Investing guide
Base rent on comparable rentals nearby with similar size, condition and amenities. Use typical rent, not the highest listing you can find. Then subtract a vacancy allowance for the weeks between tenants and the occasional unpaid month. What’s left is your effective gross income.
Operating expenses are the costs of running the property. Common ones:
Your mortgage payment is not an operating expense. It’s handled separately so you can compare properties regardless of how they’re financed.
NOI = effective gross income − operating expenses
NOI is what the property earns in a year before financing and income taxes.
Cap rate = NOI ÷ purchase price
Cap rate lets you compare properties as if each were bought with cash. It’s useful for side-by-side comparisons but leaves out financing, future rent changes, appreciation and the condition of the building. A high cap rate can signal a bargain or a property with higher risk or more deferred maintenance.
Annual cash flow = NOI − annual loan payments
Cash flow is what’s left after the mortgage. When it’s negative, you are paying to own the property every month, which can still fit some long-term plans but should be a deliberate choice.
Cash-on-cash return = annual pre-tax cash flow ÷ total cash invested
Total cash invested includes your down payment, closing costs and any upfront repairs.
Here’s a single-family rental with made-up numbers chosen to show the math. It isn’t a typical or expected result.
| Purchase price | $500,000 |
|---|---|
| Market rent ($3,000 × 12) | $36,000 |
| Vacancy allowance (5%) | −$1,800 |
| Effective gross income | $34,200 |
| Property taxes (assumed) | −$6,000 |
| Insurance (assumed) | −$1,800 |
| Maintenance and reserves (assumed) | −$3,000 |
| Property management (8% of income) | −$2,736 |
| Net operating income | $20,664 |
| Cap rate ($20,664 ÷ $500,000) | 4.13% |
Now add financing. Assume 25% down ($125,000), $10,000 in closing costs and a $375,000, 30-year loan at 7.0%:
| Monthly principal and interest | $2,494.88 |
|---|---|
| Annual loan payments | $29,939 |
| Annual cash flow ($20,664 − $29,939) | −$9,275 |
| Total cash invested | $135,000 |
| Cash-on-cash return | −6.87% |
In this example the property loses money each year at that price, rent and rate. The rent would need to be about $3,880 a month to break even. That doesn’t automatically make it a bad purchase, but it means you would be relying on rent growth, appreciation and loan paydown instead of cash flow. Running the numbers this way, before you write an offer, is what lets you make that choice on purpose.
Rerun the numbers with a longer vacancy, a major repair in year one, a higher insurance quote and, if you plan to refinance, a higher rate. If the property only works under the best case, it doesn’t really work.
General information only. This guide is educational and isn’t financial, tax or legal advice. Talk with a qualified professional about your situation.