt:
Principal: A portion of your monthly payments to the bank go towards paying down the original balance that you borrowed. The portion that goes toward principal will be small in the beginning, but it will grow over time.
Interest: The bank is happy to loan you the money because you will pay them a substantial amount of interest. A large portion of your monthly payments goes toward interest (doesn’t reduce the amount you owe to the bank). The portion that goes toward interest will decrease over time as you pay more and more of the principal down.
Debt Service Coverage Ratio (DSCR): The ratio of NOI (see above) divided by annual debt service cost. The bank usually wants to make sure that you have enough cushion to pay off the debt service - even if operating costs increase. A healthy debt coverage ratio is anything greater than 1.25 - this means your NOI isn 25% greater than your annual debt service cost.
Loan to Value (LTV): Loan to Value or (LTV) measures the loan balance as a % of the value of the property. For example, say I purchased a house for $100K and I put 20% down and I borrowed the rest. My LTV at the time of purchase was 80%.
Cash Flow 💵
Now that we’ve estimated income and all the related expenses, we’re finally ready to calculate our cash flow! To revisit the formula:
Income - Expenses = Cash Flow
Now that we have more knowledge, we can add more detail to the formula:
Income = Rental Income + Other Income (if applicable)
Expenses = Operating Expenses + Reserves + Debt Service
Cash Flow = Net Profit
When done correctly, an investment property generates enough income to cover all of it’s expenses (current + future), and there will still be extra cash flow every month to cover your personal expenses (or reinvest to buy more real estate). At this point you might be wondering, how much cash flow is good? In order to answer that, we need to introduce one of the most important metrics in real estate, the Cash on Cash return (CoC %).
Cash On Cash ♻️
Certain properties are just better at generating cash flow than others. What if I told you Property A was generating $250/month and Property B was generating $500 a month. You would logically think that Property B is better, right? But what if I told you that property A cost $100,000 and Property B cost $500,000? Property B is generating 2X the cash flow, but it cost us 5X more. In this instance, Property A seems to be much more efficient at generating cash flow. The Cash on Cash return (CoC %) is the metric that helps us measure this.
Cash on Cash return = Net Cash Flow / Total Cash Invested
For example, if I put 20% down to purchase a $100K house, my initial investment is $20K. If that same property generates $2K in annual net cashflow, my Cash on Cash % would be 10% (2K cashflow / 20K investment). Another way to think about this is - it would take approximately 10 years for this property to payback my initial investment in pure cashflow.
It's hard to provide guidance about what is a "good" cash on cash return. Some investors want to see at least a 10% return, while others might be ok with 3% to 4%. It just depends on your investment goals/criteria. Generally speaking, a solid investment property will cash flow $200 to $500/month initially. Important to note, that net cashflow grows over time, so your Cash on Cash return in Year 5 is likely a lot better than Year 1 (and cash flow is only one of the ways real estate makes you rich).
Rental Property Calculator 📊
After going through all of this, you might be thinking to yourself “there is no way I’m going to be able to do all this math”. The good news is that you don’t have to! There are a lot of tools out there that will crunch all the numbers for you and show you the expected returns for the property. These calculators will save you a ton of time as you start to analyze deals.
If you want to use the same one that I use, you can grab it here (for free). Here is a quick demo of me using the calculator to analyze a deal in 60 seconds! If you found the video helpful, give me a follow on instagram 🙏🏼.
Wrap Up
If you made it this far into the article, I truly admire your resolve! Remember, while all of these numbers and metrics might seem overwhelming at first, you can absolutely master deal analysis. One of the biggest mistakes investors make is not deeply understanding the numbers before jumping into a deal. If you dedicate the time into the skill of analyzing deals, you will increase your chances of success and you will build more confidence as an investor. There is a saying in real estate that “you’re going to analyze 100 deals until you find 1 that works”, so what are you waiting for 😏?
Stay committed to the journey, my friend. Your future self will thank you.
