Want to buy a rental property? Read this first

I own seven rental property units across five buildings, which I slowly purchased over the past five years. I earn roughly $4,000 to $5,000 per month – after expenses – from these properties, and I spend less than one hour per week managing these units. I’m 32 years old and could retire today on my real estate income.

On my blog, I’ve opened my books to the public, showing my investment income and expenses with total transparency. If you’re wondering how much money you can make in real estate, check out my monthly income reports.

I’m sharing this publicly in the hopes that I can encourage more people to consider real estate investing. I understand that this path isn’t for everyone. But if you’re interested in building streams of passive income, I’d encourage you to at least consider whether or not rental properties are right for you.

If you decide to become a rental property investor, be prepared to work hard for several years. Passive income isn’t free money. You’ll need to pay the groundwork upfront, so that you’ll be able to kick back and enjoy the rewards for years to come.

Teaching the nuts-and-bolts of real estate investing requires more than a single article can cover. But as an introduction to investing, I’d like to share two formulas that can help you decide whether or not a property is a good investment.

Ready? Here we go!

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Cap rate

The cap rate is a measure of your return-on-investment. Specifically, it measures the net operating income of a property relative to its price or value.

‘What?’

I know, I know — those are confusing terms, so let’s walk through this one step at a time.

Let’s imagine that you own a house that rents for $2,200 per month. At full occupancy, this would be $26,400 per year.

Then we subtract vacancy to find the ‘effective rent.’ If this house is vacant for one month per year, we’d subtract $2,200 (one months’ rent) from our gross rent. This would give us an annual ‘effective rent’ of $24,200.

Then we add the operating expenses, such as repairs, maintenance, management, capital expenditures, utilities, water, trash, sewer, and more. Let’s say this comes to $10,200 per year.

Your operating expenses don’t include debt servicing (the principal and interest on your mortgage), but it does include property taxes and insurance (the other portion of your mortgage). Why? We want to evaluate the strength of the property itself, not the strength or weakness of the financing arrangement.

Subtract the operating expenses from the annual effective rent. The result is your net operating income.

Still with me? Okay, good. Next, let’s compare this to the price (or current value) of a property. Let’s say that you purchased this house last week for $150,000.

$14,000 / $150,000 = 0.093, or 9.33 percent.

This shows that if you purchased the property in cash, you’d get a 9.3 percent annual return on your investment. This is a measure of your cash flow only, and doesn’t include any additional value you might (or might not) receive from property value appreciation.

How does that compare to your next-best-alternative? It’s certainly higher than the interest you’d collect from a bank CD or a savings account, and it’s likely to be higher than the returns you’d get from a broad-market index fund.

Cash-on-cash return

Be cautious about this next equation, the cash-on-cash return (CoCR). This is one area in which you might want to limit your upside.

The CoCR formula measures your cash flow, relative to the cash that you’ve invested. In the example above, you’re getting cash flow (before debt servicing) of $14,000 per year.

Let’s say that you made a $50,000 downpayment and borrowed the other $100,000. (For the sake of example, we’ll assume closing costs are included in that figure). Let’s say your loan carries a 5 percent interest rate with a 30-year amortization. Your payments are $537 per month, or $6,444 per year.

Subtract these payments from your net operating income. You’re left with $7,556 per year in cash flow on an investment of $50,000 in cash. Divide the cash flow that’s remaining by the amount you paid out-of-pocket to acquire the property.

Be careful about how to handle this equation, since it’s set up to reward the maximum leverage. I find it better to decide on an optimal range. If your return is too high, you may have some cause for concern.

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Conclusion

As you can see, there’s a lot of number-crunching that happens before you buy a property. But it’s worth doing the heavy lifting upfront, because the rewards down the road can be substantial.

For more real estate advice, see our Homes & Real Estate section.