Flipping Houses

How I Do My Real Estate Math (Accurately) in Just 10 Minutes

Expertise: Personal Development, Business Management, Real Estate Investing Basics, Landlording & Rental Properties, Personal Finance, Flipping Houses
120 Articles Written
real_estate_math

I get to chat with a lot of new investors through email, telephone, and Facebook, and one of the questions I hear a lot is how to figure out if they can actually buy the house and make MONEY buying it. Sure, we can guess here, guess there, I think the cabinets will be this much, or the driveway be that much. But how much is it REALLY going to cost me?

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That’s the ticket. How much can I do the work for, and how fast can I turn the property?

How much can I buy the house for, what it is worth redone, what will it cost me to fix it up, and how long will it take me to sell it? And of course the final question: How much money can I make on this deal with all of those figures?

ARV (after repair value) – (Purchase + Reno + Holding Costs + Realtor Fees) = Profit

How I Estimate Numbers on My Properties

Through a lot of screwing up, missing things, living through jobs, learning from smart people, and doing the work, we get to know our costs. We learn how our GCs operate and bid their jobs, understand the sub contractors and work they can do, and what we need to look out for within all the different trades. I have been learning to be tighter and tighter on my budgets. Within the construct of my bids, as I walk through a property, I write up a list of things that basically go in two different categories:

  • Regular Items: “Fix plumbing here, put a door there, change this fixture here, put in a vanity here, painting (although not “cheap,” you are probably almost always painting),” etc.
  • Big Items: “Windows, hardwoods throughout house, kitchen cabinets, foundation repair, HVAC, granite tops, major framing and wall layout changes, deck,” etc.

Within these two categories, right there at the property I then write down an estimate of the number of windows times cost, the hardwoods’ approximate square footage, the linear feet of the kitchen, and a ballpark of the exterior and interior paint as I make my way through the rooms. For a bathroom in a rental house, I can do it for $1,500-$2,500 depending on the house. And for a fix and flip, I am usually into them for more like $4,500 – $6,000 depending on size and finish. I’d rather be over than under! Don’t get crazy with going over, just give yourself $1,000 for a vanity or whatnot depending on the kind of flip/finish you are doing.

Once I get back to my office, I have a one page “workup” that I put my numbers into. It calculates a total based on what I put into it as far as the costs. And then I also put in contingency amounts (you better — this will bite you if you don’t have contingency funds) and the holding costs, if any. I plug in for taxes, insurance, and utilities and add realtor fees — and then finally… my favorite line, profit.

Now, you spent just a couple minutes writing down items and ball-parking your property, you inputed those items into your workup in 60 seconds — and bam, you have a number to work from. As you get more and more comfortable, you can also have a really good sense of these costs hammered out on your notepad or tablet right there from the property.

You obviously need to know if YOUR numbers are correct with the GC you use or the subs who will be doing the work. Here is my modus operandi for GC bids.

4 Tips for Working With Your General Contractor

Ask Yourself: Am I REALLY Making an Offer?

If the answer in my gut is yes, I like the house enough that I will be making an offer if all the numbers work, I have a GC or two out and get a real bid. This takes a LOT of time on their end. Don’t waste your guy’s time. When I am ready to make an offer on a house, sometimes I go ahead and make the offer (don’t do this unless you have been locking down your numbers for a while — don’t get ahead of yourself!) and then let my GC know I need the bid within X days (yes, days, not weeks).

Related: How to Accurately Estimate Expenses on a Rental Property in 3 Easy Steps

Sometimes these guys will ask how much time I need. Sometimes I say it’s a HUD property, and I can’t even make an offer until 10 days out and have them ballpark it for me. Be careful when you ask for this because it’s almost surely wrong. BUT you should at least have some idea: “We are in the $40k range” or “the $65k range.” Clearly, $25k could kill your deal! Or at least take all your profit.

Don’t Forget the Unforeseen

There are several things that come up just often enough to be easy to forget. For instance, this week I had a rental house we were renovating, everything was on budget, going well, and guess what, gas has been off for long enough that it needs to be inspected. I should have already pulled that from the gas company (my fault) — and then come to find out the gas line needs to be replaced. OUCH.

#ihatesurprises #atleasttheonesthatcostmemoney

I couldn’t sleep. I was so pissed at myself! I hate making mistakes. It hasn’t killed the deal by any means, but it was well beyond what I had expected. I know in the future I am going to have a line item in my “pre-check” sheet to call the city utilities on the houses that have been vacant for a while and ask about their utilities so I can be sure I don’t get surprised with another gas line situation.

Check. No more gas line surprises. I hate surprises.

Another unforeseen situation is broken or ugly trees. Grading and dirt work. Servicing your HVAC or other systems within a house.

Make Sure You & Your GC’s Bid Expectations Match 

One thing that came up within a job was the wall vents. I asked why they weren’t changed out, and he said they weren’t in the bid. We made them work for that job, and then I said, Always include them. I expect them to be there.  

We learn, we work it out, and we do it better next time.

Or how about whether you have a shower door or not, and what kind of door. Say, a $700 shower door. I’ve had that conversation too. It’s definitely a more expensive problem. #lessonlearned

Related: 3 Types of General Contractors (& How to Choose One for Your Project)

Have Open and Transparent Communication With Your GC

Within a large project (we have both a $95k project and a $47k project going right now), there are always variables. Always. Plumbing line needs to move. Or galvanized line has failed. Or subfloor is rotten. Or termites. Or trees. Or a deck you can’t salvage. (Yes, most of these are things I myself have dealt with.)

Both of my go-to GCs are good to work with on these kinds of things. For instance, one will suggest, “I have X dollars set aside for __________, but what if we do _________ instead?”

I love collaboration. I’m not too proud or too smart ever to hear another opinion. And when he asks me something like this, I always listen. You have a set budget, so use it the very best you can to get the very best house you can, to sell it as quickly as you can, and get OUT of the deal as fast as you can.

And it all starts with making sure you buy it right. Get your numbers, work up your deal, and don’t be afraid to pull the trigger.

What are you tips and tricks for quickly putting together your property workups, and do you have apps or other tools you use to do that quickly, accurately, and efficiently?

Leave a comment below, and let’s talk! 

Nathan Brooks is the co-founder and CEO of Bridge Turnkey Investments, a Kansas City-based company renovating and selling more than 100 turnkey properties per year. With over a decade of experience in real estate, Nathan is a seasoned investor with a large personal portfolio and a growing business portfolio. Just last year, through Bridge Turnkey Investments, he helped investors add over $12 million in value to their real estate portfolios. Nathan regularly produces educational content to fuel his passion for helping other people learn about and find success in real estate investing. He has been featured regularly on industry podcasts such as the BiggerPockets Podcast, Active Duty Passive Income Podcast, Freedom Real Estate Investing Podcast, Fearless Pursuit of Freedom Podcast, Titanium Vault, The Real Estate Investing Podcast, The Best Real Estate Investing Advice Ever Show, the Good Success Podcast, FlipNerd, Wholesaling Inc., The Real Estate Investing Profits Master Series, Flipping Junkie Podcast, Flip Empire podcast, Think Realty Radio, and more. He is a sought-after speaker and writer and can be found on stage regularly at events across the country.

    Glenn Espinosa
    Replied over 6 years ago
    Great post Ali! I can totally see this as a great beginner resource for new investors.
    NA Kellz
    Replied 5 months ago
    This is a great post! Love it!
    Ali
    Replied over 6 years ago
    Thanks, Glenn! It’s definitely geared towards simple. Numbers can obviously get more complicated, but they don’t need to start out that way. Thanks for the comment!
    Akhil Khurana Flipper/Rehabber from Long Island, NY
    Replied over 3 years ago
    very helpful !! I put the formulas into Excel and just for kicks ran the #s for a property that was on sale in my neighborhood. Made me realize in less than 5 mins that I would have lost money had I put money in it. LOL
    Jay Lighten from London, Essex
    Replied over 2 years ago
    Absolutely agree!
    Mark
    Replied over 6 years ago
    Absolutely a fantastic resource for new beginners.
    Ankit Duggal
    Replied over 6 years ago
    Awesome job. Clear and concise way to analyze income properties on a back of the “napkin”.
    Ali
    Replied over 6 years ago
    Thanks, Ankit! The trick is to remember not to throw away the napkin or use it to clean up a mess or you have to start all over again 🙂
    Alexis Bulongo
    Replied 7 months ago
    Is it okay to add the closing cost to purchase price to get a Cap rate?
    Brandon Turner
    Replied over 6 years ago
    I like the approach to this, Ali. I think too many people complicate the math – but it’s really fairly simple. Then again – I was the co-president of my High School Math League… so I’m kinda a math nerd.
    Michael Rodriguez from Fort Lauderdale, Florida
    Replied over 2 years ago
    Sorry maybe I’m overthinking or not thinking but I have a question I’m lost from where you got the 9168/ 94,500. On the napkin example?? We’re did you get 9168 from?
    Doug Moe from Portland, Oregon
    Replied over 2 years ago
    358 is the cashflow per month after all expenses (including the mortgage), you subtract the cost of mortgage which is 406 per month so cashflow increases up to 764 per month in that scenario so that we can determine the cap rate. 764 X 12 months = 9,168
    Michael Rodriguez from Fort Lauderdale, Florida
    Replied over 2 years ago
    @ doug moe thank you for clearing that up really appreciate it.
    Aaron Hall from Reston, VA
    Replied almost 2 years ago
    Ahhhh I was wondering those numbers as well. This clears it up, THANK YOU!
    Joshua Busbey from Jonesville, South Carolina
    Replied over 1 year ago
    Thank you very much. That had me stumped as well.
    Account Closed Real Estate Broker from Phoenix, AZ
    Replied about 1 year ago
    Ha, I just realized I saw PM as PMI and hence my math wasn’t working out! As a real estate Broker in AZ I use a version of this constantly just to weed out properties (Cap Rate) that are or aren’t a consideration. I use 50% for expenses if it’s not individually metered and 40% if it is and tenants pay utilities, then 5 or 10% for vacancy depending on the property/tenant type (like for Sec 8 tenants I use a 5% vacancy). This helps me in case the seller’s numbers are off or there just aren’t any, which is very common on the wholesale deals I get.
    Ali
    Replied over 6 years ago
    Hey Brandon, does it help you feel better about being a math nerd if I tell you I minored in math in college? Not quite as stellar of a nerd ranking, but at least I was trying 🙂
    A.King
    Replied over 6 years ago
    Great article! In your Cap Rate calculation on the napkin, where are you getting the Annual Net (minus mortgage) value of $9168? I’m just not seeing it. Thanks!
    Josh g
    Replied over 6 years ago
    The $9168 is the monthly net (cash flow-$358) plus the mortgage payment added (406) then multiplied by 12 months
    Ali
    Replied over 6 years ago
    Thanks, Josh! You nailed it. Sorry, A.King, I should have clarified that better. I kind of snuck that one in there.
    Brain Helfrich
    Replied over 6 years ago
    So, even though you say “NOTE: I don’t include the mortgage payment in this calculation.” You do need to include the mortgage payment in the Cap Rate calculation. Right? Thanks, -Brian
    Ali Boone
    Replied over 6 years ago
    Hi Brian (I assume Brian, not Brain? haha). No, the cost of financing (in this case the mortgage payment) is never included in a cap rate. It is, however, included in a cash-on-cash return. That is standard. Basically, whether or not a buyer is financing is, as I like to say, their own problem and should not reflect on the purchase price of the property, which is what a cap rate is used for. Cash-on-cash returns are what you care about as a financer, and there you would include the mortgage payment.
    Ali Boone
    Replied about 6 years ago
    (this response is months late… I wrote this a while ago and just now realized it never went through!) Hi Brian (I assume Brian, not Brain?). No, the cost of financing (in this case the mortgage payment) is never included in a cap rate. It is, however, included in a cash-on-cash return. That is standard. Basically, whether or not a buyer is financing is, as I like to say, their own problem and should not reflect on the purchase price of the property, which is what a cap rate is used for. Cash-on-cash returns are what you care about as a financer, and there you would include the mortgage payment.
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    So then its $1325 Income – $561 Expense(minus Mortgage) = $764(Cash Flow) * 12 months = $9,168. OK I get it now.
    Dennis
    Replied over 6 years ago
    Just figuring there are some on this site who are not completely familiar with financial calculations. That being said I would also include dividing the number arrived at after dividing net yearly income by purchase price should be multiplied by 100 to acquire a percentage figure. I just received a panicked email from a person who ran a deal past me a year age, I told him to grab the place. He was heart broken with his result $13,260/$50,000 = .2652. Thinking the cap rate as less then 1 percent. He is now beaming with a 26.52% cap rate.
    Dennis
    Replied over 6 years ago
    I should have proof read a bit better, I hope you get the idea, multiply fraction by 100 to gain percentage figure.
    Remrie
    Replied over 6 years ago
    Aka move the decimal two places.
    Mark
    Replied over 6 years ago
    exactly.. just move the decimal point two places to the right to get a percentage from a decimal.
    Ali
    Replied over 6 years ago
    Ooh, Dennis, great note. Yes, 0.2652 is definitely a bummer of a deal! 😉
    Bryan Scott
    Replied over 6 years ago
    Hi Ali, Good article. Just some added food for thought… If you intend to buy-and-hold for 5 years, one’s “back of napkin” estimates are quite different than holding for 30. In that 5 years, it is very unlikely that any rehab will be required before selling the property (while ROI can be maintained at a high percentage). However, hold that property for 10, 20, or even 30 years (part of the 401-K plan) and returns can very quickly turn back to “ho-hum” (not including effects of appreciation, which we hope there will be) after having to upgrade the kitchen and the 2 bathrooms, along with replacing carpet and lino, repainting inside and out, replacing the roof and siding and also the outdated appliances, etc., before the property will sell at that point. As a matter of fact, in 30 years, it is possible to do at least 2 fairly major rehabs just to keep pace with renter expectations and to maintain the highest rental income. So, I guess my concern is not just exit strategy as a buy-and-hold vs. fix-and-flip, but that they also know how long they intend to hold. This would give rise to the need to “budget” the big items at certain intervals in order to make sure enough cash-flow is held back to pay for these items when it comes time. Additionally, having been a landlord for many years, I can personally attest that the HUD-recommended amount of hold-back for expenses and vacancy is very nearly 16% across a portfolio of many different properties with varying Year of Construction. This is pretty much in lock-step with your estimate of 10% for vacancy + another 5% or so for repair. The above might imply that we need to “schedule” the big-ticket replacement items over time and derive a monthly percentage to hold back in addition to repair.
    Ali
    Replied over 6 years ago
    Hi Bryan, great add! Yes, the reality of repairs is a serious consideration. Obviously there is no golden formula to predict everything that may go wrong with a property, but all things should be considered. Definitely when I buy the turnkeys at least, since they are freshly rehabbed, I don’t usually have anything in terms of maintenance for quite a while. but I still throw in that estimate even in the beginning because it will average out later when repairs do start popping up. Anytime an investment opportunity arises, an investor should always think about exit strategy. Your point definitely goes towards the debate of buying really cheap older properties… even if you get it fixed up to start, what hasn’t been fixed and how much could that cost you later? Excellent note! Thanks for sharing.
    Ali
    Replied over 6 years ago
    Hi Bryan, great add! Yes, the reality of repairs is a serious consideration. Obviously there is no golden formula to predict everything that may go wrong with a property, but all things should be considered. Definitely when I buy the turnkeys at least, since they are freshly rehabbed, I don’t usually have anything in terms of maintenance for quite a while. but I still throw in that estimate even in the beginning because it will average out later when repairs do start popping up. Anytime an investment opportunity arises, an investor should always think about exit strategy. Your point definitely goes towards the debate of buying really cheap older properties… even if you get it fixed up to start, what hasn’t been fixed and how much could that cost you later? Excellent note! Thanks for sharing.
    Andrew C. from Jacksonville, Florida
    Replied over 1 year ago
    Good point – I am just getting into this industry, but I do believe that an investment is only as good as its exit strategy. Bumping up your expense % in a more detailed analysis will save you later in the game. Question: can you budget into your growing equity in your home as an option to tap into when you need to do any major home repairs/CAPEX?
    Mark
    Replied over 6 years ago
    Wonderful information. Never thought of adding in non-vacancy and maintenance and repair into the numbers. I’m a new investor, and will definitely put those percentages into the equation on my first rental purchase.
    Ali
    Replied over 6 years ago
    Hi Mark, glad that helps! You aren’t alone by any stretch. Most investors, oftentimes even the experienced ones, don’t account for vacancy and repairs. I didn’t know to do that when I first started either. Funny it’s not more widely known since those two things are usually, if not always, what end up costing an investor money! Just be sure to always gauge your estimates wisely… like higher repairs % if the property is an old foreclosure. Happy investing! I hope you’re enjoying it so far! Warning, it can be a bit addictive 😉
    Lucas Hall
    Replied over 6 years ago
    Ali, Well Done. I’ve often tried to think of the best, most simplistic way to explain the preliminary calculations for a rental purchase. I never thought about framing it in a napkin. Even the most novice of investors would be open to hearing about that! Brilliant!
    Ali
    Replied over 6 years ago
    Thanks for the comment, Lucas! But don’t let me mislead you… writing on your hand, chalk on the driveway, dry erase marker on your mirror, crayon on your kid’s homework… they all work just as good as a napkin. Never limit yourself. 🙂
    Lucas Hall
    Replied over 6 years ago
    Ali, Well Done. I’ve often tried to think of the best, most simplistic way to explain the preliminary calculations for a rental purchase. I never thought about framing it in a napkin. Even the most novice of investors would be open to hearing about that! Brilliant!
    Giovanni Isaksen
    Replied over 6 years ago
    Great article Ali. One simple next step is to compare the Cap Rate to the Cash On Cash Return (CCR). If the CCR is higher than the Cap Rate you have positive leverage, i.e. you can expect a better return using the financing you have in mind. If the Cap Rate is higher than the CCR then your leverage is negative and your return would be higher buying all cash. If that is the case the deal needs to be reviewed more closely. Not saying it’s a deal killer, just that revisiting the financing options would be worthwhile. To take a step up from the napkin/kid’s homework we developed the Dealizer, which crunches all those numbers and more. It’s an Excel template so it’s easy to store your numbers for each deal you look at and come back to them when you need to. We use it every day in our business and are in final testing on version 5 which includes more what-ifs, more detailed financing options and a couple new reports.
    Giovanni Isaksen
    Replied over 6 years ago
    Great article Ali. One simple next step is to compare the Cap Rate to the Cash On Cash Return (CCR). If the CCR is higher than the Cap Rate you have positive leverage, i.e. you can expect a better return using the financing you have in mind. If the Cap Rate is higher than the CCR then your leverage is negative and your return would be higher buying all cash. If that is the case the deal needs to be reviewed more closely. Not saying it’s a deal killer, just that revisiting the financing options would be worthwhile. To take a step up from the napkin/kid’s homework we developed the Dealizer, which crunches all those numbers and more. It’s an Excel template so it’s easy to store your numbers for each deal you look at and come back to them when you need to. We use it every day in our business and are in final testing on version 5 which includes more what-ifs, more detailed financing options and a couple new reports.
    Ali
    Replied over 6 years ago
    Thanks for sharing, Giovanni. Any tools available for investors helps. I’ve seen various Excel spreadsheets and have made some myself and they can definitely come in handy.
    Christopher
    Replied over 6 years ago
    Hey everyone! I got lucky awhile back with finding a excel spreadsheet that did all the calculations for me that basically were used in the great “napkin presentation”. It helps to understand the numbers more I agree. Here is my biggest issue right now REPAIRS! If I look at a property and know it will need 30k in repairs upfront because it is a foreclosure or something how do I add this to my financing equation? For straight cash I figured you just add it to the purchase price and great the cap rate will be easy, but for financing I am stuck since that is what I want to use. I wonder why anyone ever uses cash since leverage is so powerful in rentals (and is the only way I think makes holding rentals worth it). Should I simply figure out how long I plan to hold the property, and then from there I can bump my repair % to match that? heeeeeelllllllppppppppp.
    Giovanni Isaksen
    Replied over 6 years ago
    Christopher, that is a great question. When we run numbers on the Dealizer it shows the Cap Rate based on the purchase price and it also shows the ‘All in’ Cap Rate based on the total investment, including the repairs and costs to close. The ‘All in’ Cap Rate is the one you should use for analyzing a potential purchase, Since it represents your real investment in the property. When you’re trying to sell a property most brokers will show the regular Cap Rate to a potential buyer, hoping they don’t know the difference. You can check out the Dealizer by clicking on my name, above.
    Giovanni Isaksen
    Replied over 6 years ago
    Example of ‘All in’ Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 All in Cap Rate* 6.49% *All in Cap Rate = NOI / Total Investment Example of regular Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 Cap Rate* 8.0% *Cap Rate (regular) = NOI / Purchase Price Note how the regular Cap Rate makes the deal look better…. unless you are the buyer who still has to come up with the 5k of closing costs and 30k of repairs, which will have a real impact on returns; it’s also how sellers make a 6.5% Cap Rate deal look like an 8% Cap Rate.
    Giovanni Isaksen
    Replied over 6 years ago
    Example of ‘All in’ Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 All in Cap Rate* 6.49% *All in Cap Rate = NOI / Total Investment Example of regular Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 Cap Rate* 8.0% *Cap Rate (regular) = NOI / Purchase Price Note how the regular Cap Rate makes the deal look better…. unless you are the buyer who still has to come up with the 5k of closing costs and 30k of repairs, which will have a real impact on returns; it’s also how sellers make a 6.5% Cap Rate deal look like an 8% Cap Rate.
    Giovanni Isaksen
    Replied over 6 years ago
    Christopher, that is a great question. When we run numbers on the Dealizer it shows the Cap Rate based on the purchase price and it also shows the ‘All in’ Cap Rate based on the total investment, including the repairs and costs to close. The ‘All in’ Cap Rate is the one you should use for analyzing a potential purchase, Since it represents your real investment in the property. When you’re trying to sell a property most brokers will show the regular Cap Rate to a potential buyer, hoping they don’t know the difference. You can check out the Dealizer by clicking on my name, above.
    Giovanni Isaksen
    Replied over 6 years ago
    Example of ‘All in’ Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 All in Cap Rate* 6.49% *All in Cap Rate = NOI / Total Investment Example of regular Cap Rate: Purchase Price + 150,000 Closing Costs + 5,000 Repairs 30,000 = Total Investment 185,000 Net Operating Income 12,000 Cap Rate* 8.0% *Cap Rate (regular) = NOI / Purchase Price Note how the regular Cap Rate makes the deal look better…. unless you are the buyer who still has to come up with the 5k of closing costs and 30k of repairs, which will have a real impact on returns; it’s also how sellers make a 6.5% Cap Rate deal look like an 8% Cap Rate.
    Ali
    Replied over 6 years ago
    Sorry Giovanni, have to admit I’m a bit lost on your numbers. I’ve never heard of an “All in” cap rate versus a regular. Without sitting down and trying some different math, I don’t know where your numbers are coming from.
    Giovanni Isaksen
    Replied over 6 years ago
    Ali, sorry I couldn’t demonstrate the numbers better due to the nature of the comment form here. Let me try a different way of explaining it. A cap rate is essentially the cash on cash return you would earn on a property you bought with no loan. So imagine that the property your considering will be an all cash purchase, even if you do intend to mortgage the property. The purchase price is $150,000.00 The closing costs are $5,000.00 The repairs are $30,000.00 In our imaginary scenario we’re buying with all cash so the question is; what number are we going to base our cash on cash return on? Will you use just the $150,000 purchase price? No because you’re actually putting $185,000 into the deal so your cash on cash return, and therefore your cap rate, should be based on your entire investment, not just the purchase price. To differentiate that from the seller’s version (based solely on the purchase price) we call it the All In Cap Rate at Ashworth Partners, my apartment investment company. No need to apologize Ali, but if you ever wonder why your property that the seller told you was an 8 cap performs more like a 6-1/2 cap hopefully you’ll remember this thread.
    Ali
    Replied over 6 years ago
    Hey Christopher, thanks for writing! I agree with you about the paying all cash versus leveraging thing, but truthfully I think people tend to be scared of being “in debt”. I’ve heard arguments for and against there being a difference between ‘good’ debt and ‘bad’ debt, but I’m definitely on the bandwagon of good debt rocks! The returns on your money are much higher and less risk to your own pockets. I haven’t worked with rehab jobs yet since I only buy turnkeys, but I would imagine you could just add in the cash required to fix her up to the amount of ‘total cash invested’ in that cash-on-cash return and get an accurate % of your return. For the cap rate, add that $30k to the purchase price, since that total is really what you’d be buying the property for (technically), to see if that cap rate is still good. Know what I mean?
    Christopher
    Replied over 6 years ago
    Hey everyone! I got lucky awhile back with finding a excel spreadsheet that did all the calculations for me that basically were used in the great “napkin presentation”. It helps to understand the numbers more I agree. Here is my biggest issue right now REPAIRS! If I look at a property and know it will need 30k in repairs upfront because it is a foreclosure or something how do I add this to my financing equation? For straight cash I figured you just add it to the purchase price and great the cap rate will be easy, but for financing I am stuck since that is what I want to use. I wonder why anyone ever uses cash since leverage is so powerful in rentals (and is the only way I think makes holding rentals worth it). Should I simply figure out how long I plan to hold the property, and then from there I can bump my repair % to match that? heeeeeelllllllppppppppp.
    Frank Gallinelli
    Replied over 6 years ago
    Ali – I’ve made a career (or maybe a nuisance) out of telling people it’s all about the numbers, so I couldn’t be happier than to hear you saying the same. Also, I love simple — and you’ve done a spectacularly good job of keeping the basics just so. Please permit me to offer a minor tweak to your approach; there’s a more-or-less standard drill where the sequence is slightly different, but which ends up in the same place as yours — and it should fit on the same napkin: Potential Gross Income (same as your monthly rent, but usually expressed annually) minus Vacancy and Credit Loss Allowance equal Gross Operating Income minus Operating Expenses (mortgage is not an OpEx, so don’t include that here) equals Net Operating Income apply the cap rate to NOI to get your estimate of value take that NOI and now subtract your annual debt service that equals your annual cash flow Of course, in real estate investing as in real life, things can get complicated. If you’re planning to hold for several years, you need projections of how the future might look, and it might not be a linear path. Tax calculations can get messy (don’t even ask about the new Net Investment Income tax or the changed capital gains rules); and partnership allocations, if you need them, are no picnic. What you have here is an excellent way for an investor to start looking at an income-property investment. Then, if the deal looks promising, he or she can take the numbers to the next level. Maybe a roll of paper towels, landscape mode? 😉
    Chris
    Replied over 4 years ago
    What is the estimate of value used for? How does one “apply” cap rate to NOI. Multiply? Divide?
    Ali
    Replied over 6 years ago
    Hi Frank, I love it! I’m a fan of paper towels myself. I do believe I’ve jotted down some numbers on them before. I wouldn’t put it past me. Thanks for the different order of calculating things. You are very right that some people prefer to look at everything annually from the start, so good note there on being able to do that. And you nailed it with noting where in the process the financing amount comes out and where it is included.
    Christopher
    Replied over 6 years ago
    1) Ali- Thanks for the response! It got me to the right place on where I need to put my numbers in. I have been wondering where to put closing costs and repairs in for awhile. Xcel spreadsheets are great only if you know what they mean haha! I basically need to figure out my end number for the strategy I intend to use. I plan on using Hard Money to buy residential detached housing and instead of flipping it I will turn it into a rental. There are lenders out there that will re-finance at 70% ARV, so if the deal is good enough I can practically have 100% financing for my rental. Now that is a fun cash on cash return isn’t it? The banks blow and I am not about to put 25% down for a non-owner occupied and sink another 30k into the property, so Hard or Private Money can be a great avenue for investors to keep their OWN CASH working for them. 2) By the way Ali, There are many people who have no clue how to utilize leverage but what we do is a BUSINESS. Still boggles my mind to see duplexes out there that were selling 5 years ago 3-4x what their true value was, but that is why investors are different. Leverage is the reason why real estate produces more millionaires than any industry, because it allows you to purchase assets you otherwise could not. It also allows you to get an ROI of 50+% on your money from borrowing which is stupid crazy. You just need to know how the numbers work, which is why I am glad I found this website! Unless you are already rich (which I sure as hell am not) the only way to truly acquire wealth in real estate is through leverage. Borrow capital an make a spread with your investment. Everyone has different ways of explaining it, but the important thing is that you KNOW if you have positive leverage and what the spread is. The larger the spread the less risky the property is to you. 3) Hey good point there too Giovanni! In my example where I am doing a rehab project with the intent to refinance (the only way to make the numbers work well in my view) I just have to come up with my “end cash invested”, but for anyone else it makes sense. 4) Basically Ali the cap rate is somewhat flawed in that a true “purchase price” of a home is really my ACQUISITION COSTS. I tend to think this a better term because that is essentially what I am doing. Because most of us always are utilizing a mortgage we put closing costs and repairs (as in your response to my question) in the CASH INVESTED OUT-OF POCKET side, but as Giovanni states they should really be added to the purchase price as well to give you a more accurate view of the CAP RATE. After all, if I am an all-cash investor my ROI is based off of the TOTAL amount of cash it took me to acquire the property not just the purchase price. 5) Lastly, I think
    Christopher
    Replied over 6 years ago
    Lastly, I think UNDERSTANDING YOUR LOAN CONSTANT is extremely key to understanding leverage and the spread you are making. To me, it gets real messy just looking at cash flow or cash-on cash return and being OK with just saying “yep I got positive leverage!”. Or really any other method. Your interest rate is NOT your loan constant! Also, the down payment does not come into play for loan constant. This is helpful because we all know the less cash you put into the property the higher the cash-on-cash return is. However, if you have a very small spread and the house is very risky would you consider it still a great deal? Ultimately it is like I said: The spread between the Cap Rate and your Loan Constant is one of the most important things to understand when utilizing leverage. The larger the spread mean the asset you are purchasing is less risky. THIS IS THE REASON WHY CAP RATE IS STILL IMPORTANT to those of us who always plan to use financing because It used to determine risk. Don’t know if that can fit on a napkin LOL but for the basics and newbies like me I know personally this was valuable information I learned.
    Ali
    Replied over 6 years ago
    Hey Christopher, thanks for the detailed response! And you know, I think you busted me. You are totally right about adding the closing costs into the total purchase price of a property. I totally flunked on that one! See, perfect example of even the experienced investors can leave stuff out sometimes. Similar to the comment above about making sure to multiply by 100 🙂 I always run the same numbers multiple times because sometimes I start writing something quick and leave something out or write a wrong number. Can you elaborate on what you mean by “loan constant”? I’m not even sure I know what you mean by loan constant, so I know the newer investors probably don’t either.
    Jeff Smith from Tampa, Florida
    Replied about 3 years ago
    The loan constant is just another way of saying mortgage loan constant or more correctly is the mortgage capitalization rate aka the cap rate. To figure it out, divide the monthly debt service payment by the principal. An annual mortgage constant is just that number multiplied by twelve. Not too difficult and I bet it could even fit on your napkin!
    Frank Gallinelli
    Replied over 6 years ago
    @Giovsanni_Isaksen Sorry to pile on here, but I have to express a bit of skepticism about the usefulness of “all-in cap rate.” Essentially, there are typically two flavors of cap rate in common use: Market cap rate (NOI / selling price), which is the rate at which similar properties in a given market have actually been selling, and Derived cap rate, which is weighted average of the equity investor’s required rate of return and the debt investor’s (i.e., lender’s) required rate of return (i.e., interest rate). In practice, the two typically end up being quite close because, I believe, the investor market generally factors in the realities of the local financing market. In my experience, I find that most appraisers and investors use the market cap rate. Isn’t this “all-in” approach really just assigning a different meaning to “value” (price + acquisition costs + “repairs”)? And if the primary purpose of capitalizing income is to estimate the current value of an income property, aren’t you really using a non-standard metric to come up with a non-standard measure of value? I’m not sure I see how that’s helpful. A wildcard here is the use of the word “repairs.” A repair is an operating expense, and is not the same as an improvement — although I often see them discusssed as if they were the same. Identifying a cost as one or the other is not always clear, but the difference in how they’re treated is important. An improvement is not a deductible expense and has no effect on the NOI. It is a capital cost. It adds to the basis of an income property (hence reducing the gain at sale) but it doesn’t really affect the market value of the property directly. It should, however, affect it indirectly by increasing potential revenue and/or decreasing operating costs. On the other hand, a repair is a currently-deductible operating expense and reduces the NOI. From my experience, an income-property investor who is buying a property that needs improvements might estimate its current value based on capitalizing the property’s as-is income stream before fix-up. But then he or she would look at the expected stabilized income stream after the improvements and repairs are made; next, use the standard income capitalization approach to estimate its resale value; and finally do a discounted cash flow analysis to decide if overall return would be satisfactory, considering the time and capital required. I find this more straightforward, and I think it has the advantage that all parties involved are using common terminology.
    Ali
    Replied over 6 years ago
    I completely agree, Frank. Excellent add-in there about the repairs vs. improvements. Any information about initial rehabs helps because I don’t work with those myself. Thanks for elaborating on that one and good information to always think about. I’m with on the All-In Cap Rate thing. Never heard of it. Sorry Giovanni.
    Christopher
    Replied over 6 years ago
    I tend to disagree Frank because if I am an all cash buyer I want to know what my ROI is for the total cash invested is to the property. The closing costs are what $1300 bucks for a cash buyer? Regardless they are minimal. The repairs are really the question here. I would think that when determining whether repairs should become an added cost for Cap rate or simply used in your operating expenses is whether the house is rent-able or not. I sold a rental last summer where you could probably have put 7k into the property if you wanted to but the condition was fine as-is for a rental. To me then you just bump up your maintenance and repairs to include the deferred maintenance that eventually will need to be replaced. For what my question was specifically is foreclosed single family homes that are not rentable in their current condition. I know this will be an upfront cost to me, because I will have to put money into the home so it is up to code for the city and rentable. It should only make sense then that I add these costs to the purchase price to reflect a more accurate ROI that I can expect as a cash buyer. That is because I am also putting in a rent number that I know I can get premium dollar for since it will be turn-key. IN THAT REGARD THEN I AGREE WITH YOU THAT THE EXAMPLE ABOVE IS INACCURATE. If you are putting 30k into the property the NOI should look and be quite different, because by golly the rental income should be dramatically changed! As well as the maintenance % as Ali described effecting the expenses of course. I think from a practical standpoint most people that use financing are buying turn-key properties where they will always have repairs as part of the operating expenses. It then just comes down to figuring out if the property is 100% move-in ready or has deferred maintenance. Ali made a good point of this. If there is one thing I have learned from this discussion is that there are many ways to analyze a rental property beyond the simplest methods. Ali’s napkin example is excellent when dealing with turn-key properties or ones that have very little deferred maintenance, and thus you can always factor in maintenance and repairs to your operating costs. Where it becomes a little more challenging is in my scenario is buying foreclosed properties in very bad condition that are un-rentable in their current state. Of course the added layer is then when I refinance as well.
    Christopher
    Replied over 6 years ago
    Haha hey Ali I am probably the most knowledgeable guy that has never bought a rental…which kinda sucks but hey I am working on it. As a realtor though I work with both flippers and landlords, and so I have just kinda had to learn this stuff when analyzing deals to make sure I know what I am talking about. http://www.investopedia.com/terms/l/loanconstant.asp#axzz2Ip5XOp9f You can pretty much google loan constant but I used this off of Investopedia. As you will see understanding the “true cost of borrowing” is essential when looking at different financing options. From a practical standpoint it is not like there are a ton of options for financing, but what if I buy a contract for deed property? If I set up the terms correctly to get the lowest loan constant possible it may drastically change what I am willing to pay. It will offset the higher interest rate and probably more. In general these variables effect the loan constant: 1) Interest rate- pretty self explanatory the lower the better 2) The length of the loan- this is where I think people may get a little confused, because the longer the better. If I have a great interest rate but it is only 10-15 years I will most likely pay something higher to have it at 30 years. I have the equation on my excel so can’t think of it off the top of my head, but this is where knowing the loan constant can help. 3) Whether it is interest only or amortized- Like I said there are not a ton of financing options available and who can get interest only? This would probably only come into play for contract for deed homes. So to me the loan constant is best used when trying to figure out a loan that may be 10, 15, of 30 years in relation to the interest rate. You as the investor always want the lowest cost of borrowing. I think where people make the mistake is they always assume the lowest interest rate is the best option and that would be incorrect! Secondly as I stated loan constant is the “true cost of borrowing” so you can’t use the interest rate when figuring out leverage. You must determine this number and see what the spread is in relationship to cap rate. I don’t know what the rule of thumb should be, but my best guess is you need 4% or more for the asset to be considered less risky. For example, let’s say you are paying something like 6% for a 30-year conventional loan, and you are an average joe using his w’2 because he does not buy in a LLC. You put 20% down. Your loan constant is going to be around 7.2%, which means 11% or more cap rate. Now sure you will still have positive leverage if your cap rate is at 8% but boy you ain’t making much of a return on that. And on top of that we all know crap don’t work out the way we think it should most of the time haha! If you get that tenant from hell or some major repairs you did not see coming things can get bad real quick. It just goes to show you that even when using financing for rentals you must not use the cash-on-cash return when determining if the property is a good buy or not. I think it is the #1 reason why people get into trouble buying rentals. Now technically it is true that if the cap rate is higher than cash-on-cash return you will have negative leverage, but the point I am trying to make is for the people who get excited on 12-15% returns. I am telling ya it is not worth it! You have one bad year and those numbers can go negative really fast. It is also possible to have negative leverage but still positive cash flow. Like I said you all that own rentals probably know more than I do, but as a realtor I see deals every day that do not make sense. I work with the part-time wannabe investors, and it never ceases to amaze me the difference between them and the full-time investors who run this like a business. For myself I appreciate the dialogue on this thread because I certainly don’t want to be classified in the wanna-be group!
    Ali
    Replied over 6 years ago
    Hmmm. Thanks for the explanation, but I still can’t say that I have a clue what a loan constant really is or how it gets calculated. Even the Investopedia article didn’t explain much. I’m going to have to stick to my napkin on this one. I understand where you are coming from but for me this is teetering paralysis by analysis. Yes, you are correct that there are always things we can’t anticipate for fact with any investment, but my theory on that is leaving a big enough margin. Most of my properties are netting $500/month or so, so I consider that to be plenty of margin to make up for any complicated (if not impossible) unknowns. Thanks again for sharing. I’ll keep an eye out for that term in my readings, but for now, it just won’t fit on my napkin and I don’t believe it can make my investment 100% fool-proof anyway, so at that point it is going a little too far. For me, at least. Not saying it should be for anyone else.
    Giovanni Isaksen
    Replied over 6 years ago
    The loan constant is the amount of the loan you have to write a check for every payment period. With an interest only loan the constant will equal the interest rate. If you have an amortizing loan like a standard thirty year mortgage your monthly payment will be include the interest owned on the balance plus an amount of principal, which means that your payment will be higher than an interest only loan for the same amount. To figure out what your loan constant is divide the total of your annual payments (monthly X 12, quarterly X 4, etc.) into the loan balance. If you are borrowing $100,000 at a fixed annual rate of 6% for 30 years with monthly payments your payment will be $599.55*. Multiply 596.6 X 12 to get the total annual payment which is $7,194.60. Divide 7,194.6 into 100,000 and you get the loan constant of .071946 or nearly 7.2%. *Calculated with payment due at the end of the period. Conversely, if you know the loan constant for a particular interest rate and term you can calculate the payment. So for any 30 year 6% loan with monthly payments you can multiply the loan amount by the constant .071946 to get the total annual payment and then divide that by 12 to get the monthly payment.
    Christopher
    Replied over 6 years ago
    haha indeed the KISS rule (keeping it simple stupid) is usually the best in most cases.
    Ali
    Replied over 6 years ago
    Muah! ha. I agree. Not to be confused with Stupid Simple. Just Simple, Stupid. Stupid Simple is dangerous, as opposed to his brother Smart Simple. Have to be smart about it, but being smart doesn’t mean it can’t still remain (fairly) simple.
    Ali
    Replied over 6 years ago
    Muah! ha. I agree. Not to be confused with Stupid Simple. Just Simple, Stupid. Stupid Simple is dangerous, as opposed to his brother Smart Simple. Have to be smart about it, but being smart doesn’t mean it can’t still remain (fairly) simple. Reply Report comment
    Ali
    Replied over 6 years ago
    Muah! ha. I agree. Not to be confused with Stupid Simple. Just Simple, Stupid. Stupid Simple is dangerous, as opposed to his brother Smart Simple. Have to be smart about it, but being smart doesn’t mean it can’t still remain (fairly) simple. Reply Report comment
    Ali
    Replied over 6 years ago
    Muah! ha. I agree. Not to be confused with Stupid Simple. Just Simple, Stupid. Stupid Simple is dangerous, as opposed to his brother Smart Simple. Have to be smart about it, but being smart doesn’t mean it can’t still remain (fairly) simple.
    Frank Gallinelli
    Replied over 6 years ago
    @Ali Loan constant is the payment amount for a loan of $1 at a given interest rate and term. Yes, it’s usually a long decimal and there are eyesight-destroying tables of these things you could download. If you know the constant for a $1 loan, you can multiply it by the actual amount of a loan to get its payment. Very 20th-century method, but in short it is a single numeric representation of the rate/term. In one of my books, I have a crafty formula that includes the use of the mortgage constant, and which allows you to calculate the maximum possible amount that a lender might approve under a set of underwriting guidelines. @Christopher Sorry to be an old curmudgeon, but the whole discussion of cap rates and NOI is pretty much irrelevant to single-family houses, and to most 2-4’s as well. Those properties are typically not valued for their ability to produce income, but for their amenities as a personal residence. Hence, the price you pay to buy and the price you receive when you sell will not be governed by the property’s actual or potential income stream, but rather by comparable sales of similar properties, adjusted for the subject’s condition and amenities. The value tends to rise and fall in step with movement in the neighborhood’s housing market, while the value of a true income property is a function of its income stream.
    Ali
    Replied over 6 years ago
    Sorry, Frank, I can’t totally agree with you on that one. What you say is correct that you can’t determine the value of the property ahead of the time you plan to sell it because it will be based on comps rather than income, but you can definitely (and should) calculate NOI and cap rates when you go to buy the properties because you are buying for the purpose of getting a return. You have to know what that return is going to be, and you have to know what kind of deal you are getting when you buy it (cap rate). You’re right, cap rate and NOI don’t matter for a sale later, but it needs to be clear that these numbers DO matter at some point, specifically the purchasing.
    Frank Gallinelli
    Replied over 6 years ago
    @Christopher — btw, the use of a cap rate applied to NOI as a method of valuation of a true income property does in fact assume you are an all-cash buyer. Remember, NOI is before debt service. This is how a professional appraiser would approach the matter, and when you think about it, it makes perfect sense. The value of the property should not be affected by the kind of financing a particular buyer could obtain. If you had perfect credit, and I were a deadbeat, you might get better terms, but should that mean the property’s value should change depending on who is buying it. Going beyond the appraisal issue is the question, “At what price the property meet my investment criiteria?” That’s when you want to take into account your financing costs, if any, and do a discounted cash flow analysis over time. It’s not just the number of dollars returned, but also the timing; the latter can have a significant impact on your overall rate of return.
    Christopher
    Replied over 6 years ago
    Man my head is starting to hurt. Now I know why people just tell me to get them $500-$600 positive cash flow and be done with it hehehehe! Since I am starting to write a novel I am going full circle back to Ali’s napkin approach:)
    Frank Gallinelli
    Replied over 6 years ago
    @Ali Actually we don’t disagree very much at all — I just didn’t express myself as clearly or completely as I should have, and you’re raising an important point. In fact it’s a discussion I often have with my students on the subject of current appraised value vs. the price the investor should pay to achieve a certain objective. So, to try to clarify what I bumbled over before: With a single-family house, its appraised market value is based on comparable sales, not on its ability to produce income. By analogy, with a true investment property (i.e.,commercial or residential larger than four units), its current market value by standard appraisal technique is its capitalized NOI. The question that comes up in my grad class usually is, “So is that the price is I should be willing to pay as an investor?” The answer is, “Not necessarily.” The typical income-property investment scenario is to buy and hold for some period of time. Hence, you’re not looking at a once-shot stream of income (current NOI) but rather an ongoing series of cash flows, including what you hope will be a big one when you sell. The best way to start the decision process is first to decide on a target IRR. Mid-teens is what I usually see from our investment analysis customers, but it can be higher or lower depending on the perceived level of risk. Then build a pro forma for some number of years to hold the property and work backwards to determine what purchase price will allow you to achieve that rate of return over the holding period. You’ll use cash flow and net sale proceeds for this, rather than just NOI because the financing does have an impact on the return on your cash investment, as does the timing of cash flows and the overall holding period. It’s not uncommon to see the IRR peak for a certain holding period, but then decline if you keep the property longer. The short version here (sorry for too many words) is that I absolutely agree that you must try to make a sensible estimate of your expected return, regardless of the type of property. Where the single-family is different from conventional income properties, however, is in the fact the your ultimate resale (which is really the last of your cash flows) will not be based on the property’s capitalized income, but rather on its comparable-sales value as a home. Add your original purchase price should also not be based on NOI or comparable sales, but rather on the type of DCF analysis I described here. Hence, discounted cash flow analysis can just about always contribute to your decision-making, but capitalizing NOI doesn’t have much of a role with single-family.
    John
    Replied about 6 years ago
    Frank, Can you explain why IRR’s sometimes peak for a holding period, but then decline if you keep the property longer? Thanks!
    John
    Replied about 6 years ago
    Frank, Can you explain why IRR’s sometimes peak for a holding period, but then decline if you keep the property longer? Thanks! Reply Report comment
    John
    Replied about 6 years ago
    Frank, Can you explain why IRR’s sometimes peak for a holding period, but then decline if you keep the property longer? Thanks!
    David
    Replied over 6 years ago
    Wow, I couldn’t get through all the comments, so a very interesting topic, nice job! That said, I think 5% for maintenance/reserves is inadequate. Even if every mechanical system, and the roof, is brand new (which I doubt, even in a renovated turnkey), then you need to start putting aside 5% per year just to cover reserves. On top of that, you will have your turn expenses (cleaning, paint, possibly floor replacement and other repairs) that will amount to a few percentages points, and this correlates directly to the average length of tenancy, and whether you have a peaceable turn or an eviction. And then there are some inevitable work orders that come up in the course of a year. In short, 10% is the minimum that I think makes sense unless you are absolutely certain that you plan to sell the property before anything needs to be replaced (in which case you theoretically get less since buyers will discount the “old stuff”; I know I pay more for a house with new mechanicals). So in the end, I’d content that 10% is the better (and conservative) number. Length of tenancy is the key driver. It determines lease-up fees, vacancy rate, and turn expenses. This is one of the factors favoring single family homes that gets overlooked sometimes. And I’d contend that often the “stickiest” tenants are in the working class areas, where they tend to be long term renters.
    Ali
    Replied over 6 years ago
    David, you make extremely valid points here. Every investor needs to figure out for himself what he (she) believes makes sense for how much % to allocate for both vacancy and repairs. You bring up excellent points for additional expenses in the repairs category to consider.
    Michael
    Replied over 6 years ago
    Love the napkin post Ali. I use the quick # approach to determine quickly if I want to dig in more. There is so much to look at & this helps to weed out a lot in a short time. Good debate going on here & my head is spinning. LOL. Still love real estate & buying and holding now as well. Great Job!!!
    Ali
    Replied over 6 years ago
    Thanks, Michael! You totally nailed it. I always scratch out the basics on a napkin or my hand or wherever else is handy just so I can know if I want to continue to dig in more. If the napkin numbers don’t show me anything good, I can toss the property, with the napkin, into the trashcan.
    JKC
    Replied over 6 years ago
    Great article Ali! And great discussion in the comments. What I wanted to focus on is the last paragraph of your article and how location impacts cashflow – as you point out with your example of Detroit. In my experience, the worse the location, the “better” the numbers. Just keep in mind that those numbers aren’t free (you have to earn them). If you are in a rough location, your napkin calculation may look good, but make sure you put your boots on the ground before you buy. Alternately, in some of the nicer neighborhoods in a given area, the “napkin numbers” may not look as good, but the unit attracts nicer tenants and the area is often perceived as “less risky” in terms of appreciation and resale value. My rule of thumb is: “The nicer the neighborhood, the worse the cashflow.” I believe each investor needs to find a balance of return and risk that is comfortable to him/her.
    Ali
    Replied over 6 years ago
    I can’t agree with you more! And I think investors need to understand this. There are always exceptions of course… not every expensive property with lesser cash flow will end up with perfect tenants, and not every cheap property with huge returns will end up with bad tenants, but it’s a chances game. Your chances are better with better properties and worse with the cheaper ones. No doubt. Some investors are fine going the cheap route and actually make a lot of money doing so. Others don’t. Some don’t like expensive. You’re right. It’s about everyone’s individual comfort levels.
    John
    Replied over 6 years ago
    I was doing a few calculations and came up as follows… Assumes the following – Purchase price 40k / 15 yr mortgage @ 4.25 with 6k down Gross mo income – 650 Expenses Tax – 175/mo Insurance – 50/mo Mortgage – 260/mo Vacancy – 65/mo Repairs (15) – 100/mo Net Income – 0 Cap rate – 3120 / 40k – 7.8 percent COC Return – 3120 / 6000 – 52 percent Is this right? If so, how can net income be zero but cap rate and COC return be high?
    Ali
    Replied over 6 years ago
    Hi John, thanks for sending a sample problem! So a couple things I see here: – $3,120 is the net income not including the mortgage. Correct. But you should only use this one for the cap rate. So you’re cap rate is correct, because it does not include financing costs. – For the cash-on-cash, you do need to include the financing cost, meaning the zero net income. So essentially you would be doing 0/6,000 = 0. You are making no money on the money you invested. Is this a real property you found? What market? Ali
    John
    Replied over 6 years ago
    So in other words, run from this one… Yes, I live in Sioux City IA. There are several properties available in that range. The monthly rental income may be slightly low in my example (although I did figure it at 19.5 percent of purchase price). Is that appropriate? I may have some wiggle room with my banker as well which could affect the numbers. What term are you figuring your mortgage payment on? I am searching for my first rental and want to get this right.
    Ali
    Replied over 6 years ago
    John, I definitely want to suggest in this case that you work with a local real estate agent or property manager to determine what the realistic monthly rent should/will be. How did you come up with the 19.5% number? Either way, there is no magic formula for knowing what you can predict for rents. You can only go off the comparables in the area, and that’s where you need a professional. Especially in this case since you are so close to the fence of having zero net income. That’s a huge problem if you want this property as an investment. Remember- First rule of investing: Don’t lose money. This house is really close to wanting to break that rule. As far as mortgage, you can probably lessen the payment by switching to a 30-year but it depends on what is more important to you. Cash flow or paying it off quicker. Also, where are you getting $6,000 down from? Have your lender provide you with the definite numbers because I’ve never seen a lender do an investment property loan for under 20%, and you are estimating a 15% down payment. Plus, you are going to have closing costs that need to be factored into your returns equations. Hope that gives you some ideas to work on. But in general, I’d run far away from this property if those are the actual numbers. Ali
    Julia Rowling Real Estate Investor from Greenville, SC
    Replied almost 5 years ago
    Just wondering…where on earth a $40,000 home would cost you over $2000/year in property taxes. That doesn’t seem to me to be a very good area to invest in at all!
    Aaron Moayed Rental Property Investor from Sacramento, CA
    Replied 4 months ago
    Julia – late the comment, but landlord/rental property taxes are higher than homestead generally… I’ve seen them go as high as 5% in some places..
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 5 years ago
    Where did you see a $40k house with $2000/year in taxes Julia?
    Jeffrey Levy Investor from Brooklyn, NY
    Replied over 3 years ago
    Hi Ali. She is talking about about John’s house that was in the thread where she commented. He noted taxes on the 40k house are $175/month ($2,100 year) Nice post 🙂
    David
    Replied over 6 years ago
    John — try to get a 25 or 30-year amortization. Also, your insurance and taxes look ridiculously high. Insurance shouldn’t be more than 1% of your purchase price (annually), and I can’t imagine your tax rate there is more than 2.5% of assessed value (annually). You may need to appeal the assessment upon purchase. In most jurisdictions, it is fairly routine to get the assessed value knocked down to your purchase price (Detroit may be an exception, for example). The 15% maint is on the high end of what most would use. I’d recommend 10-11% for SFRs in working class neighborhoods, as long as they have been reasonably rehabbed on the front end, and the house isn’t extremely old. DON’T determine rents based on a swap % of the purchase price. You need to do a rent survey, using Craigs List, For Rent signs, Zillow, rentometer, calling prop mgr’s, etc. A gross yield of 20% or so is pretty decent, it’s just shy of the exalted 24% target (ie. 2% rule) that everyone chases. Depends entirely on the quality of the neighborhood and quality of the property whether it is the right target, however. People routinely buy at 15-18% gross in “nice” neighborhoods, but lower neighborhoods you won’t make a penny if your gross rent is less than 24%, due to the higher maintenance and greater tenant issues.
    Ali
    Replied over 6 years ago
    Great adds, John! And I agree. The numbers look really off.
    John
    Replied over 6 years ago
    Thanks for the info. My tax numbers come directly from the county assessor page. Property is a foreclosure assessed at more than 2x listing price. I just guessed on insurance at this point. The 15 percent down figure comes from meetings I have had at the bank. They are a small, local bank. What percentage do you figure for closing?
    Ali
    Replied over 6 years ago
    And you definitely made sure to clarify that this will be a mortgage on an “investment property” rather than an owner-occupied property? That makes a big difference for down payments and interest rates. But if you did clarify that with them and you can definitely do a 15% down loan, that is awesome and I’m quite jealous. I don’t want to give you a % to use in calculating closing costs. You need to get an actual number from the bank for those. There are some basic %s you could use, but I feel like they will mislead you. You are safer to get the numbers from the lender. They can give you those. I caution you in general to be very wary of assigning uniform estimates to any property you look at. Like assuming the rent will be a % of the purchase price or property value. Or assuming an exact % of the loan for closing costs. Because success in real estate investing is so dependent on numbers, always always always try to get exact numbers whenever possible. Because even with almost all “exact” numbers, there will always be something to throw those numbers off. So you want to estimate as accurately as possible to start.
    John
    Replied over 6 years ago
    Thanks for your help. Yes my banker knows this is an investment property. Having a good relationship with him and the bank probably helps. I will get some definite insurance numbers. This is just one I found a very prelimary figuring at this point. Wanted to make sure I was on the right track. Thank you again.
    John
    Replied over 6 years ago
    Thanks for your help. Yes my banker knows this is an investment property. Having a good relationship with him and the bank probably helps. I will get some definite insurance numbers. This is just one I found a very prelimary figuring at this point. Wanted to make sure I was on the right track. Thank you again.
    Sabrina Laplante
    Replied over 6 years ago
    Ali, awesome article!!!! Love how simple you make it. I appreciate the time you take to explain these things to some of us beginners! What some could say about numbers and them being scary, you show us a very appealing version!! Thank you so very much, and good luck with everything! Looking forward to reading many more of your blogs on here!!!
    Ali
    Replied over 6 years ago
    Thanks, Sabrina!
    Jacquelyn
    Replied over 6 years ago
    Hello Ali: Maybe I missed it but on the cash-on-cash example, I am not seeing where you got the 4296. I thought that the annual net was 9168. Thanks
    Ali
    Replied over 6 years ago
    Hi Jacquelyn! No, you didn’t miss it, I just didn’t expand on that as well as I should have. I’ve had a lot of questions on it. So for the cash-on-cash return, you want to use your annual net income, but unlike the cap rate you do want to include financing costs here. So the $4296 is the monthly income, after all expenses including mortgage, times 12. The cap rate number didn’t have that mortgage payment taken out of it. Hope that helps!
    Ali
    Replied over 6 years ago
    Hi Jacquelyn! No, you didn’t miss it, I just didn’t expand on that as well as I should have. I’ve had a lot of questions on it. So for the cash-on-cash return, you want to use your annual net income, but unlike the cap rate you do want to include financing costs here. So the $4296 is the monthly income, after all expenses including mortgage, times 12. The cap rate number didn’t have that mortgage payment taken out of it. Hope that helps!
    Junior
    Replied over 6 years ago
    Hey Ali, Great post by the way! Especially amazing for someone like me who is looking to get into the basics of renting turnkey properties. One question, why when you calculate your cap rate do you exclude the mortgage payment from your net per year?
    Ali Boone
    Replied over 6 years ago
    Hey Junior, love your name 🙂 Good question. The cost of money is never calculated into a cap rate. If you are financing, you always want to go the extra step and calculate that cash-on-cash return because that will account for the mortgage or financing cost. Cap rates are a measure of a property price versus the income it brings in. That doesn’t include financing. As I like to put it, financing costs are your own problem, not the sellers’. And by problem of course I mean gift from heaven 🙂
    Chris K.
    Replied over 6 years ago
    Ali, How would i calculate cash on cash return for a property i’m now renting that was my primary residence for approximately 8 of the last 11 years? Assumptions: Total purchase price: $269K in 2002 Total improvements: $31K Current monthly costs: *$1,187 Mortage (30yr @ 4.625%) *$342 Taxes *$85 Insurance *$100 Vacancy (this is conservative since we’ve had, and still, have a great tenant since Day 1) *$100 Repairs and maintenances (again, very conservative, knock on wood) Current monthy rent: *$2,100 (this is low – comparative rents are $2,350-2,500) It seems my cap rate is especially low. Part of my short-term strategy to hold the house while we moved to Woodland Hills, CA was to let the property re-appreciate, and that seems to have occurred. Worth about $375-425K when we moved almost 3 years ago, the property is worth about $600K right now. My long term plan, however, was to hold the house as income property, pay it off, and have it in our retirement as an income-producing asset. That is still feasible, but i suspect i need to reduce current expenses, increase revenue, or both, to make it a good play for my money (return wise). But we’re also very seriously considering selling right now to take advantage of the IRS code that allows me and my spouse, filing jointly, a cap gain exemption of up to $500K for living in the house 2 of the last 5 years. I would clear about $300K tax free in this scenario….money that could perhaps be reinvested in income property with better returns? Your or anyone else’s thoughts here would be greatly appreciated. PS – i have really benefited from this napkin posting and all the comments and replies, so thank you…
    Ali
    Replied over 6 years ago
    Thanks Chris K.! Glad the article has helped. Your cash-on-cash return would just be calculated using your net income and how much cash you have actually put into the house (not how much the total purchase price was, how much you owe, or how much it’s worth). You can’t really calculate a cap rate on this, I mean you can, but there is no point. Cap rate is only related to buying or selling a property. If you have that nice of equity and profit potential, I’m in favor of the idea of selling that house and using that profit to buy properties with higher returns. Multiple properties, higher returns, more tax benefits, etc. Just my 0.02 tho!
    Chris K.
    Replied over 6 years ago
    Thanks Ali. I only owe $215K on the note now. So, if it was you, you would take the one-time tax savings huh, and not try to pay down the note aggressively? (goes against your strategy of using leverage to create positive cash-flow, i know) Is there a point, in your opinion, in calculating cash on cash return then? i mean, how much money i put in the house would be difficult to calculate (beyond the improvements i know about, it would be 8 years of mortgage payments (P&I) and taxes and insurance….and that can’t be good for any cash on cash return calculations).
    Ali
    Replied over 6 years ago
    It would only be relevant if you want to keep it as an investment. But it would still only give you a heads up about the return you are getting on your money, it wouldn’t change any of the numbers. But yes, you’re correct, I’m a HUGE fan of leveraging and never paying anything off. 🙂
    Michael Spindler
    Replied over 6 years ago
    Hi Ali, Thank you so much for this. Normally formulas boggle my brain and I just shut down. But your intro made it so easy, I actually started looking at and understanding the more advanced stuff, ROI, NOI, etc… This goes along way to answering my own questions rather than asking for group consensus on a deal. I am a firm believer in paying myself first and then use the net profits to reinvest. Does anyone else include themselves in the equation. Ex: Instead of paying a PM, reassign the 10% to self pay? Or even in addition too? Thanks again! Sincerely, Michael
    Ali
    Replied over 6 years ago
    Hey Michael! You can definitely tweak the numbers any way you want. The net cash after everything on the napkin is the money that would go in your pocket, but if you want to split that up further somehow, you totally can. Glad you like it! Thanks for the response.
    Sarah L
    Replied about 6 years ago
    Hi Ali, Thanks so much for posting! This article is so helpful! I’m just starting out and this article made all the real estate finance not so intimidating. I assume this would just be a good starting point to decide if it’s worth looking into a property more – are there additional formulas I should be looking at?
    Ali
    Replied about 6 years ago
    Hey Sarah. Not that I can think of to start!
    Lisbeth Madrigal
    Replied about 6 years ago
    Ali, Great article! I have not yet bought my first investment property but am one day closer. Using this time to continue educating myself to be a well informed RE investor and minimize my error and maximize my potential cashflow via reading some of these post. I have found some property evaluators on different sites etc., but I would like to see numbers on extra principle payments, so if I apply cashflow towards principle payments. Also calculating percentage of tax on that earned income deducted monthly. I am working on setting these formulas on an excel spreadsheet, etc. Not a math nerd, but like to know how things work.
    Ali
    Replied about 6 years ago
    Hi Lisbeth, good for you for getting all set up so you can evaluate properties quickly. One thought for you is to maybe not worry too much about the tax because if normally your expenses, once written out as write-offs, should balance out the taxes you would owe on the income. So any house expenses, depreciation, travel expenses, etc. are usually enough to make it a situation where you won’t owe any taxes. It’s one of the mega benefits of rental properties. Look into it though.
    Joe Butcher
    Replied about 6 years ago
    Hi Ali, I know this is an old post, but I have a question, and I’m sure it is something I am overlooking, as I am not much for math, but under the Cap Rate equation, you have your Annual Net as $9168, and under the Cash On Cash equation you have the Annual Net as $4296, but since the cap rate doesn’t include the mortgage shouldn’t the Annual Net be LESS?? How did you arrive at $9168? I know this is something I am overlooking I am sure, so apologies in advance. Thanks Joe
    Lisbeth Madrigal
    Replied about 6 years ago
    Morning Joe: Here you go: Josh g January 20, 2013 at 7:53 am The $9168 is the monthly net (cash flow-$358) plus the mortgage payment added (406) then multiplied by 12 months REPLY Ali January 21, 2013 at 2:23 pm Thanks, Josh! You nailed it. Sorry, A.King, I should have clarified that better. I kind of snuck that one in there. REPLY
    Joe Butcher
    Replied about 6 years ago
    Thank you Lisbeth…..so just to clarify we are INCLUDING the mortgage in our Cap Rate equation, but NOT our COC, correct? Thanks Joe Butcher
    Giovanni Isaksen
    Replied about 6 years ago
    Joe the standard cap rate is calculated before any debt service, as though you bought the property for all cash. To get the cap rate you divide the NOI (Net Operating Income which is rents less vacancy plus other income minus expenses) by the purchase price. To calculate the cash on cash return you subtract the debt service from the NOI to get your pre-tax cash flow and divide that by your total cash invested. The cap rate is a better measure of the property’s performance while the cash on cash return is a measure of your investment results. For illustrations of NOI, Cap Rate and Cash-on-Cash Return click on my name above and go to the Investment Property Analysis page on our website. I highly recommend reading Frank Gallinelli’s “What Every Real Estate Investor Needs to Know About Cash Flow… And 36 Other Key Financial Measures “. This is the investor’s bible on analyzing real estate deals and if you know how and when to use the formulas Frank lays out you will know as much as or more than most RE brokers. That’s key because the difference between a sales ‘proforma’ and reality is the difference between success and failure in real estate.
    Genna
    Replied about 6 years ago
    Ali, Can you use COC formula for more than the first year of a property? Does it work to use all the money invested up front in down payment, then use the net income of the property to figure out what your COC returns are at any point during the investment?
    Giovanni Isaksen
    Replied about 6 years ago
    Gemma I would add to Ali’s reply that while you can look at COC returns every year over time or over a span of years there are better ways to measure your returns. $100 of cash flow today is worth $100 but $100 of cash flow seven or ten years from now will not be worth as much because of the time value of money. When looking at property returns over multi-year spans or the life of the investment measures such as IRR (Internal Rate of Return) or MIRR (Modified Internal Rate of Return) work better and are favored by those who work with property investments for a living… or whose living depends on those investments.
    Ali Boone
    Replied about 6 years ago
    You definitely can Genna. And it’s good to. Like if you buy a property and originally calculate 7% for vacancies and and it is actually 15% once you get into it, you can recalculate and see your actual returns. Now, whether you can do anything about it then or not is another story. Until you go to sell, what the returns are really don’t impact anything, other than potentially triggering you to want to sell. But yes, you can always adjust. Especially for repairs…they will only become more and more as you go on.
    Mike Glass
    Replied almost 6 years ago
    Ali help here, Hoping to pull the trigger on a deal in the coming days, but I want some feedback if possible. At first when I was doing my numbers I was certain it was a good deal but lately seems like my numbers are getting clouded by too many opinions. Based on your plan can you tell me what you think. Turnkey property (section 8 housing) that I will get once a 1 year lease is signed Sale price 35,000 Cash at closing $11845 Monthly income $725 Tax $100 Insurance guessing $50 Prop management $80 Mortgage $100 Vacancy $50. ( I know a little lower than %10) Repairs %30 Napkin test please?
    Ali Boone
    Replied almost 6 years ago
    Hey Mike! Sure, I can try to help. I didn’t go through actual calculations on these just because I can tell the numbers work out fine just by looking at it. You’re basically at the 2% rule already (only using that as a guideline, never a rule) which pretty much means the numbers will work out. When you say “opinions”, are those from other people or your own? I think in this case, you should definitely weigh any “opinions” you hear. Remember, while numbers are the most important thing, they aren’t the only important thing. With this property being turnkey and that cheap… I have hesitations about it without even seeing it. Also, do you know for sure you can get a mortgage on it? I don’t know any lenders who will lend that low.
    Mike Glass
    Replied almost 6 years ago
    Opinions meaning lots of crazy optimistic opinions and lots of negative ones, they all seem to take their own experiences and print them as the gospel of real estate investing. Yes, I was able to qualify through Huntington bank for this loan. I do have cash if needed but I really would like to use the banks money. Yes the houses are section 8 and location is not great but with it being section 8 I’m banking on the success of a close family friend who manages @200 of these as well as owns many as well. I know the appreciation probably won’t be great but I’m really in it for the passive income and tax breaks. Am I thinking about this the wrong way? It’s a 3br, 1.5 bath, no basement. This was appealing as I hope repairs are kept to a minimum. Again I’m very to new to this and want my deal to be good. I have several others just like this lined up to look at so this is the target market I seem to be headed toward. Thanks for the quick reply
    Ali Boone
    Replied almost 6 years ago
    Hey Mike, sounds like you are on a smart path with it! I’m usually pretty big at knocking cheap property investing but it sounds like you have the right team in place and it could work for you. I’d go for it!
    Donald M
    Replied almost 6 years ago
    Not sure if anyone brought this up, but how do you account for personal federal and state income taxes? Why doesn’t the cash on cash return factor this in, if you’re going to have to pay 20%-35% on your income? Do people not factor this in with respect to real estate investments? Thanks.
    Ali Boone
    Replied almost 6 years ago
    Hey Donald, no it’s not factored into rental properties because if done right, for the most part rental income ends-up being ‘tax-free’ income, essentially. All of the write-offs, and the big one being depreciation, ends up usually equaling pretty close to what taxes would run, so it balances out to be tax-free income. That is not however true for active income investments, such as flipping.
    Eric
    Replied almost 6 years ago
    Forget about all the numbers and ROI. If you have had two back-to-back evictions, you need to get some education in tenant screening. You obviously do not know how to screen tenants. As an experienced landlord, with 25 current renters, you need to look at credit score and know what it means. It means more than a criminal record ever could. Income tells me the renter’s ability to pay, credit score tells me the renters desire to pay. With the national average renter credit score at ~658, anything below that and you are taking in a BELOW average renter. Stay above 620 and you will have fewer issues. If you take in a renter paying more than 30% of their gross income in rent, and a sub-600 credit score, you are a fool.
    Ali
    Replied almost 6 years ago
    Thanks, Eric. I don’t landlord properties myself though and I wasn’t the one who put those tenants in. The property managers I had working the property were absolutely horrible, unbeknownst to me in the beginning, and they’ve since been fired and I have a great manager (who knows what he is doing) taking care of the property. Tenants will make or break an investment property all day long. Bad tenants = cost a fortune. It’s up to the landlord/manager to find the good people.
    Matt Henderson
    Replied over 5 years ago
    Hello, I have a rental property that I’ve owned since 2007, and recently sat down and attempted to analyze the investment, to determine whether I should continue with it, or sell it and deploy the proceeds into other investment vehicles. The property equity, right now, is what I consider is the capital that could otherwise be invested in an alternative investment, and that brings me to the first point: Shouldn’t current value be used in the above calculations, as opposed to purchase price? (Or at least, should it be used in my context?) Second, the mortgage payment is comprised of two components: Interest and principle. The interest is an expense, but the principle payment increases my equity in the property. So my second question is whether that increase in equity over the year (due to the principle portion of the mortgage payments) should be taken into account in an analysis? Thanks so much.
    Ali Boone
    Replied over 5 years ago
    Hi Matt, thanks for reaching out. For your first question, no the value on a house doesn’t even matter if you aren’t going to sell it (or buy it), and it doesn’t matter unless it’s what you sell or buy for. The only price that matters is the one you will actually buy it or sell it for, regardless of the true value. For the second one, regardless of what is what in the mortgage payment and the equity you are building, that set amount is still an ‘expense’ for the month. It doesn’t matter what it’s doing to the value of your investment, it affects your monthly cash flow the same way regardless. Hope that helps. Reply Report comment
    Ali Boone
    Replied over 5 years ago
    Hi Matt, thanks for reaching out. For your first question, no the value on a house doesn’t even matter if you aren’t going to sell it (or buy it), and it doesn’t matter unless it’s what you sell or buy for. The only price that matters is the one you will actually buy it or sell it for, regardless of the true value. For the second one, regardless of what is what in the mortgage payment and the equity you are building, that set amount is still an ‘expense’ for the month. It doesn’t matter what it’s doing to the value of your investment, it affects your monthly cash flow the same way regardless. Hope that helps.
    Paul
    Replied over 5 years ago
    Matt, If your question is whether it would make sense to sell the property and deploy the proceeds elsewhere, then absolutely the relevant number is the current market value of the property, not the capital cost. So I disagree with Ali on this point. It doesn’t matter if the cap rate looks great because your initial investment was low; if you are sitting on a meaningful capital gain, it might make sense to sell. In fact, since the average yearly return for the S&P has been about 8% historically, you can’t easily justify keeping a property that generates any less. (The fact that it’s so easy to make money in the stock market is precisely why I haven’t gotten involved with all the hassles of real estate–at least not yet.) Now on to the second question: that’s exactly why the cap rate doesn’t take financing into consideration. You’re making a return, and the cap rate simply tells you that return; whether you decide to plow part of it into a mortgage payment is your business and isn’t related to the performance of the investment itself. But by the same token the cap rate doesn’t reflect your degree of leverage, so for that they’ve devised cash-on-cash. If your strategy is to focus on paying down your debt rather than logging a large monthly cash flow, then you could have a zero cash-on-cash and still be increasing your net worth by building equity in the property. Just not a strategy that most real estate investors favor.
    kris
    Replied over 5 years ago
    What if you assume the existing mortgage on a property? What number do you use for the Cash-On-Cash to divide by?
    Ali Boone
    Replied over 5 years ago
    Hey Kris. Whatever money you put into the deal should be in the denominator.
    MAY LE
    Replied over 5 years ago
    Hi Ali, Thank you so much for great information. So, base on your calculation, I set the cap rate as 7% as my goal, and calculate backward to find the ideal purchase price range. However, I have been looking for houses for 6 months, and as far as I know, there’s no house that under $200,000 can rent out for $1300. Only condo or townhome can have that price, however their HOA is usually high ($250/month). So, I’m not saying that the numbers you give are not realistic, but I just wonder how you find such a good deal house that is low price, no HOA, and high rent. Maybe I have been searching for houses in the wrong way. Please advise.
    MAY LE
    Replied over 5 years ago
    Hi Ali, Thank you so much for great information. So, base on your calculation, I set the cap rate as 7% as my goal, and calculate backward to find the ideal purchase price range. However, I have been looking for houses for 6 months, and as far as I know, there’s no house that under $200,000 can rent out for $1300. Only condo or townhome can have that price, however their HOA is usually high ($250/month). So, I’m not saying that the numbers you give are not realistic, but I just wonder how you find such a good deal house that is low price, no HOA, and high rent. Maybe I have been searching for houses in the wrong way. Please advise.
    MAY LE
    Replied over 5 years ago
    Hi Ali, Thank you so much for great information. So, base on your calculation, I set the cap rate as 7% as my goal, and calculate backward to find the ideal purchase price range. However, I have been looking for houses for 6 months, and as far as I know, there’s no house that under $200,000 can rent out for $1300. Only condo or townhome can have that price, however their HOA is usually high ($250/month). So, I’m not saying that the numbers you give are not realistic, but I just wonder how you find such a good deal house that is low price, no HOA, and high rent. Maybe I have been searching for houses in the wrong way. Please advise.
    Ali Boone
    Replied over 5 years ago
    Hi May, thanks for writing. Chances are the issue is the market you are looking in. There are a lot of markets that have plenty of houses for say $150k and rent for $1300. Let me know what market you are looking for those in currently.
    Griff
    Replied over 5 years ago
    Ali, One quick question. In your napkin figuring when looking at potential investments, do you typically use a percentage of the purchase price to estimate closing costs? It appears in your example for “Cash to Close” you had 20% down and then tacked on an additional $5K for closing costs (roughly 5% of $94,500). Much appreciated post and thank you.
    Ali Boone
    Replied over 5 years ago
    No Griff I don’t usually go off of a set % of the purchase price. I used that $5k ballpark just based on what I had seen at the time, but I would definitely recommend clarifying with your lender how much exactly in closing costs you will be looking at. You could even get a ballpark to start and then confirm exact numbers later with him if that’s easier. It’s hard to say an exact % because lenders will vary in their fees. Not drastically, but I would always just ask them for what number to use.
    Jessica G
    Replied over 5 years ago
    Let me start this with a caveat, I’m not a huge fan of math…but I know I have to understand it, especially in the world of investing. With that being said, I’m still stuck on the napkin calculations. From reading the article, I was thinking the equation for the cap rate would be $4296 ($358×12) / $94,500 = 4.5% and the cash on cash equation would be $9168 ($358+406×12) / $23,900 = 38.35% but the numbers on the napkin were different. Clearly, I missed something. Could you point me in the right direction and tell me where I messed up?
    Jessica G
    Replied over 5 years ago
    Let me start this with a caveat, I’m not a huge fan of math…but I know I have to understand it, especially in the world of investing. With that being said, I’m still stuck on the napkin calculations. From reading the article, I was thinking the equation for the cap rate would be $4296 ($358×12) / $94,500 = 4.5% and the cash on cash equation would be $9168 ($358+406×12) / $23,900 = 38.35% but the numbers on the napkin were different. Clearly, I missed something. Could you point me in the right direction and tell me where I messed up?
    Ali Boone
    Replied over 5 years ago
    Hey Jessica, great question! I realize I didn’t clarify well on those equations. You have it almost exactly right, but switch which equation you involve the mortgage payment in. The cap rate is not calculated with a mortgage payment, so it’s that one where you would do the ((358+406)*12)/94,500. You are just subtracting out the mortgage from the expenses, as you did for the cash-on-cash. The cash-on-cash needs to include that mortgage payment as an expense so that one stays $358, so (358*12)/23,900. Does that make sense?
    Carrie
    Replied over 5 years ago
    Thanks for the unique strategy of using a napkin! I really enjoyed the way you broke down each step for an easier understanding. If you’re looking more into RV’s and Cash Flow equations, check out one of our podcasts at hartmanmedia.com!
    Ali
    Replied over 5 years ago
    Thanks Carrie!
    Matt Svajda
    Replied over 5 years ago
    Ali, Are you still seeing this figures in today’s market? I’m in SoCal and have been looking at rentals in the desert area, but the numbers have been shifting. Where else are you seeing this napkin return? M
    Ali Boone
    Replied over 5 years ago
    I’ve definitely never seen those numbers anywhere in SoCal, Matt. At the time I did the article, that was an Atlanta property but it’s doubtful you’d see those there now. It depends a lot of what kind of property you are looking for. Distressed properties and lower-priced properties will yield those numbers a lot easier. So it really depends. You can see those numbers in Philly for sure, mayybe Houston but probably not quite there and the CoC wouldn’t be there. Chicago.
    Matt Svajda
    Replied over 5 years ago
    Ali, Are you still seeing this figures in today’s market? I’m in SoCal and have been looking at rentals in the desert area, but the numbers have been shifting. Where else are you seeing this napkin return? M
    Ken
    Replied about 5 years ago
    Ali, So I am currently still trying to get the hang of the evaluating process. So my question is why didn’t you include water, sewage, trash,etc… In the expenses? Wouldn’t that then give you your true cash flow? Or is this just a screening process and you use a much more in-depth analysis later on?
    Ali Boone
    Replied about 5 years ago
    Good question Ken. No, the only time I would include the utilities as expenses is if I would be the one paying them (i.e. the owner). Typically tenants pay for all of those themselves, so it would not be an expense to me. More with multi-families or condos or apartments you might see owner-paid utilities. If I am looking at a property, I will ask if I would be responsible for those as the owner and if the answer is yes, I will include them in my calculations.Same with HOA. A lot of properties don’t have an HOA fee, but if one does, I will include that as an expense. Ultimately, if you are analyzing a property, you should be fully aware of all the running expenses that you will be responsible for. And then, be sure you include all of those in your calculations to make them more accurate. Whatever the expenses may be, include them. But typically the owner is responsible for utilities.
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    Why isn’t the the electricty and water added in under the expense? I know the tenant will pay it but does this fall under the vacancy?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Ayodeji, that’s a good thought. It could be included, for sure. I really hadn’t thought of it. Usually those expenses are very minor, if much at all. Depends on the location and time of year. Although those expenses could just be included in the estimate % for vacancy.
    Paul
    Replied over 4 years ago
    Electricity and water shouldn’t amount to much if the unit is vacant.
    Paul
    Replied over 4 years ago
    Electricity and water shouldn’t amount to much if the unit is vacant.
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    Thank you for replying Ali. After reading your blogs, it became painfully clear (due to lack of knowledge and awareness of proper real estate investing) I bought a property that is bringing a very low cash-on-cash return. I plan to move out of one of the units to buy a single family house. I plan to rent the top unit (I have a prospect tenant who agreed to $915 rent.) This is the breakdown: Property: $154K (2 units) Duplex Unit 1 $900/month, Unit 2 $915/month Total: $1,815 EXPENSES Property tax is $4,630 divide by 12 = 385 I round up to $400/month Insurance $68/month Vacancy (10%) $182 Repairs (10%) $182 PM $182 No Mortgage INCOME – EXPENSE ($1,815 – $1,065) $801Cash Flow CAP RATE = Annual Net/Purchase ($1,001/$154K) = 0.65% CASH-ON-CASH $801/$154K = 0.52%
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Good news Ayodeji, you have an error in your numbers that actually results in your favor. You used the monthly net income instead of the annual income. So instead of $801, you want to use $801*12=9612. So then put that in the equation and you get 9612/154000=0.0624, so a 6.2% cap rate. That’s not bad at all! And if you don’t have a mortgage, your cash-on-cash is the same- 6.2%. Not a bad investment!
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    Oh wow you’re right I missed that. Thanks for the correction. Isn’t a cap rate or cash-on-cash of 8% or higher better though?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Ayodeji, it depends on the situation. If it’s the same property and you are comparing 6% to 8%, then yes. But if to get 8% you have to take on a riskier property, then not necessarily because realistically you may never actually get 8%. It’s all a trade-off on risk vs. return. The riskier the investment, the less likely you are to actually collect the projected returns. And if the 6% is way less risky, what’s 2 percentage points in the long-run? Not a lot.
    Paul
    Replied over 4 years ago
    My concern about a cap rate in the ballpark of 6%, especially for someone purchasing without a mortgage, is that there are several solid real estate investment trusts offering a comparable dividend–and they come with zero landlord’s headaches and unparalleled liquidity. No worrying about whether you’ll be able to unload your property, and of course no realtor’s fees! Even staid old AT&T was flirting with a 6% dividend during the market’s swoon in October. It has retreated somewhat since then (the yield is about 5.6% as of this writing), but the point is that with any capital appreciation at all, it will outperform a real-estate investment that has a cap rate of just 6%. And all you do is sit back and watch the dividends roll in quarterly. In order to compete with the stock market, a real-estate investment needs a cap rate of at least 8-10%. Otherwise the return scarcely justifies all the time and effort that you’re going to have to put into managing your property.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Good points Paul, but remember, that cap rate is only referring to just the cash flow off of a property. That’s not the only money you make with a rental property. You have the tax benefits (which turn out to be substantial each year in most cases), you have appreciation, and you have equity build (whether appreciation happens or not). All of those pan out to be a significant amount of money, on top of just the 6% you make in cash flow. That is a trade-off with the security/safety of a trust….that income is guaranteed and no tenant issues or offloading complications, but you also miss out on major financial benefits that you get if you own the real property.
    Paul
    Replied over 4 years ago
    Ali, I can see your points for someone purchasing with a mortgage, but Ayodeji said he didn’t have a mortgage, so the tax benefits are going to be negligible and he’s not building equity. Besides, if he did have a mortgage, he would not be building equity AND collecting 6% a year. It’s one or the other. Paul
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    1) To add to the Expense: Lawn Care/ Snow Removal. For me, lawn care is $60/month which brings my cap rate down to 5%. Question. 2) As a Landlord in my current duplex, do I have to pay for water? Even after I completely rent out my units? Currently I pay for water.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    I’m not sure Ayodeji… I’ve never landlorded or rented out anywhere I’ve lived, so not sure the logistics on that one. I would assume so for an MFR because it’s one bill.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Paul, he is still getting major tax benefits. Depreciation is one of the biggest tax factors involved with rental properties. Mortgage interest is a big one, but that one isn’t near as good as depreciation because you still have to pay out in order to get the interest write-off (i.e. pay the mortgage interest in the first place and then write it off…you don’t get it all back, only a portion). Rental property income can usually be made to be tax-free income because of the write-offs…with or without the mortgage interest, depending on the numbers and such, mostly because of depreciation. Rental properties are the only income-producing asset where you get both depreciation and appreciation at the same time, and can collect money on both of those. And you are still building equity back whether you have a mortgage or not because you are paying down what went into the property. You can then use that equity again later.
    Paul
    Replied over 4 years ago
    Ali, That’s a good point about depreciation. Dividends offer a tax advantage too, namely that they’re taxed at a much lower rate than ordinary income (though REIT dividends are typically taxed at an effective rate somewhere between that of qualified dividends and ordinary income). One other point about REITs: they allow an investor to get involved in real estate while committing much less capital. You can open a position for virtually any amount (and keep contributing to it, if you wish, at your own pace)–instead of the $50,000-100,000 minimum investment that you’d usually need for a rental unit. Thanks for this very thought-provoking blog! Paul
    Paul
    Replied over 4 years ago
    Ali, That’s a good point about depreciation. Dividends offer a tax advantage too, namely that they’re taxed at a much lower rate than ordinary income (though REIT dividends are typically taxed at an effective rate somewhere between that of qualified dividends and ordinary income). One other point about REITs: they allow an investor to get involved in real estate while committing much less capital. You can open a position for virtually any amount (and keep contributing to it, if you wish, at your own pace)–instead of the $50,000-100,000 minimum investment that you’d usually need for a rental unit. Thanks for this very thought-provoking blog! Paul
    Ayodeji Kuponiyi Investor from King of Prussia, Pennsylvania
    Replied over 4 years ago
    Is the mortgage included in the cap rate? For instance, when I’m calculating my expenses with the mortgage included and I subtract the expense from the rental income, I’m left with the cash flow. Do I mutiply the cash flow by 12 OR do I add the cash flow plus mortgage and then multiple by 12 to get the Cap Rate? Monthly Rent $1860 Expenses: Prop Tax $400, Insurance $85, Vacancy(10%) $186, Repairs(10%) $186, Mortgage $575, PM(11%) $260 Total: $1,632 Cash flow: $1860-$1057= $228 Cap Rate 8.03% Is this correct?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    No mortgages in Cap Rate, Ayodeji.
    Neil Schoepp Real Estate Investor from Milford, PA
    Replied over 4 years ago
    Ali, Thanks for taking the time to put this together. It makes perfect sense to me. I am new to the numbers and this is EXACTLY what I needed to read. Your the best.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Thanks, Neil! I don’t think I’m the “best”, but I’ll take it 🙂
    Paul
    Replied over 4 years ago
    Ali, it’s a very helpful page and you deserve the credit!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Well in that case Paul, I’ll take it 🙂
    Brad McCulloch Rental Property Investor from Askov, MN
    Replied over 4 years ago
    Just came across this blog and very helpful to those like myself who aren’t too good at arithmetic or ciphering….:) Thanks Ali.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Haha. You’re welcome, Brad!
    Scott
    Replied over 4 years ago
    I bought my first 4 plex today for $115. All rented at $525 a month. My realtor is newer and told me that the 17% was outstanding. Thanks for the explanation.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    You bet, Scott! And congrats on the property!
    Jeffrey Goers Investor from Vienna, Virginia
    Replied over 4 years ago
    Fantastic post, thanks so much. I was doing everything except including the costs of repairs and vacancies. I also am buying fully rehabbed turnkey properties, so I will use the 5% value for repairs. jeff
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    Awesome Jeff! Just make sure to have an inspection done on the property to confirm it really is in good freshly rehabbed (and quality) condition so the 5% won’t be too far off (check roofs, water heaters, AC, etc.)
    Robert P. from New Bedford, Massachusetts
    Replied over 4 years ago
    This has helped me with my first property and good news is that all I am seeing are positive numbers!!! Thank you for the great step by step direction!!!!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 4 years ago
    You’re welcome Robert, and glad to hear you have positive numbers! 🙂
    Thomas Hubbard Rental Property Investor from Little Elm, TX-Texas
    Replied over 4 years ago
    2 1/2 years later and people are still benefitting from this post. Great job Ali. I just signed up on BiggerPockets so pardon me not having a picture yet. Anyway I refinanced a house I’d been living at for 7 years and now have it rented out so I’m struggling a bit on the cash on cash calculation. When I did the refi my closing costs were $1867. My annual net on the property will be 4500. 4500/1867 is giving me a wacky value of 241% cash on cash return. I must be doing something wrong. Do I need to go back in time and figure out my initial closing costs (7 years ago) and factor them into this calculation? @Ali Boone
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied about 4 years ago
    Hey Thomas! Sorry for the super-late reply. For some reason I’m not getting notifications of new comments lately. Well that CoC would be right for those numbers, but I think it’s more complicated since you lived in the house for awhile. So one question would be whether just doing a straight CoC calculation would be accurate or not…leaving out the expenses that you incurred while you lived there? (I’m actually not sure). The other would be…is $1867 all you paid at closing? No down payment?
    Ben Staples Investor from Malden, MA
    Replied over 4 years ago
    Thanks for this. Very helpful!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Thanks Ben, and you are very welcome!
    Sasha
    Replied about 4 years ago
    This is a great post and great dialogues with so many people sharing their situations/numbers. I understand how cap rate and cash on cash are helpful factors in determining the investment roi on rental properties. But I wonder why you are not including the income tax one pays on annual rental income ? If you are getting 1325/month, assuming you pay 25% income tax, that is $331/month on tax that you pay out which brings your expenses to $994/month. At the same time, you can also include the income from tax deductions from your (interest, property tax, hoa and insurance that you spend as a landlord). In your case, you will get some money refund. But it will still be lesser than the income tax you pay. Any reasons why this wasn’t included in your calculations ?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hi Sasha! Great question (and sorry for a super-late reply….I wasn’t getting comment notifications for months!) I didn’t include it, because in fact, rental property income should become tax free after all the write-offs. The big write-off being depreciation. That is the one that typically soars the write-offs higher than the tax amount. It’s one of the biggest financial benefits of rental properties, and them being classified as passive, is essentially (usually, and if done correctly), the income becomes tax-free.
    Scott
    Replied about 4 years ago
    I’m curious in the same thing Sasha mentioned. Would love to see calculations that included income tax at the end of the year. It looks to me like it will wipe out any positive cash flow and then some come tax day. Is this not the case?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hi Scott! Just replied to Sasha and answered that. Sorry for the delay!
    David Supple Design Builder from Boston, Massachusetts
    Replied about 4 years ago
    On HOA. I got this is home owners association but doesnt this just apply to a condo building? If I was purchasing a mult-family and renting out the individual units I would not have an HOA right?
    David Supple Design Builder from Boston, Massachusetts
    Replied about 4 years ago
    Ali, in the napkin example you give I am not tracking with how you came up with $9,168 as the Annual Net for estimating the Cap Rate. I get this is supposed to be the Net with the mortgage payments subtracted but the math does not come out to $9,168 when I do this. Could you please give me the formula on how you come to $9,168? Thanks!
    Erika Carter Residential Real Estate Broker from Chicago, IL
    Replied about 4 years ago
    Awesome article! Thanks for sharing!!!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hi David. It completely depends on the properties. Some properties in certain subdivisions will have an HOA as part of being in that subdivision. Same thing with MFRs…only really depends on the complex they are in…not necessarily up to the buyer/owner. If that makes sense? So if you were to buy a property, it would already have or not have an HOA with it.
    Dominique Javon Hill from Fort Wayne, Indiana
    Replied almost 4 years ago
    I am such a number cruncher! I really appreciate this article. I am currently working on my first investment(owner-occupant) and I have a question. After running the numbers, what advantage will I have by using my VA loan with no money down? Does this change the cap rate or cash-on-cash return I should look for?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hi Dominique, great question. Yes, it will affect the numbers, but only the cash-on-cash. You put the amount of money that you put into it in the denominator of the equation. So if you literally put $0 into the property, well that’s just infinite returns. But if there is some % of down payment, put that in, and always include closing costs as well.
    Arn Cenedella Real Estate Broker from Greenville, SC
    Replied almost 4 years ago
    Ali Good summary of rental property calculations. I believe an important distinction I would make is: Net operating income is not a function of the loan payments. Cash flow is but net operating income is not. The NOI and cap rate of any property is the same no matter how an investor finances purchase. You did not out loan payments in your cap rate calculation. I believe it is “cleaner” to calculate net operating income as gross rent income less OPERTING expenses (not loan) to get net operating income. NOI less loan payments is cash flow. NOI/Price is Cap rate. This may be a matter of semantics but I see many investors get tripped up and confused on how to handle loan payments. Keeping the loan out of NOI call keeps things clearer IMHO. Minor point. Just a clarification. Arn
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Good input Arn. The loan payment is definitely left out of my cap rate calculation, as it follows your explanation of why it shouldn’t be included in that kind of number. I didn’t specify a definition of NOI specifically, I only discussed cap rates and cash-on-cash returns. “NOI” vs “cash flow” vs “cap rate”, etc. would certainly need to be defined further for full clarification.
    Cameron Bagherpour Contractor from Cary, North Carolina
    Replied almost 4 years ago
    Great article!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Thanks Cameron!
    Perry Z. Investor from Seattle, WA
    Replied almost 4 years ago
    Those numbers are too good $1350 monthly rent on a <100k purchase? Wow! What is the cap rate of the typical rental property in West coast? I feel like they are definitely less than 6%..
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hi Perry! Well, to be clear, those numbers were real for a property I bought in late 2012. Those numbers don’t exist today by any stretch. It was a nicer time back then…. West coast? Certainly under 6%, maybe with some exceptions in neighborhoods I don’t know about, but worse than that….I usually assume I won’t find anything positive at all on the west coast. Anything with positive cash flow is very hard to find on the west coast now. Phoenix used to have great stuff, and Vegas held it’s own in the returns dept (although I hated the market), but those are pretty much gone now too.
    MJ
    Replied almost 4 years ago
    Great article, Ali! I’ve done some numbers, but mine are not quite as good as yours. Can I ask why you don’t factor in things like pest control, termite control and lawn service?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 4 years ago
    Hey MJ! Thanks! I didn’t factor those in because typically, and it may vary between markets, tenants take care of those expenses. It’s unlikely you’ll find that good of numbers in general though these days….this property was from a couple years ago when the RE economy was in a completely different place and the deals were insane. Now, there is still good stuff out there, but it’d be hard to hit these kinds of numbers.
    Ginger Black Homeowner from Cedar Rapids, Iowa
    Replied over 3 years ago
    Enjoyed the article and I absolutely agree it is necessary to go through the activity of running the numbers. You want the deal to work so it is easy to be underestimate the real costs:) I have been there.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    I totally agree Ginger 🙂
    Abdulaziz Albahrani from Wilkes Barre, Pennsylvania
    Replied over 3 years ago
    Hi, Nice post for beginners like me in real estate investing. I understood nearly everything about this process, but I have a simple question. How should I put the income tax from rents I get into the equation. It because a little bit complicated with that to me. Could you help in this problem. @ALI
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    Hi Abdulaziz. Thanks for the compliments, and for the income tax, I don’t include it because if you work the taxes right, you shouldn’t have to pay any income tax. The write-offs for expenses + the depreciation write-off usually allow rental property income to essentially be tax-free.
    Abdulaziz Albahrani from Wilkes Barre, Pennsylvania
    Replied over 3 years ago
    Hi, Thank you for your comment, but could you explain a little bit more how rental properties could be tax free. A don’t know much about tax and I’m planning to invest in real estate as an International real estate investor. @ALI BOONE
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    Hi Abdulaziz, well I unfortunately can’t speak necessarily for other countries in terms of how they do taxes so not sure what applies to you and what doesn’t, but here the write-offs–depreciation being the biggest–typically counteract the tax you would normally have to pay. That’s how it oftentimes ends up being tax-free income.
    Gene Cook Residential Real Estate Broker from Penn Valley, California
    Replied over 3 years ago
    Wow! just spent some time reading several years of this blog thread. It obviously has caused people at many different experience levels and locations to add to the discussion. Nice Job! I really appreciate your patience in In answering the same questions over and over (yes depreciation still exists!). As a west coast (northern California) investor I too look back at 2009-2013 as a period of amazing opportunity. Glad that I took advantage of it but wish I had been even more aggressive. A comment on the person who asked about analyzing his property for returns based upon its current value vs what he/she has invested into it. I have had that discussion debate with a number of people. When you own a property that is currently worth significantly more than it was when acquired, I think it is critical to consider whether it is still a good investment. It seems to me the question that should be asked is “would I buy it now for what I can sell it for? “ if the answer is no then you should sell. Assuming you are realistic about transaction costs , can do 1031 exchange, have some better options to invest the money into etc etc… Ali, I am curious as to what advice you have for people that live in areas that the numbers do not work well in? Long distance Investing? I made that attempt unsuccessfully mostly due to my unwillingness to really create the right resources. I too got to experience really bad management. My current solution is to go to more remote areas (but still closer to home a 2-3 hour drive) that have not rebounded in value as much and where returns are still reasonable.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    Hey Gene. I’m in that boat myself– LA is crazy so I have to buy out-of-state. I’ve always gone the turnkey route myself. I’ve certainly had some hiccups, mostly all with PMs (as you suggest), but nothing that I can’t overcome. To me the benefits/pros still outweigh the cons. Even if I had a property locally, I’d probably still use a PM. I just have no interest in dealing with properties myself. So yeah, it’s doable, but it really is all about the team that you have in place.
    Dusty A. from Saint Cloud, Minnesota
    Replied over 3 years ago
    Most of it can be done on a napkin! Great read.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    Thanks Dusty!
    Dennis Meppelink Investor from ERICA (7887), Holland
    Replied over 3 years ago
    Hi Ali, Thanks for sharing your information. When you count the morgage are you just taking the payment of the intrest or also the pay off the loan? Maby you can give a webbinar about this subject? Because I see a lot of people who struggle with the exact numbers. Have a wonderfull day, Dennis Meppelink
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    If only I knew how to do webinars, Dennis 🙂 Lol. Technology has proven not to be my strong suit. But yes, you want to include the interest in the mortgage payment because that is an expense associated with the property.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    If only I knew how to do webinars, Dennis 🙂 Lol. Technology has proven not to be my strong suit. But yes, you want to include the interest in the mortgage payment because that is an expense associated with the property.
    Christopher
    Replied over 3 years ago
    When do you add in the PMI? I don’t see that listed here. Thanks for the help!
    Christopher
    Replied over 3 years ago
    Also, I assume since I won’t have a property manager, I can exclude this-
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 3 years ago
    Yes Christopher, for both the PMI and property manager question…add in any expenses that you will have in addition to the ones listed and delete any that won’t pertain to you.
    Randy Philpot Rental Property Investor from Versailles, KY
    Replied about 3 years ago
    What term of loan do you use to calculate the mortgage payment? 30 years? I would prefer to finance on 20 years if possible, although it would reduce your net cash flow. What is recommended?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied about 3 years ago
    Hi Randy. It completely depends on your goals. If maximizing cash flow is your goal, you’d want to do the longer term loans. If you aren’t as worried about it and you are more in it for the long-term returns, the shorter terms work well. There’s no wrong way to go….just whatever fits your plans best!
    Lisa Widdowson Investor from Arlington, Virginia
    Replied about 3 years ago
    Great article. I’ve seen lots of financial metrics to evaluate purchasing a property but none around when to sell. I understand some investors will say to never sell however I believe you should always evaluate your investments and if they are under performing compared to other options you have then it’s time to sell. Do you know of any metrics for sales?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied about 3 years ago
    Hey Lisa! Well, losing money is definitely one 🙂 Otherwise, it just depends on your goals and what other opportunities are around. If a property is performing great, keep it. But like I buy turnkeys for example and eventually there will be big CapEx items (even despite the fresh rehab to start). So a strategic move for me would be to sell right before all those things start going bad and buy in a newer market with more growth potential. So Id be maximizing profits at all times. But that’s just one strategy. Also depends if a property is paid off or not, if returns are better elsewhere, etc. Lots of ways to do it.
    Chris Low Investor from Redding, California
    Replied about 3 years ago
    Hi Ali – what % return are you looking for on your cash-on-cash return? You gave an expected target for Cap rate, but not for COCR. Any suggestions?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied about 3 years ago
    Hey Chris, good question. Well, it’s kind of hard to answer. For one, this article is a bit older so that Cap Rate target probably isn’t valid anymore (can’t remember what I wrote). Cap Rates were much higher back in the day and now they aren’t, so I’d probably have to lower my expectation. Cash-on-cash is hard because it can vary so much depending on what financing you use. I have run a cash-on-cash lately to see what a good expectation would be. Plus it will vary between things like turnkey properties versus BRRR projects. Do you have any properties in your sights? What are the cash-on-cashes? The one thing I can say for them– make sure they are positive! 🙂
    Raymond
    Replied about 3 years ago
    Hi Ali! Great article, great handwritting 😉 I’m planning on going the same route but I have no idea where, in which cities would you invest now in 2016? Given that your budget is max 200K (so no Cali of course). I would also have to get a mortgage. I know that the interest rate for primary residence and for rental properties is different. If don’t own a single property yet, can I go with the primary residence even if I don’t live on it and rent it? Or do I have to go with the rental property interest rate just because that’s how I’m going to use it? Thank you!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied about 3 years ago
    Haha Raymond…I’ve never had a compliment on my handwriting before (in my whole life!) I think I upped it a little for the napkin… You’ll still need to go with the higher. Unless you get fraudulent about it, which I don’t recommend. It’s not a deal-breaking difference anyways. $200k can get you a ton if you buy in the right places. Right now I’m doing mostly Chicago and Indy, and a little in KC and Philly. Shoot me a message anytime, happy to show you what’s out there.
    Bill Stamp from Oneonta, New York
    Replied almost 3 years ago
    Great posts… Would you say that these same “simple” rental principles apply to vacation style properties (e.g. FL beaches) or would there be other variables to consider?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 3 years ago
    Hi Bill, good question. The same equations certainly apply, you just may need to adjust them slightly to incorporate any differences on vacation rentals. All you need to know though is the total income and the total expenses, compared to how much you put into it. For vacations it may be more just an issue of estimating some of those (like using an average income, or a conservative income per month since your occupancy rates may vary).
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied almost 3 years ago
    Hi Bill, good question. The same equations certainly apply, you just may need to adjust them slightly to incorporate any differences on vacation rentals. All you need to know though is the total income and the total expenses, compared to how much you put into it. For vacations it may be more just an issue of estimating some of those (like using an average income, or a conservative income per month since your occupancy rates may vary).
    Nina Rosen from New York City, New York
    Replied over 2 years ago
    Hi Ali, Thank you for your posts, they are clear and informative, and I appreciate the education. I especially appreciate that you are a woman math/real estate whiz who is imparting her wisdom. Rock on!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    Haha, thanks Nina!
    Mike Lauer from Milwaukee, Wisconsin
    Replied over 2 years ago
    Hi Ali, this post and the discussion following are really great and I feel like I learned a ton. Keeping it simple really works! One thing I’ve been struggling with is the constant reference in RE books/articles to “creative financing.” Granted, some of this comes from books written pre-2009, so I take those with a giant block of salt. But I notice that experienced RE investors (including yourself) still claim it as a major component of building wealth with RE. It obviously makes a huge difference with COC return and many other aspects of the numbers. In the markets I’m searching, putting 25% down (which every lender I’ve spoken with has required) pulls the numbers down to the point that I question why anyone would invest. So, can you point me to some resources to help understand “creative financing?” Thanks.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    Hey Mike, good question. I want to answer with a couple things: 1. If the markets you are looking in don’t leave anything for cash flow after debt service, you may want to look in different markets. Not all markets, and in fact most, don’t cash flow. But there are markets that do. So that’s one issue–knowing where to shop. On average, 80% of properties make horrible rental properties. Most people don’t realize that. You won’t be able to make a bad deal work. 2. Creative financing, that is really part of the game of REI. It’s not always easy and you oftentimes will have to look hard and get creative. I have done some creative financing with my properties. My biggest move was to pull in an investor partner who had the cash I needed. I wrote out details of how I structured that here- https://www.biggerpockets.com/renewsblog/2015/12/03/structuring-partnership-rental-properties/ Hope that helps get you started!
    Mike Lauer from Milwaukee, Wisconsin
    Replied over 2 years ago
    Thanks Ali.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    You’re very welcome Mike!
    Nicholas Zdvorak from Poway, California
    Replied over 2 years ago
    Great article, especially the napkin example. I’d love to see an article like this that talked about acquisition costs instead of holding costs (how exactly you got the cash to close value of $23,900 and all things that should be considered).
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    Hi Nicholas! Well for straight-forward properties it’s just your down payment (typically 20% of the purchase price for SFRs or 25% for MFRs) plus any closing costs. If you are rehabbing properties, then you’d need to account for the rehab expenses. Were you looking for something more detailed?
    Shasha Jhaveri from Irvine, California
    Replied over 2 years ago
    This was an amazing article. I think if you know the %s (say for property tax or homeowners insurance in your area) and numbers for the main multipliers (like water and trash) then this can be done. My question is when you are adding in rehab costs, do you just add it to the CASH TO CLOSE and use it for Cap Rate and Cash on Cash section or do you factor it into the monthly expenses?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    Hi Shasha. I have never rehabbed properties so can’t say for certain, but I would include it in the cash to close. The “purchase price” should be assumed to be the total it’s going to take to get the property rent-ready.
    Sam Taylor
    Replied over 2 years ago
    Ali, you stated that you would run from a property that didn’t have a positive cash flow, but what if the cash flow was break even or slightly negative? Is it possible that the value of the property could increase enough over time that you could turn it into a decent investment via the capital gains appreciation when you sold it? The reason I’m asking is because a real estate agent friend of mine told me that I should buy a condo on Maui and rent it out when I’m not staying there. She said the return on investment was superior to the return on my 401K. However, when I do the math, a sample property comes out with a significant negative cash flow. My thoughts are that she either doesn’t understand the expenses that are involved for a vacation rental (I’d be using a turn key property management company), or she’s thinking that I would eventually sell the property and make a killing on capital appreciation. Any thoughts?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 2 years ago
    Hey Sam! When it comes to real estate agents (and I can say this because I am one), it’s most likely the former…she has no idea. Maybe she’s thinking appreciation, but that’s a bad bet in that case. Especially since you are talking about a condo, so at a minimum you’ll be stuck with condo fees along the way. As for your question, my answer COMPLETELY depends on one thing- are you planning to get a mortgage on the property? Mortgages, to me, blow the appreciation idea out of the water. For one it’s risky because you’ll owe a payment every month and with negative cash flow (or no cash flow), that’s on you. For two, calculate the interest you’ll pay on that mortgage. The appreciation on said property would have to be high enough to cover at least that interest (have you looked at mortgage interest total cost lately? Wowza), and also cover all of the expenses on the property during the holding time. If you are paying cash, you have more wiggle room. It doesn’t surprise me that condo doesn’t cash flow. Condos rarely cash flow because of the condo fees, and I haven’t heard of Hawaii cash-flowing in quite some time.
    Sam Taylor
    Replied over 2 years ago
    Thanks Ali. I hadn’t even thought about the interest on the loan. Silly me. That’s why I ask the experts!
    Danielle Yerezian Professional from Los Angeles, California
    Replied about 2 years ago
    Love this post, Ali! It is one of my favorite posts I’ve come across so far. And I keep coming back to it. It lays everything out so perfectly and makes it clear for someone, like me, who’s just starting out and trying to learn the numbers and equations, etc. This is one of my top bookmarks to reference. (Hope you’re well, by the way! Got an email from Melissa the other day, I’ll be emailing you soon.)
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Hey Danielle! Awesome! Glad it helped. (sorry, I’m way late on this but never saw a notification) Let me know if I can be of any help on emails.
    Jodi Blankenship from Warren, Michigan
    Replied about 2 years ago
    Thanks for the article Ali! I appreciate the explanation and details for the expenses.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    You bet Jodi! 🙂
    Taizion Durr from Tampa, Florida
    Replied about 2 years ago
    Great article
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Thanks Taizion.
    Daniel F. Harb ARRT, RT(R) / Rental Property Investor from Newport Beach, CA
    Replied almost 2 years ago
    Thank you, Ali!! So clear, concise, and powerful. Start writing that first book!!! Daniel F. Harb
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Haha, Daniel. Well, I’ve started about 4 books. I seem to not be able to finish one. 😉
    Evelyn
    Replied over 1 year ago
    Loved it! Created an excel template to just plug in the numbers. Can you talk about rental property in California? 🙂
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Hey Evelyn! Well, now I can actually. I just bought one about a month ago. 🙂 Reach out anytime.
    Georges Martin from San Rafael, California
    Replied over 1 year ago
    Thank you for this! I’ve been using this religiously for SFR, but how does this work for MFR? i.e. quads and up?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Same, Georges. Just be sure to add in any additional expenses. As long as you have all income, expenses, and down payments and such, it’ll still work.
    Georges Martin from San Rafael, California
    Replied over 1 year ago
    Thank you Ali!
    Matthew Chappel Investor from Garland, Texas
    Replied over 1 year ago
    Hi Ali! Question for you: I am selling a vacation rental property and I was wondering if these are the same formulas I would use to calculate Cash-on-Cash and Cap Rate ROIs on the sale of that property. For example: Sale Price (minus taxes, fees, carrying costs, etc) / Purchase Price = Cap Rate Sale Price (minus taxes, fees, carrying costs, etc) / Total Cash Invested = Cash on Cash Would that be accurate?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Matthew… Yep!
    Roosevelt
    Replied over 1 year ago
    How would you classify the $967 divided by $1,325. This would be your annual cash flow, but is there a term associated with the rate? Also, would this computation be the most important one for a rental property considering that if it’s negative, the cap rate and cash on cash return are irrelevant?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Sorry Roosevelt, not sure I understand exactly which numbers (or what ratio of numbers) you’re talking about.
    Roosevelt
    Replied over 1 year ago
    My apologies. I meant (1325-967) / 1325 = 27%. This is your monthly profit margin relative monthly rental income and expenses. My question is whether this computation would be more important than cap rate as this represents actual profit.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Well, it doesn’t necessarily. Because you’re looking at the monthly expenses versus what money you actually invest. And what anyone is really concerned about in investing is the return they are getting on their money. So, like Cap Rate and Cash-on-Cash both have ‘your money’ in the denominator. Because you compare the income to how much you put in. The Cap Rate is less accurate and not a great tell of your actual return (unless you pay cash for the property), but the Cash-on-Cash is the exact return (less any additional appreciation or tax benefits, etc…it just looks at cash low). So that 27% number is really only a number that could be interesting from a curiosity standpoint. Like people talk about the 50% rule- this is that percentage. So this number would be evidence that the 50% rule is often bunk. 😉 Hope that helps.
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Well, it doesn’t necessarily. Because you’re looking at the monthly expenses versus what money you actually invest. And what anyone is really concerned about in investing is the return they are getting on their money. So, like Cap Rate and Cash-on-Cash both have ‘your money’ in the denominator. Because you compare the income to how much you put in. The Cap Rate is less accurate and not a great tell of your actual return (unless you pay cash for the property), but the Cash-on-Cash is the exact return (less any additional appreciation or tax benefits, etc…it just looks at cash low). So that 27% number is really only a number that could be interesting from a curiosity standpoint. Like people talk about the 50% rule- this is that percentage. So this number would be evidence that the 50% rule is often bunk. 😉 Hope that helps.
    Bob R
    Replied over 1 year ago
    How would you calculate the Cash on Cash and Cap Rate for a property that I currently live in? I’m planning on renting it out, but would I use the purchase price from 7 years ago? Great article and Thanks in advance!
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied over 1 year ago
    Hi Bob! Yes, I would do it off the numbers from when you bought it. Just to give you a starting idea of where it stands. The Cap Rate won’t technically be applicable because you aren’t buying or selling it right now…a Cap Rate refers to the value of the return you get vs. the purchase price which is more of an indicator of whether it’s a good investment buy or not. The Cash-on-Cash would be more applicable but won’t be totally accurate over the full term of your hold because you weren’t renting it for the first however long. But it would at least give you an idea of your cash flow income versus what you put into it.
    Bob R
    Replied over 1 year ago
    How would you calculate the Cash on Cash and Cap Rate for a property that I currently live in? I’m planning on renting it out, but would I use the purchase price from 7 years ago? Great article and Thanks in advance!
    Jennifer Rodriguez Real Estate Investor from Chicago, Illinois
    Replied over 1 year ago
    Great article! However, the one thing I’m a little bit confused on is the annual net. Where did he get the number $4296 as the annual net?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied 7 months ago
    Hey Jennifer! $4296 is the annual net cash flow (12 months x the cash flow), less the annual mortgage payment as well. The cap rate is the annual net cash flow NOT including the subtraction of the mortgage payments, and the cash-on-cash does subtract those mortgage payments. Hope that helps. – Ali
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied over 1 year ago
    There are a few material misstatements in this article. The cash flow description and calculation in this article is incorrect. The article incorrectly refers to cash flow and net income and mixes them up. They are entirely two different financial statements and calculations. Calculating expenses never includes the mortgage. That is balance sheet transaction and not a statement of operations transaction. When the mortgage is paid cash on the balance sheet is reduced by the amount of the mortgage payment. the loan on the balance sheet is reduced by the amount of the mortgage payment that is principal. Lastly, the interest portion of the mortgage payment is deducted from in income as a part of expenses on the statement of operations. “Cap Rate– This gives you an idea if you are buying the property at a good deal. It basically compares the return on investment (ROI) to the purchase price.” The is incorrect. Capitalization rate has ZERO to do with ROI. Capitalization rate is an index or data point and nothing else. Capitalization rate is based on Net Operating Income (NOI). ROI calculations are based on cash flow. Cash flow and NOI are not the same. “The Cap Rate equation: Net Annual Income / Purchase Price = Cap Rate”. Net Annual Income sounds like Net Income. Net Income is not part of the equation. Net Income and Net Operating income are not the same. Capitalization rate is NOI / purchase price. Cash on Cash Return (CCR) is poor measure of an investments performance. It only pertains to the first year. If fails to account for successive years and fails to include discounted cash flow analysis. the proper calculation for ROI or interest on your investment is Internal Rate of Return (IRR) or Net Present Value (NPV). I have no idea what is on the napkin. Its not NOI, Net Income, or cash flow. The mortgage is never deducted as part of OpEx. Statement of Operations Gross Rental Income -vacancy = Effective Rental Income + other income such as laundry and vending = Gross Operating Income – Operating Expenses = Net Operating Income (NOI) – Mortgage interest (not the mortgage payment) – Cost Recovery or depreciation – Loan amortization costs = Net Income Before Tax (NIBT) That is your statement of operations or income statement or P&L. additional steps are necessary to calculate cash flow. Cash Flow NOI – Annual Debt Service. This is the full principal and interest payment. = Cash Flow Before Tax (CFBT) Capitalizaiton Rate = NOI / Price CCR = CFBT / Cash to acquire (down paymet plus all closing costs)
    Gloria Sheridan Rental Property Investor from Marietta, GA
    Replied 8 months ago
    Is it fair to assume that the various calculators on the Bigger Pockets Tools section calculate the Purchase Cap Rate by ignoring whether I’m financing the property or not, as you suggest? I’ve tested a few samples of my own reports, and I can’t get the calcs to match. So, it your way correct, or the method used on the BP calculators?
    Ali Boone Business Owner & Investor from Venice Beach, CA
    Replied 7 months ago
    Hi Gloria, I’ve never used any of the BP calculators to know what they use to be able to respond. Sorry!
    Jason Laabs
    Replied 5 months ago
    Cap rates always “ignore” debt service. I’m comfortable saying that BP calculators do as well.
    Zachary Dahlke from San Diego, CA
    Replied 7 months ago
    Hey Ali, I love numbers and have been running number, using spreadsheets and using the BP rental property calculator a lot to compare and get good at analyzing deals. With that said, I have a few questions: 1. I noticed you did not include CapEx at all in your numbers? A lot of folks use anywhere from 5-10% of rent for Capex. This would drastically change your CAP rate and Cash on cash return numbers. So my question is, are you leaving out CapEx because these are TK properties and you are not planning on replacing big items like electrical/plumbing/HVAC/Roof/windows anytime in the next 10 years? 2. I saw you had minimum criteria for CAP rate of 6% (usually works if you can meet the 1% rule and 50% rule)… do you have a minimum cashflow per property and/or a minimum CashonCash return you need to hit? e.g. “I need 8% ConC, 6% CAP rate, and $150 cashflow/unit.” Thanks for your awesome content!
    Jerry W. Investor from Thermopolis, Wyoming
    Replied 5 months ago
    Hey Ali, For an engineer you did a good job of making your calculations simple. I also love that you got Frank Gallinelli pulled into a small debate. That guy is scary smart. I wished I had taken a class from him 40 years ago. Turn key absolutely will not work in my area, but you have had some good results in different areas. I understand you got into Atlanta before it took off. Despite this article being quite old in BP years it is still very spot on. I do use a 5% cap rate on my calculations, but other than that I do the same thing you do. I have literally done it on a napkin and made an offer shortly afterwards. Thanks for taking the time to write this 6 years ago.
    Jason Laabs
    Replied 5 months ago
    @Ali Thanks for proving that its really simple and the millions of words wasted and arguments that ensue are really a waste of hot air. It can be as complicated or as simple as you make it. The most successful single investor in the world, Warren Buffet, is a very simple man. He either understands it or he doesn’t. If he doesn’t, he moves on to things he does and he deals in the billions of dollars range and he is a long term investor. The longer the investment horizon, the more irrelevant the advanced calculus becomes.