When it comes to Rental Property Investing- Why do we want to buy right?
Because it gives us confidence we are making a sound decision, thus drowning out that scaredy cat habit of failing to pull the trigger.
Buying right is something I have posted about before and will likely post about again, because it is that important. So let’s review what it is!
Steps to buying Right?
1st – You run the Financials
The first thing I do when I see a property for sale is run the numbers. If the property is not going to cash flow when I take all the anticipated expenses and subtract them from the going rental rate then I move on. No point in viewing the property.
Luckily, we can use a simple property calculator to find this result.
(Success Note: You should have a property calculator that analyzes the financials of every deal you consider – download the scaredycatguide calculator on the homepage)
However, in the end here is your formula you should understand.
(Taxes + Insurance + Vacancy + Maintenance + Reserves) = Operating Expenses
Operating Expenses equal your total cost per year to hold that property.
(Note: there can be additional expenses, such as management if you hire a property mgr. or an HOA fee if there is a homeowners association.)
There is a general rule of thumb that Operating Expenses will cost 50% of your total rental income. It’s good for a quick calculation. However, I have found it more in the 40-45% range for all the properties I’ve analyzed.
Once we know are Operating expenses we can find our Net Operating Income (NOI)
Total Rent – Operating Expenses = Net Operating Income.
Now we can see how much cash flow the rental property is creating each year.
Net Operating Income – Debt Service = Cash Flow
(Debt service assumes you took a mortgage to buy the property, if not than your NOI is your cash flow)
Now for the most Important Number:
The Cash on Cash Return
Cash on cash return is the main number I use to decide whether a property is worth pursuing.
This will tell me what return I am getting on my money. I generally look for at least 8%, because otherwise I mind as well put my money in the stock market given the long term historical returns there are 8%. However, with real estate I have a HARD ASSET that someone else is paying down the mortgage on!
Cash on Cash Return = Cash Flow/Total Investment
That’s the key number. I want to see 8% or better, that is my preference. I know investors that won’t accept less than 10%.
This is a partial screenshot of the scaredycat calculator showing the applicable items for this example.
(Note: The percentages I use for maintenance, vacancy and reserves are not set in stone, they are what I’ve found to be realistic but they can certainly be adjusted up or down depending on how conservative or aggressive one is)
Looking at it you see all our Operating Expenses (red cells) summed up to get the Net Operating Income (row 14)
Less the annual debt service (row 15) to get our cash flow (row 16)
Cashflow is divided by my total investment (not shown), which was made up of: down payment, closing costs, initial repairs.
And we get a Cash on Cash Return (CCR %) of 8.04%
Generating just enough for me to pursue this property.
And that is how to run the financials on a rental property
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Don’t forget to download the property calculator so you can run the numbers and “buy right”– my gift to you.