Recently a number of listeners to the podcast have asked about evaluating real estate investments. They want to know how much rent they would need to charge for a specific property to make it a “good” investment. The good news is that evaluating the numbers is really simple.
Today we’ll look at 3 key ratios you can run on any property. I’ll use the numbers from one of my investment properties to walk through how each of these ratios work. The results of these simple formulas will help you evaluate a potential real estate investment you may be considering. Frankly, I use just the first of these three formulas, which you can calculate in your head, to evaluate a property in about 20 seconds flat.
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The property I’ll use in this article is a 3 bedroom one bath ranch I bought in 2009. Here are the numbers:
Purchase Price: $42,000
Rehab & Other Costs: $25,800
Total Investment: $67,800
Amount Financed: $64,000
Cash Invested $3,800
Monthly Mortgage Payment: $403.69 (P&I)
Estimated Repairs: $66.58 per month
Estimated Annual Vacancy $74.55
Net Operating Income (excludes mortgage payment (P&I): $6,778.44 (annually)
Total Monthly Outflows (including mortgage): $733.82
3 Key REI Ratios
The rent ratio is calculated by dividing the monthly rent by total cost of the property (purchase price + financing costs + rehab costs):
rent ratio = monthly rent / cost of the property
For example, if the total cost of a property were $100,000 and monthly rent were $1,000, the property would have a rent ratio of exactly 1%. In the example of my property above, the rent ratio is a bit higher at 1.32% ($895 / $67,800).
Generally, we look for a ratio of at least 1%. Some investors that I know look for ratios as high as 2%. Obviously the higher the ratio the better, all other things being equal. What I found, however, is that for a single family home in a good school district in central Ohio (where I invest), 2% is not feasible.
Note that this ratio does not factor in expenses. This is important to understand. We don’t buy properties with HOA (homeowners association fees) and we are able to finance the purchases at competitive rates. As a result, I am very comfortable using this as an initial assessment of a property.
The next two ratios, however, do factor in costs.
Short for capitalization rate, the cap rate enables you to evaluate and compare properties without factoring in financing. The formula is simple:
Cap Rate = Net Operating Income / Total Cost
Net Operating Income, or NOI for short, is based on annual numbers and is gross rents minus all expenses, but excluding the P&I portion of a mortgage payment. For many properties, expense include taxes, insurance, repairs and vacancy.
Note that it is critical to estimate the cost of repairs and vacancy. You’ll see above the estimates that we use for both of these costs. Running the numbers for the above property yields a cap rate of 10% ($6,778.44 / $67,800 = 10%).
Generally, a cap rate of at least 6% or better is a must. While we don’t always calculate a cap rate for our investments (the rent ratio is enough), our properties fall in the 8 to 10% range.
Note that the cap rate does not factor in the cost of financing. Our third and final ratio does.
Cash on Cash Return
The final ratio is the cash on cash return. You calculate this ratio by dividing your cash flow by the cash you have invested in the property:
Cash on Cash Return = Pre-Tax Cash Flow / Total Cash Invested
Pre-tax cash flow is simply annual rents less all cash outflows (including the P&I of the mortgage payment. Apply this formula to my property above yields a cash on cash return of more than 50% ($1,934.16 / $3,800 = 50.9%).
Most look for a ratio of between 15 and 25%. For us, the actual ratio is meaningless. As you can tell, the more leveraged you are, the higher the ratio. But this doesn’t make an investment a reasonable one. We absolutely look at the actual cash flow we believe a property will generate. A positive cash flow is a must. But calculating a cash on cash return ratio is of little value to us.
If you use other metrics to evaluate a real estate investment, share them with everybody in the comments below.