The following is a method we use to analyze rental (“buy and hold”) properties to check the anticipated rate of return against the risk, looking mainly at capitalization rate (“cap rate”), cash on cash return, and debt service coverage ratio.
(This isn’t an exhaustive analysis method, but is just something quick which allows us to eliminate most properties that cross our desk, and focus on the ones which deserve more time. If you’re actually considering making an offer on a specific property then it’s worthwhile to break out specific expenses, for example finding out the property taxes, getting an insurance quote, etc.)
First, we only look at current rents, never could-be (“pro forma”) rents. One of our favorite phrases is, “if rents could be higher, why aren’t they?” Don’t assume you can raise rents, just because the owner or listing agent claims you can. After all, it’s in their interest to get you to pay more for the property, even if it’s based on
empty promises potential rents.
If some of the units are vacant, we’ll try to get a sense of market rents by looking on Craigslist/RentProv/Zillow/etc. We might also ask other investors, if we know anyone with similar properties in the area.
Once we have reasonable monthly rents for each unit, we multiply them by 12 to get yearly gross rents.
We then subtract an amount for yearly operating expenses using an operating expense ratio. We’ll use 50% if the tenants pay for their own heat and electric, or a bit higher if the owner pays for heat or electric (55%), or 60% if owner pays both heat and electric. You’ll sometimes see this referred to online as the “50% rule”.
Note that the “operating expenses” accounted for with that ratio do not include mortgage payments. Different owners may have different financing, and some may have no financing at all. To be accurate and compare one property to another as an operating business, it’s better to look at the financing separately from the income and operating expenses.
If you take the yearly gross rents and subtract an amount for operating expenses based on that ratio, you end up with Net Operating Income (NOI) which is the basis for the three figures we’re aiming at (cap rate, cash on cash return, debt service coverage ratio).
To find the capitalization rate (“cap rate”) you divide the NOI by the purchase price, and you’ll end up with a percentage, usually somewhere between 4 and 12%.
The cap rate is your rate of return if you didn’t have any mortgage payment, and is a way of comparing “apples to apples” between different types of property since the type/amount of financing isn’t included in the calculation. It’s purely a way of saying, “how good or bad is the price, relative to the income left over after operating expenses?”
As a buyer, you want cap rate to be higher because it means you’re getting more of a return for the same price. Of course, as a seller you’d like the cap rate to be lower because it means the buyer is paying more for the same property income.
Everyone wants a cap rate of 10%+ but these days, anything 7% or higher is worth looking at, and we’d consider 6%+ for the right property/area/etc. At this time we wouldn’t look at anything under 6%, but that’s up to you of course.
If the cap rate indicates that the property looks worthy of spending more time on, then you can start to look at the financing aspect.
Here you have to think about what kind of mortgage you’d be getting, how much you’d be putting down as a percentage of the loan amount, what your rate would be, etc. The goal is to calculate the monthly mortgage payment, but also to make sure you can afford the down payment of course.
Usually with an owner-occupied loan, people do 3% of the purchase price as down payment, so the loan is 97% of the purchase price.
With non-owner occupied loans we assume 25% of the purchase price as down payment and 75% of the purchase price as the loan amount. We’ll assume a 30 year term for 2-4 families, or a 25 year term for 5+ units (commercial properties, which have different financing).
You’ll also need to determine an interest rate. The best way is by talking to a mortgage broker about the type of property you’d be looking at (owner occupied, investment etc.), and then they might pull your credit and give you an idea of the rate.
But for quick analysis purposes you can just go online and look for a “market” or “average” rate for a 30 year loan, at a page like 30-Year Fixed-Rate Mortgages Since 1971 (we ignore the Pts column on that page and just look at the Rate column). If it’s more than 5 units we typically add 1 percentage point to the rate.
Using that info (loan amount, term years, and interest rate) you can use any number of websites to calculate the monthly mortgage payment (principal and interest only, without taxes and insurance, since those were already included in operating expenses above). We also have a page for calculating 30 year mortgage payments, and if you’re looking at a shorter term that page also has a downloadable spreadsheet.
Once you have the monthly mortgage payment, multiply it out by 12 to get the yearly mortgage payment which is also known as “annual debt service” or ADS.
If you subtract the yearly mortgage payment (ADS) from net operating income (NOI) you get what we call free cash flow (FCF), which should be what you’d end up with on a yearly basis after all the operating expenses and financing expenses (mortgage) are paid for. Obviously, that should be a positive number 🙂
To get the cash on cash return (CCR) you take the free cash flow (FCF) and divide it by the total amount of money you had to put into the property to get it up and running (i.e., rented out) which we call “initial investment”. With a property that’s rent-ready, that’s just the down payment amount (you can throw in a few thousand for closing costs if you want but we usually don’t). However if you have to put work into the property to get it rent-able, then you should absolutely include that amount in addition to the down payment.
Cash on cash return is a percentage that’s usually 7% or higher; obviously, higher is better. We like to see 10% or higher here, but just like with the cap rate, you have to take the whole picture into account. Maybe you’ll take a lower return if the property is near you, or newly renovated, or in a great area, etc.
Finally, while CCR measures a sort of “real world” return (money you get back compared to money you had to put out initially), the equally-important other side that goes hand-in-hand with CCR in our opinion is the debt service coverage ratio (DSCR), which is a measure of risk.
To get the debt service coverage ratio (DSCR) you divide the NOI by the ADS (yearly mortgage payment). You’ll end up with a number which is usually between 1 and 2. Anything about 1.2 or 1.25 is good, anything under 1.2 is not good. Anything under 1 is very bad.
The DSCR tells you how much of a margin/buffer of safety you have between your net income after operating expenses, and your fixed mortgage payment. If it’s under 1 it means you’re losing money every month. A ratio of 1.25 means you have a 25% buffer between your net income and mortgage payment, in case anything unexpected comes up, before you go cash flow negative for the year. Banks usually like to see 1.25 or higher.
Generally, the more leverage (bigger loan amount) you use to buy a property, the higher your cash on cash return, but the higher your risk (which shows up as a lower DSCR). Higher leverage means you can be involved in more properties for the same amount of money, but it also means, because you have higher loan payments, you have less of a margin of safety in case unexpected things pop up.
In real estate, unexpected things always pop up sooner or later, so to us the DSCR is at least as important, if not a little more important, than the CCR, but that’s our personal preference. We’d rather do fewer deals that are safer, than do a bunch of high-leverage deals but feel like it’s built on a house of cards that could come crashing down if the market turns (e.g., renters start to buy houses again which weakens rental demand and rents).
You may also take market cycles into account here, and be more aggressive (using more leverage) in the early stages of a rising market to acquire more properties, and then shift to be less aggressive (bigger down payments and smaller loans) as the market starts to top out or turn. That’s an excellent strategy, but of course the trick is that it’s not easy to call the bottom or top of a market when you’re in the middle of it (and incredibly easy in hindsight!).
To summarize the formulas/calculations:
yearly gross rent = monthly rents x 12
for monthly rents, only use current rents; for vacant units use Craigslist/RentProv/Zillow/other landlords to estimate
for operating expenses use 50% op ex ratio, or 55%/60% depending on who pays which utilities
net operating income (NOI) = yearly gross rent – operating expenses
cap rate = NOI ÷ purchase price
7%+ is good, 10%+ is great, 6%+ is OK, 5%+ is meh, under 5% is not great
determine % down payment (e.g., 3% or 25% of purchase price)
100% – % down payment = % loan amount (e.g., 97% or 75%)
use above percentages to determine down payment amount and loan amount
determine mortgage rate from mortgage broker or Internet; add 1% for commercial mortgage
determine monthly mortgage payment via Excel or Internet
annual debt service (ADS) = monthly mortgage pmt x 12
free cash flow (FCF) = NOI – ADS
initial investment = down payment + any $ needed to get all units rentable
cash on cash return (CCR) = FCF ÷ initial investment
higher is better obviously, would like to see at least 8%+, 10%+ better; evaluate with DSCR to find right risk-reward balance for you
debt service coverage ratio (DSCR) = NOI ÷ ADS
under 1.2 is bad, 1.2 – 1.25 is OK, 1.3+ is good