The 2 Biggest Mistakes Made in Calculating Rental Property Returns

by on February 8, 2014 · 44 comments

Not only should you avoid these mistakes when you run your own numbers on a property, but you should also be on the lookout for anyone else who is making these mistakes when they try to sell you a property that is supposedly a great investment.

For anyone newer out there who doesn’t understand what I mean when I say “the numbers,” I am referring to the numbers used in calculating the projected returns on an investment property.

You’ve probably heard the term “cap rate” and “cash-on-cash return” and likely some other ones. More or less, they are all measures of the return you will get, or are getting, on your investment. “The numbers” are what are used in calculating those returns. For a more detailed breakdown of these numbers and formulas, check out Rental Property Numbers So Easy You Can Calculate Them on a Napkin.

So what are the biggest mistakes people make when running numbers on an investment property? Are you ready?

1.) Using Estimates Instead of Actual Numbers

There are actually three different ways I see people using estimations when trying to project returns on an investment property.

a.) The 50% rule

I hate this rule. I don’t know why, but I just don’t like it. Actually, I do know why. I don’t like it because it can steer new investors (and even some experienced) along a path of believing it should be used for actual evaluation rather than be used as a guideline.

However, I know a lot of people advocate this “rule”, so I’ll leave my opinions about it at that and look at it factual. The 50% rule says that, in theory, 50% of the rent you collect from a property will go towards expenses.

People use that as a guideline for whether they want a particular property or not…does it meet the 50% rule?

Here’s what you need to understand about this rule. The term “rule” is a hugely misleading term. Technically the “rule” should have been labeled “the 50% guideline.” It should absolutely only be used as a guideline when you initially glance at a potential property.

If it meets the 50% rule, great, go ahead and pursue it. But at that point, drop the “rule” from you mind and actually calculate the real expenses and don’t assume they equal 50% of the rents. If you were to pull that on a FL property for example, you could be setting yourself up for a major loss when you find out how much the actual insurance and taxes are down there. So much for that 50% safety net!

Never decide on a property solely because it meets the 50% rule. Use it only as a guideline (or if you’re like me, don’t use it at all) and then drop it.

b.) Calculating expenses

Oh MAN does this one drive me crazy. I hear it more than I could ever imagine; someone is evaluating a property to buy and they share the numbers associated with that property and they say things like “insurance is usually around \$300/year”, “the taxes should be about \$179/month”, “I should be able to get \$1100/month in rent”, “I think it will be about \$8,000 for the rehab”…

You get my drift. Please stop doing this when you evaluate a rental property. Yes, there are some numbers that will require your best guesstimate but those numbers are few.

If you are looking to buy a rental property, you can expect to have the following monthly expenses once you own the property: taxes, insurance, property management fee (if applicable), homeowners’ association (if applicable), mortgage (if applicable), vacancy, and repairs. Of all of those numbers, the only ones you can’t know for sure are the vacancy and repairs.

You do have to estimate those. The rest of the numbers, however, you can absolutely get actuals for.

Ask the current owner what they pay in taxes or look it up on the county’s tax assessor website, get a quote from your insurance company, ask your property manager how much they charge, call the homeowners’ association and find out how much they charge, and get a quote from your lender on what your payment will be. Easy!

And for the rents, because people love to guess on these too, find out how much the current tenants are paying and if there are no current tenants, have a property manager or a real estate agent run comparables in the area and determine what they deem to be a viable rent for that property in that area.

Lastly, if you are rehabbing the property to any extent, don’t just get one quote for the rehab. Get two or more to be safe. I’m telling you, there are so many unknowns and estimates required in real estate investing, get actuals in every single place you can find them. Because trust me, the numbers that you are forced to estimate can end up stressing you out enough by themselves.

Never use an estimate when you can use an actual!

c.) Projecting and speculating

Planning on raising the rent on your rental property by 3% in the next year is crazy. Almost as crazy as projecting appreciation. Guess what, you don’t get to choose when you raise the rents.

That is a common misconception, which even I had when I started, that should be thrown away. Raising rent on a property is not done just because you want it to. It’s done when the market supports it.

You can try to raise the rents but if that puts your rent over market rent, who will want to rent your house? No one, because they can rent a different property for cheaper (market rent). Same with estimating appreciation.

You have no idea how much, if any, a property will appreciate in the next 1, 5, 10, 30 years. Ask anyone who bought solely for appreciation prior to the most recent crash. Do you realize how many speculators went under in this last crash? Too many to count.

Why did they go under? Because they bought assuming appreciation rather than buying on solid fundamentals (i.e. buying for cash flow and taking any appreciation as a bonus). You are more than welcome to run a separate side sheet and add in raising rents and appreciation to see what hot shot returns both of those will get you, but don’t use that sheet as your primary motive to buy. Use only today’s (actual) numbers to evaluate a property.

2.) Thinking Numbers are Everything

Guess what, they’re not. Yes, numbers are critical in evaluating a property and they are really the only non-negotiable of all the factors that go into what makes for a good rental property. They are not, however, everything. I’ve mentioned a couple times these other “factors”, well what are they?

Keep in mind these points have room for maneuvering.

• Location. Is it in a growth market? Is the population there on the rise or declining? Is the area safe? How are the schools? What kind of tenants will want to live there?
• Property condition. What is the age of the property? Does it need any rehabbing? If so, what? What kind of tenants will want to live there?
• Property management. Is there access to a good property manager to manage the property? Even if that is you because you plan to landlord it yourself, are you available to handle it?

There may be others that can be added to this list. The most important question of those, in my opinion, is what kind of tenants will want to live there? (if you didn’t notice by my italics there).

It comes down to “quality” of a property. Quality of the market, quality of the property, quality of the management. If any of those are lacking, you may hit some trouble.

Not always, and a lot of people make serious bank by investing in bad areas or by buying old, ratty properties, but be aware of the implications of those things before you buy a property should they be applicable.

You will always see returns get higher and higher (on paper) the more you go into less desirable neighborhoods and older properties. Always! And the returns may show substantially higher than of nicer properties!

Remember though, those numbers are only what is written on paper. They are not a sure thing. As soon as you get in a position of having bad tenants (especially if on a consistent basis) and an older property needing repairs, those phenomenal returns you projected could easily end up being more realistically much lower than you projected, if not even negative.

Numbers themselves are non-negotiable, but once you find a property whose numbers work, you must assess the viability of those numbers. They are far from guaranteed, I promise.

Any stories of actual returns turning out to be so far from what you originally projected you could barely believe it?

Photo Credit: striatic

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Adam Schneider February 8, 2014 at 7:05 am

Great article…anyone who always uses a “rule” and doesn’t peel the onion is going to be in the business a short time. It doesn’t take much work to do the research on the known numbers. When doing formulas, lean conservative on vacancy calculations, and provide cushion for the unknown repairs…be proactive when purchasing by replacing worn out small plumbing related issues that create high risk of leaks!

Ali Boone February 10, 2014 at 1:01 pm

Roy N. February 8, 2014 at 7:11 am

Ali,

I agree, the 50% “guideline” is best used when going through the new “for sale” lists from MLS or your “favourite wholesaler” to weed-out the possible from the improbable. Once you have your shortlist, it’s time for real numbers and a some solid discounted cash flow analysis.

And, while I agree that numbers are not everything, for me they are the *first* thing – if the numbers don’t work, I do not bother walking the property.

Ali Boone February 10, 2014 at 1:02 pm

Exactly right Roy. And I’d even go further and say numbers are the *first* thing and the *last* thing. Check them initially, and double-check them before you pull the trigger. Then all the other stuff, check in the middle. The numbers have to work and the middle parts need to support the numbers to make sure they work.

Dennis February 8, 2014 at 8:01 am

This is again where we are at in the market, folks rounding things off instead of actually analyzing the investment.

We read prices are heating up in many markets, folks just don’t use their gray matter.
I see some pretty close deals coming across my desk, properties with little real hope of cash flow, with thin rehab margins. I am assuming we are once again in the “hope the deal works out market”.

Recent deal pitched to me, excluded the many City fees, lacked a total understanding of what the building is really going to need to rehab to rental standards for the area.

Some guru must be selling a wholesaling for big dollars course.

I know a crash is on its way again when I see shabby rehabs in the hope of a quick flip actually selling for high numbers. The rehabs are shabby because the numbers are not working out.

Ali Boone February 10, 2014 at 1:03 pm

Great put Dennis!

Lisa Phillips February 8, 2014 at 8:09 am

Nice article! I do not like how the 50% rule has become gospel for new investors, its so arbitrary it can only really keep people out of the market if they are searching for it. And yes, there are so many actual numbers you can get, you just have to take the time to search them out (if not all), and most can be found on the internet without too much effort.

Ali Boone February 10, 2014 at 1:04 pm

I completely agree Lisa. You said the perfect word, “gospel”. I cringe every time I hear investors on the forums saying something met the 50% rule, yayyy! Oiiiphgh, makes me nervous. And exactly, the actual numbers are easy to find so why not find them.

Christopher McGuire February 8, 2014 at 8:43 am

I guess I’ll be the one to “go against the grain” here. The 50% rule and the 2% rule are simple and easy to understand. It’s how I have been buying and pretty much guarantees a nice a cash flow.

I’m probably one of Ali’s biggest fans. However, her bio says she has been investing for only 2 years and she also lives in Atlanta. She has only experienced a great market (low vacancy for rentals) and has not held her investments a significant amount of time. Those that have held properties a long time will tell you there will be plumbing repairs, an AC will go out in July, you’ll need a new roof, you WILL eventually have a bad tenant, etc.This rule protects the newbies from these surprises.

The 50% rule should be the gold standard for all new investors and once they gain knowledge and competency, they can deviate to what suits them best. Again, just my lowly opinion.

Ali – On a side note, I would love if you did a blog post on your knowledge of the Nicaraguan real estate market. Thanks!

Shawn O'Shea February 8, 2014 at 10:06 am

I learned the hard way when purchasing my 1st property and not factoring in all of the expenses. It is a condo that has HOA fees, but quarterly they add special assessment fees I did not consider. Additionally FEMA put the property in a flood plain since the last owner purchased the property. He did not have to pay flood insurance, but my bank was making me pay it now. All of these eat into my cash-flow that I did not anticipate. I have had the property reassesed and am overturning FEMA’s assessment so hopefully I can avoid paying flood insurance. This was definitely a learning moment to understand all of the numbers.

Ali Boone February 10, 2014 at 1:10 pm

Great example of why those ‘rules’ don’t always work Shawn. Where is that property? Indianapolis by any chance? Indy has gone crazy with the flood issues and extremely high insurances wiping out cash flows all of a sudden.

Ali Boone February 10, 2014 at 1:09 pm

Thanks for making me realize I need to update my bio Christopher! Although not sure why it says at all I live in Atlanta because I live in LA. My properties are in Atlanta though. And I wish more than anything that your suggestion that my investing experience has been easy with no complications was true. I’ve lost thousands, had tons of fails, and far from experienced ‘low vacancy’. And while my properties are in Atlanta, I work heavily with investors in several other markets (and barely touch Atlanta right now) so I’m well aware of the investing world outside of Atlanta.

What market do you invest in that the 50% and 2% rules never fail you?

And no need to write a whole blog on Nicaragua, I can sum it up easy. Investors’ paradise, huge growth happening, extremely safe country, the people there are amazing, I’d buy there (again) in a second.

Aaron Yates February 8, 2014 at 9:34 am

Graet article Ali. I agree completely in regards to the ‘rules’ as I also have written about them only being used as a guideline and even then it could steer a new investor away from a great deal.

The numbers are a great point. I was guilty of this when I started investing a few years ago. Definitely one of the worst mistakes a newbie can make.

I disagree on being in low end neighborhoods bringing more headache and costs. In my experience it comes down to us as the landlord to repair things the correct way the first time. Its also important to screen tenants properly. But I do agree to stay out of war zones unless you really have figured out a process that works in those areas.

When you figure the process that works for you in your market you will find some great tenants. I wont go into detail on my process but it has been a huge learning experience for me.

So in short, there are alot of factors that play into turnover in a property. The best advice I can give is listen to experience but create your own path.

If I listened to everyone else all the time, I would not be where I am today. I even go against the grain of seasoned investors when their advice doesnt fit my market.

Ali Boone February 10, 2014 at 1:14 pm

I totally agree Aaron. Most everyone on here knows I go against the grain as well If I listened to everyone, I’d be swinging hammers and dealing with tenants all the time…. noooo thank you. I love your line- listen to experience but create your own path. I always say that I will listen to every single thing someone tells me because if I were to ignore advice I would not get very far, but then I also weigh the advice and who it comes from. If I would trade shoes with that person, I’m more inclined to listen to it. If I wouldn’t, then I’m careful as to whether I take the advice or not.

Few people are ever absolutely wrong in their advice, but they may be wrong for you personally as your path is just that, your path (not theirs).

Great message Aaron!

Kevin Polite February 8, 2014 at 9:43 am

@Christopher McGuire. I think the take away here is that Ali said ” I don’t like it because it can steer new investors (and even some experienced) along a path of believing it should be used for actual evaluation rather than be used as a guideline.” I like the rule as a guideline AND dig into the numbers. I’ve only been investing a short time myself, but have used P&L’s before so I know that you’ve gotta dig into the numbers.

Ali Boone February 10, 2014 at 1:15 pm

Agreed Kevin, and that is what I meant for sure. I agree with you, great guideline but dig into the numbers too.

Mike McKinzie February 8, 2014 at 1:12 pm

Ali
You always write great articles. Like you, I HATED the “50% rule” when I first started reading Bigger Pockets. I used excuses like different states having different property tax structures, how a water heater cost the same for a \$500 rental as it does for a \$2,500 rental, etc…. While others have been calling it the “50% Guideline”, I am going to start calling it the “50% ROT’” or “rule of thumb.” Rule of Thumb originated with carpenters when they would use there thumb to estimate something, but moved to an actual RULER before actual construction.

There is only ONE rule in Real Estate Investing:
1. NEVER LOSE MONEY.
2. READ NUMBER ONE AGAIN and AGAIN

And there are a plethora of GUIDELINES and RULES OF THUMB. No number in analyzing a Real Estate Investment is ever CONCRETE, EVER (with one exception)! Everything is always changing, usually higher. Just this week, I got a phone quote for insurance and when the bill came, it was actually lower by about \$15. But my premium next year will be different again. What number is ALWAYS the same in a Real Estate Investment? A fully amortized loan payment of principle and interest. If your PI payment is \$600 today on a 30 year loan, in 29 years, your PI payment will still be \$600 (barring no loan changes)

So instead of using the “50% ROT” for expenses, why not use the “50% ROT” for your PI payment. If the investment pays a monthly rental amount that is 50% or MORE of your PI, the investment has a much greater chance of success. Of course, there are many other items that you presented in your article which need to be taken into account of a thorough analysis, keeping your PI expenses under half your rent vastly helps. Buying a rental that rents for \$1,000 and having a PI of \$900 is just waiting for disaster. Even when paying all cash for a house, imagine buying the house with 25% down and figure out what the PI payment would be. If the PI payment would be 50% or less of the rent, the investment calls for more analysis.

Ali Boone February 10, 2014 at 1:17 pm

I love your rules Mike! haha. When I first started out I was hanging out with an investor guy who drove me around and showed me his properties and such, and his only rule was “never lose money”. I was sold right then. What a concept!

Mark Ferguson February 8, 2014 at 3:33 pm

Great article! The 50% rule drives me nuts too. My taxes are. .05%, but some areas have taxes ten times higher. Yet our expenses are the same when looking at the 50% rule.

Mike McKinzie February 8, 2014 at 7:59 pm

Mark
What area are you paying 0.05% Property Tax?? On a \$100,000 house, that is only \$50 a year in property taxes. In Texas, I am paying between 2.7% and 3.0%. In California, I pay 1.25% (with Property 13 rules in following years). In Oklahoma, it runs around 1% and Tennessee comes in just below 2%. I would LOVE a tax rate of .05%!

Ali Boone February 10, 2014 at 1:18 pm

Lol, me too Mike! Where in CA do you buy?

Ali Boone February 10, 2014 at 1:17 pm

Exactly Mark.

Abbott February 8, 2014 at 9:11 pm

Hey great article Ali, there are a lot of articles that seem to be written by coming up with a catchy title and figuring it out from there. But this is great, well organized and actionable content. I appreciate it!

Ali Boone February 10, 2014 at 1:18 pm

Thanks Abbott!

Abbott February 8, 2014 at 9:18 pm

dang Don’t get me wrong though the BP blog has some of the most consistently high quality content I’ve seen from blogs that post as much as it does.

Ali Boone February 10, 2014 at 1:19 pm

I agree Abbott. It’s awesome. Great resource! (thanks Josh!)

Sharon Tzib February 9, 2014 at 8:42 am

You know, Ali, I didn’t even know what the 50% rule was when I found BP about one year ago. I’ve been calculating cash flow old school for years, and much like first graders are taught to add and subtract without a calculator, new REI’s should learn how to calculate cash flow without using “rules.” It’s sets them up for a great foundation of truly understanding what makes an investment profitable, what the given costs are in a certain area, and how tweaking certain variables can definitely make or break an investment.

I see people in the forums all the time blessing an investment solely on the 50% rule, and it makes me cringe. I think Mike M above misunderstood your point. I don’t think you were saying that 50% is too much allotted to expenses, but rather, there are plenty of times 50% is not enough, so buyer beware if you rely solely on that rule.

“Quality of the market, quality of the property, quality of the management.” – Every investor should have this hanging on their bulletin board staring them in the face. Good stuff!

Mike McKinzie February 9, 2014 at 2:00 pm

Sharon
I understood Ali’s point exactly. I have many properties that the expenses go over 50% just as I have many that go under 50%. Having been in the Real Estate Investment world for well over 30 years, I think I have the experience to back up what I post. And having retired at age 50, I have the results to back up what I post. There are NO PROPERTIES that you can assign the 50% amount to because for 1/2, it will be too low and for 1/2 it will be too high. But if every single rental property in the United States were figured into a calculation, the 50% ROT would be extremely close. I saw a study on 1.1 MILLION apartment units for one year, just a few years ago, and the expense/vacancy rate was 49.98%.

Let me show an example: You buy a rental house that rents for \$1,000 a month. The 50% guideline states that your expenses will be \$500. But let’s look at the expenses:
Property Tax: \$100
Management: \$100
Insurance: \$50
One Month Vacancy: \$83
Repairs: \$50
Major Repair Reserve: \$100
Total comes to: \$483, pretty close to our 50% mark.
But let’s say that the house is in Texas, because then the monthly Property Tax is closer to \$200. Or that you are in a market where you have to pay utilities of \$100 a month. Or you have a tenant, like I did, that stayed in the house for 24 years and thus not having a vacancy factor. And the list goes on and on.

And again, I say the 50% is a RULE OF THUMB, and once you own 20 or more properties across multiple states and markets, you will see that the 50% mark is fairly accurate. BUT, when assessing a single house, try to get more accurate numbers taking EVERYTHING into consideration. That is why Ali’s BLOG is excellent.

Sharon Tzib February 9, 2014 at 2:06 pm

Oh dear, Mike, I am so sorry. I meant to say Christopher M, not Mike M. I agree with you 100% and hope I did not offend you

Ali Boone February 10, 2014 at 1:21 pm

Thanks Sharon! I had never heard of the 50% rule until I got on BP either. And to this day, I’ve never once used it either. At first glance of numbers, I mentally note what the % of the rent to price is (1%, 2% rules) but that’s about it. I go straight into real numbers from there if I think I’m interested. I couldn’t explain the 50% rule to a kindergartner right now because I’ve never used it. Not interested.

It’s all about quality indeed! At least if if you want less headaches and work, which I’m a huge fan of.

Paul Francis February 9, 2014 at 1:40 pm

Great article..

Spot on about that future appreciation being calculated in. Drove me up the wall when I would see agents using appreciation rates of 40% in Vegas back in 2005 and drives me up the wall when I see 25% being used today in their “calculations” trying to pawn off properties as good investments…. as if that’s something that continues every year.

Ali Boone February 10, 2014 at 1:22 pm

Agreed Paul. Ask all those speculators how 2008-2012 treated them with their 40% appreciation

djopgenort February 10, 2014 at 1:59 am

I’d say 50% is my carry cost (interest, taxes, insurance).
I’m in a bit of a different position, in that all that my place needs to do is “support itself while it buys itself’ — my profit is ownership of the property. All of the income stays in a “rental” account, then gets put back into the property (the house came with a LOT of deferred maintenance & items at the end of their lifespan–”the stove is possessed!” has been my favorite fix-it call so far…who knew stoves had a motherboard that could go nuts!).
Once I’ve deducted the repairs the depreciation knocks out most of the rest of the “profit”, so it’s pretty much a wash tax-wise, but of course my equity will increase as the loan is paid off.
The new 2% tax rule for rental expenses SHOULD help me out a bit, though I’m not sure yet – may be a wash (will have to look at past records). I think inexpensive properties seem to operate in their own universe, & maybe the “regular” numbers don’t work.

Ali Boone February 10, 2014 at 1:24 pm

Lol djopgenort, would love to hear more about the possessed stove!

Susan Cain February 10, 2014 at 12:42 pm

I always figure my income to be what I declare on my Tax return, which always has some deduction for depreciation. Just for fun, I decided to run the numbers. Prime property in downtown Boston has heavy taxes and condo fees. Here are my numbers: Condo one: Studio (600s.f.) Rent is \$18,000/ yr. (below market but excellent tenant.) Expenses: \$8434. Condo two: Loft (1263s.f.) Rent is \$32,000 (also below market but long-term, wonderful tenant.) Expenses:
\$20818. WOW!! What a surprise. No mortgages, but the loft has a special assessment that I chose to pay over 10 years, at a cost of \$4,524/yr. At the time I didn’t want to give them \$40,000. ( And it’s tax-deductible.) So, bottom line, I can’t imagine owning either property as an investment with a mortgage. I can never sell either one – recapturing the depreciation would be crazy. So my Estate will benefit from thirty-plus years of terrific appreciation.

Ali Boone February 10, 2014 at 1:25 pm

Excellent Susan!

Shaun February 11, 2014 at 3:15 pm

The 50% rule is a nice little screening tool.
If doing a quick calc. taking estimating expenses at half the rent gives a reasonable value for your ROI, CoC, IRR, cash flow or whatever metric you like to use then it is worth digging a little deeper.
It is of course foolish to buy strictly based on this as there are things that will vary widely in different areas. And things that can vary widely just between properties. Say I’m looking at 2 duplexes and overall they are pretty similar but one has a shared heating system that the landlord pays and the other has them split with the tenants paying there own. Think that expenses will differ a tad?

I’m all about not wasting a lot of effort evaluating crap deals so I like these little screening tools to see if it is worth digging in more. Do I miss out on a good deal here or there? Possibly, though I doubt it. Have a saved probably 100+ hours evaluating lousy deals over the last couple years? I’d bet good money on it!

Ali Boone March 26, 2014 at 7:23 pm

I agree Shaun that they are helpful for quickly looking to see which properties you want to pursue. I do that as well and I encourage others to. It’s when people use it as buying criteria that things are bad.

Shaun February 11, 2014 at 3:22 pm

I kind of disagree with it not being all about the numbers.
It is always all about the numbers.
The issue is making sure you use the CORRECT numbers.

If you are getting projections for crazy amazing returns on a property in a C-/D area because you are using the rents, vacancy, management and repair estimates for the B+ area 2 miles away, you aren’t using the right numbers.
If you factor in all of that stuff correctly then you “paper returns” should be more realistic.

You may say that you don’t want to deal with a tough property that will draw a lower grade tenant even if the return is better.
That is STILL just numbers. You are implicitly valuing your time and your effort expended on your properties so if you don’t think the lower end place makes enough to meet your thoughts on what your “billing rate” is then you don’t buy it.

My mantra is “Everything is a price adjustment”.

Ali Boone March 26, 2014 at 7:24 pm

You’re actually right Shaun, I hadn’t thought of it that way. That is definitely the more accurate way to put it and I will say that instead from now on! Good call.

Dayna March 26, 2014 at 9:40 am

Excellent advice for those new to investing! Thanks for sharing!

~Dayna @ http://www.flipt.co

Ali Boone March 26, 2014 at 7:25 pm

Thanks Danya!

Ben Staples April 20, 2014 at 1:50 pm

As someone new, I really enjoy the step by step guidance this article gives. Do you have any resources or articles you would recommend on further understanding location calculations? One of my biggest challenges is getting a grasp on where the neighborhood is headed.

Thanks
Ben