Purchasing your first rental property is one major financial decision, and a good one because real estate has historically proven to be a great way to build wealth. However, only a handful of new investors put the time into learning how to evaluate and select properties. Buying a land asset is an important decision that shouldn’t be taken lightly, so it’s important to understand what you’re doing.
For that reason, we aim to give you an overview of what aspiring landlords should know about cash flow, equity appreciation, and a few other factors. Taking the time to learn and understand how rental property investments generate cash flow can be the difference between years of strong income and lots of accumulated equity versus so-so returns.
Understanding the potential of rental properties
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There are two basic ways you can make money with a rental property. It can generate current income (cash flow) or it can build equity. As your mortgage balance declines and the property appreciates more over time, equity rises.
Many experts tell real estate investors to focus on cash flow. There’s a good reason for this. Equity appreciation can be extremely difficult to project, especially over shorter time periods. And mortgage principal reduction can be depressingly low during the first few years of ownership.
To be clear, both are extremely important to your long-term returns. In fact, if you hold a rental property for decades, equity appreciation could easily become the larger of the two components.
Over long periods of time, real estate prices have grown slightly faster than inflation. So, if you plan to hold a rental property for 25 years, it’s reasonable to expect its value to grow at this rate if it’s properly maintained. However, property value fluctuations are impossible to predict over short periods of time with any level of accuracy.
Even though appreciation is important and potentially lucrative, cash flow is the more important part of your analysis. Here’s why:
- Property values in geographical areas tend to rise and fall at roughly the same rates. If you’re looking at 10 potential duplexes in your local market, their values should rise at about the same rates over time.
- Mortgage repayment occurs at roughly the same rate for each property, assuming you get the same type of loan with the same interest rate. Say you buy two properties with 30-year fixed-rate mortgages at 6% interest and 20% down. The proportion of each loan you’ve paid off will be the same after five, 10, and 20 years.
- While equity is important, cash flow is the main differentiator. It’s the factor that generally makes one rental property investment better than another.
Your property’s cash flow
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Cash flow is a simple concept to understand. Your property’s cash flow is the income it brings in minus the expenses associated with owning, managing, and maintaining the property.
While it’s a simple concept, the calculation of rental property cash flow can be complex. Many inexperienced investors have trouble with it. Specifically, many of them dramatically underestimate the costs of owning a rental property. Things you need to account for in your cash flow analysis include the following:
Your mortgage payment: Most lenders require property taxes and insurance payments with the mortgage payment. Be sure to include that in your calculations. If you don’t pay them with the mortgage, account for them separately.
Any utilities you pay: Tenants usually pay their own electric bills, but landlords often pay for water, cable, sewer, and trash collection. This is especially true if the property is a multi-unit building. If the property you’re considering is already rented, find out what utilities the landlord pays. Then conservatively estimate how much they’ll cost.
Property management: If you plan to hire a property manager, account for the expense. The industry standard is 10% of collected rent.
HOA fees: If the property is part of a homeowners’ association, budget for this expense as well. Find out what’s included with the HOA fee. For example, in some condominiums, the HOA dues include basic cable.
Other expenses: Account for anything else you’ll pay for on an ongoing basis. Examples could include pest control or lawn maintenance. Don’t count on your tenants doing either of these things on their own. Plan on paying for them yourself or making it the tenants’ responsibility as part of the lease.
Vacancy: This gets tricky. At some point, your rental property will likely sit vacant for at least a little while. In a perfect world, you or your property manager will have a new tenant lined up before the old one moves out. But it doesn’t always work out that way. Depending on the nature of your property and current market conditions, it’s smart to assume a 5–10% vacancy rate and set aside this portion of the rent to offset the cost. After all, you still have to pay the mortgage and other expenses when your property is vacant.
Maintenance: At some point, things will need to be repaired or replaced. The property’s HVAC unit is going to die. You’ll need to pay for a new roof. Winter means you’ll have to hire a snow removal company. Set aside part of the rent so you’ll have reserves when you need them. I use 10% for a maintenance allowance and 5% for a vacancy allowance and adjust as necessary. For example, a 5% maintenance allowance could be plenty for new construction, but you may need more for an older home.
Determining the rental income of a property
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For your cash flow analysis to be accurate, you need to know how much rental income your asset will generate.
If the property is already rented, this is easy, just ask the current owner for a detailed rental history. This not only lets you know how much rent has been generated by the property but can also give you good insights into vacancy trends.
On the other hand, things can get tricky if the property is vacant or owner-occupied. Rental history is a good indicator for a property that’s vacant but had previously been used as a rental. If no rental history is available for that property, check rental listings for comparable properties in the area, ask a local property manager for their opinion, or get a rental appraisal done. Appraisals can be expensive, but many investment property lenders require one.
Err on the side of caution and be conservative when estimating rent in your analysis. If the property ends up renting for more than you think, great. But remember that as a responsible investor, you want to know what the property’s cash flow will be if things don’t work out perfectly.
Additional concepts you should know
If a property has an acceptable level of cash flow, you can use a few other metrics and concepts to evaluate them:
Cash-on-cash return
This is the annualized return you generate relative to the amount of money you pay to acquire the property. To calculate your cash-on-cash return, divide the property’s annual cash flow by the amount of money you paid to acquire it. That includes closing costs, property improvements you paid for, and other expenses incurred when purchasing the property.
Capitalization (cap) rate
This metric is a property’s pre-tax annual cash flow — excluding mortgage payments — divided by its acquisition cost. For example, a property that generates a cash flow of $7,000 per year and costs $100,000 would have a 7% cap rate. Higher is better.
Cap rate is a widely used real estate metric. It’s especially handy for rental property investors if you don’t know the details of your financing yet. If you don’t know how much you’ll need to put down or what interest rate you’ll be paying, it’s impossible to know for sure how much your monthly mortgage payment will be.
The analytical methods discussed here are pretty universal. But it’s up to you when it comes to cash flow, cash-on-cash return, or cap rate standards. Make sure that a deal makes sense for you, and that it’s better than the alternatives available in your target market, and you should be just fine.