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<\/a><\/p>\nBefore diving into real estate investing, make sure you understand how to compare markets and properties, as well as a basic understanding of how to buy rental property<\/a>. Whether you\u2019re trying to decide between investing in Boise or Sacramento\u2014or you\u2019re just comparing two similar homes\u2014this guide will walk you through all the numbers you need to know. From calculating cash-on-cash return to running a comparative market analysis, the experts at BiggerPockets demonstrate the steps you need to follow and the statistics you must know with The Beginner\u2019s Guide to Real Estate Market Analysis<\/a>.<\/em><\/p>\n So here we go. I have four things for you to think about as you begin shopping for rental properties:<\/p>\n I\u2019m going to break these four things up into two categories\u2014considerations and guidelines\/theories.<\/p>\n Ultimately, all that matters with any real estate investment is the numbers. The whole point of investing is to get a return on your money, so if the numbers don\u2019t work, what are you even in it for?<\/p>\n You absolutely should not, under any circumstances, invest in a piece of real estate without fully understanding the numbers involved. Whether this is a rental property and you are relying on cash flow from it, you are flipping and ARV matters, you are financing a property and need to know how the property\u2019s income shakes out against that, or you\u2019re buying for appreciation, numbers matter. At the end of the day, they are all that matter (except for sanity\u2014sanity matters more than money in my opinion).<\/p>\n So you\u2019re looking at a potential rental property and trying to decide if it\u2019s a good deal or not. Well, what are the numbers? Do you know what to look for? I know I didn\u2019t the first time I ever went rental property shopping. It didn\u2019t seem like the properties I was looking at were a good deal, but I couldn\u2019t point to exactly why or why not\u2014because I didn\u2019t know how to run the numbers.<\/p>\n The most useful and accurate equation for determining the return on your money is the cash-on-cash return. This equation focuses only on monthly cash flow, so it doesn\u2019t incorporate additional equity build\/appreciation or tax benefits, but you\u2019re safer to assume both of those to be a bonus anyway. But also, while the cash-on-cash return is the most accurate, you need to understand cap rate because that number is used a lot and will give you an idea of the worth of an investment. It will also happen to be equivalent to the cash-on-cash return for properties bought with all cash. But if you are financing, the two numbers will be different, and they essentially tell you different things.<\/p>\n For the most basic instructions on how to use and run these two equations, check out Rental Property Numbers So Easy You Can Calculate Them on a Napkin.<\/a><\/p>\n The even broader question to the cap rate and cash-on-cash return is will there be positive monthly cash flow or negative monthly cash flow?<\/em> Those equations will tell you that, and whatever the answer is, you need to know exactly what that means.<\/p>\n Positive monthly cash flow means the income you receive on the property is more than what you pay out in expenses. It means you pocket money every month. Pocketing money every month, rather than paying out money every month, is obviously desirable, but you\u2019d be surprised how many people don\u2019t realize that should be happening.<\/p>\n There are cases, however, when people justify having a property with negative monthly cash flow. This is often the case when someone is out for profiting off the presumed appreciation of a property. So you might lose a few or several hundreds of dollars each month because supposedly the property is going to appreciate something fantastic over the next however many years. This has certainly happened in the past, especially for people who bought at the right time in places like Los Angeles or San Francisco (or even me who bought turnkeys in Atlanta at exactly the right time and they\u2019ve all doubled and tripled in value since). But investing for cash flow and investing for appreciation, while they can certainly dovetail, are two different strategies.<\/p>\n For more information on each of these strategies, check out Investing for Cash Flow or Appreciation\u2014What\u2019s the Difference?<\/a><\/p>\n Whatever method you invest for, you want to be confident in knowing where your predicted profit is going to come from. It has to come from somewhere, or you lose. Be concrete in knowing how much you project you will earn on your investment, and be able to explain how you got to that number. If you can\u2019t do that, you need to go further with your research and learn it before you drop a dime into any property.<\/p>\n But wait\u2014once you run the numbers, is that all you need to care about? No!<\/p>\n Anybody can come up with any financial prediction they want to. Those predictions don\u2019t, however, come with any kind of guarantee that they will actually pan out. Notice in the last section I used words like “predicted,” “projected,” and \u201canticipated\u201d in terms of the cash flow or appreciation returns. I used those words because that\u2019s all your estimates are\u2014they are predictions. In no way whatsoever do your predictions dictate whether they ever come true or not.<\/p>\n So the question is\u2014how likely is your cash flow to continue at the level you predict it should? Can you sustain your predicted cash flow?<\/p>\n While several factors can play into whether or not you actually get the cash flow you are projecting or not, I think the biggest and most important factor is the market in which you are buying the property.<\/p>\n A quick clarification though before I keep going: When we think of a property\u2019s location, there is the macro-market it is in, as well as the micro-market. So the macro would be the bigger city that it is close to\u2014cities like Atlanta, Chicago, Los Angeles, Indianapolis, etc. All of those are the big metro cities in their areas that constitute the macro-market. The micro-market is the smaller city outside of that bigger city that you buy, sometimes even as detailed as which neighborhood you are buying in. Ultimately, the fate of a micro-market very strongly depends on the macro-market it\u2019s located near. If a macro-market fails, it\u2019s likely the micros around it are going to hurt as well. If the macro-market is strong, the micro-markets have a good chance of staying strong as well.<\/p>\n If in any way the market in which you invest in begins to decline, all of your projected returns may become impossible to achieve. Pretend for a minute you invested in Detroit before it went belly-up. Maybe you were getting great cash flow on a great property, but then when suddenly everyone moved out of the city and things went south, do you think you\u2019d be able to still get that same cash flow? Doubtful.<\/p>\n To help ensure your cash flow numbers are sustainable, investing in a solid growth market is imperative in my opinion. If you invest in a declining market, your property may not sustain your projected returns.<\/p>\n If you want to dive into the specific risks with declining markets, check out 5 Risks of Buying Rental Properties in Declining Markets. <\/a><\/p>\n The other joy about buying in a solid growth market, rather than a declining market, is the tenant pool. While the market you buy in can strongly dictate the sustainability of your cash flow over the long-term, the tenants you put in your property can strongly dictate the sustainability of your cash flow over the short-term. One bad tenant can almost immediately tank your returns. So the best option is to have the largest and highest-quality tenant pool that you can pick from. You\u2019re more likely to find higher-quality tenants in a stronger market. Not to say declining or lower-end markets will only offer low-quality tenants, but it\u2019s all about risk mitigation and lessening the risk of it.<\/p>\n The numbers are most important, but they don\u2019t tell the whole story. The ultimate question is\u2014can you sustain the numbers? And there is a lot that goes into that sustainability.<\/p>\n Well, I guess you can already see how I feel about using these next two guidelines as buying criteria.<\/p>\n These next two things are \u201cfamous\u201d guidelines or theories that people have come up with over the years as buying criteria when they look at possible rental property investments. It\u2019s not that either of them are necessarily wrong<\/em>, but they can be misleading in several ways, so you need to be sure you understand more about them so you know whether or not they are applicable to use as your own buying criteria.<\/p>\n I know this idea of aiming for a particular amount of cash flow per month has been around forever, but for some reason I\u2019ve been hearing a lot more people reference it lately. And somehow this popularly-referenced guideline has been set to $200\/month as required cash flow for a rental property investment.<\/p>\n It\u2019s not a bad start. You do want to have some kind of idea of what you are looking for in terms of cash flow, so I guess we can start with $200\/month. But the problem with using that set number is that whether $200\/month is a good cash flow or not is relative.<\/p>\n There are two factors that that $200\/month should be weighed against:<\/p>\n If you were to buy a low-risk property for $100,000, I would say $200\/month cash flow (assuming we are talking about after financing) might be really good.<\/p>\n If you were to buy a low-risk property for $1,000,000, I would say $200\/month cash flow would be atrocious.<\/p>\n If you were to buy a high-risk property for $100,000 or one that you had to put a lot of work into, I would say $200\/month may not be good. Maybe it\u2019s OK, but the higher the risk, the higher your returns should be in order to make up for that added risk you are taking on. Same with how much work you put into something. If you are going to be putting in a ton of work and effort into a property, you should want to see higher returns to compensate you for taking that on.<\/p>\n This article is written in terms of what cap rate you should shoot for on a property, but the same information applies to cash flow numbers. Check out How to Know What Cap Rate to Shoot For on Any Given Rental Property<\/a>.<\/p>\n The main message in that article\u2014and what you need to realize\u2014is that everything is on a scale. On one end of the scale, $200\/month might be fantastic. On the other end of the scale, it might be horrible. So instead of making your buying decisions based solely on some set number for cash flow, you have to look more at what you are buying and what you are getting from it as a whole package. If everything else about the property is great and has good appreciation potential and a high-quality tenant pool, then lower cash flow might be fine. If the property doesn\u2019t offer much else outside of cash flow, you need to only settle for higher cash flows.<\/p>\n And in addition, good cash flow in one market may be horrible for other markets. If you were to buy a decent property in a market that notoriously doesn\u2019t offer any cash flow, like Los Angeles or San Fran or New York City, then $200\/month cash flow on anything you buy might be great! Whereas if you were to buy something in Cleveland or Detroit, I\u2019d argue $200\/month is not a good deal.<\/p>\n Everything is relative.<\/p>\n And so are these rules.<\/p>\n Before I demolish both of these rules, I will say\u2014in their defense\u2014they both either have a place or have had a place in decent real estate investing thought.<\/p>\n The 50% rule says that on average, 50% of the income you collect in rent will go towards expenses. If you run this calculation in your head\u201450% of the rental income\u2014you can know how much cash flow you will receive and make a decision based on that number.<\/p>\n I\u2019m going to say no more about the 50% rule and just tell you to check out The 2 Biggest Mistakes Made in Calculating Rental Property Returns<\/a>. The first \u201cmistake\u201d in this article is all about the 50% rule. You\u2019ll see in there that the 50% rule does have it\u2019s place, but it also goes into depth about how it is also misleading. The second point in that article goes back to what I said earlier about the sustainability factor of cash flow.<\/p>\n And then for the 2% rule\u2014this one was actually useful back in the day. If a property met the 2% rule\u2014meaning the projected monthly rental income came to at least 2% of the purchase price\u2014it would be a good deal. Typically, that was true. The problem now is that because of where we are in the current real estate economy, anything meeting the 2% rule is probably a very risky property. Back in the day, there were excellent properties in excellent markets that easily hit the 2% rule. But it\u2019s just not the case now. So this \u201crule\u201d (it really should be named a \u201cguideline\u201d rather than a \u201crule\u201d) is fluid based on what market you are buying in and at what point in the real estate economy cycle you are buying in.<\/p>\n To get a full background on the idea of the 2% rule, check out The 2% Rule: Fact, Fiction, or Feasible? <\/a><\/p>\n\n
Two Primary Considerations When Buying a Rental Property<\/h2>\n
1. Cash Flow & Numbers<\/h3>\n
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\nRelated:<\/strong> 7 Factors to Examine When Shopping for a Rental<\/a><\/em><\/p>\n2. Cash Flow Sustainability<\/h3>\n
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\nRelated:<\/strong> When it Comes to Your Rental Portfolio, How Much Cash Flow is Enough?<\/a><\/em><\/p>\nPopular Guidelines People Should Stop Following<\/h2>\n
3. Ideal Cash Flow Amount\/Month<\/h3>\n
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<\/p>\n4. The 50% and 2% Rules<\/h3>\n
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