Before I bought my first rental property, I did a lot of research trying to figure out the real estate investing terms and formulas that I needed to know.
I found a lot of information through articles, books, blogs, podcasts, and so on.
But the truth is, similar to many newbie investors, I was overwhelmed and intimidated by all the real estate investing lingos and calculations.
How do I know if a property is a good deal?
What kind of ROI should I be looking for?
What is cash flow?
Now with 7 income generating rental units under my belt, I’m pretty confident when it comes to analyzing rental properties.
That is why I’m putting together a list of all the real estate investing terms and formulas that you should know to help you find your next deal.
Most importantly, giving you what you need to prepare yourself to buy a cash flowing income property.
Let’s get started! 🙂
Here is a list of the categories that we’ll cover in this post:
RENTAL PROPERTY ANALYSIS EXAMPLE
Before we go into the all the details, let’s start with an example first.
Let’s assume that we’re looking at a single family home and we want to see if it’s a good deal or not.
Purchase Price: $110,000
Down payment: $22,000
Closing Costs: $2500
Rental Income: $1600 / month
CapEx (10%) – $160 / month
Debt Services – $408
Dwelling Insurance – $110 / month
HOA / Strata Fees – None
Maintenance/Repairs (10%) – $160 / month
Property Management (10%) – $160 / month
Property Tax – $120 / month
Utilities – Paid by tenants
Vacancy Allowance (5%) – $80 /month
Gross Operating Income:
GOI = Monthly Rental Income – Vacancy Allowance
= $1600 – $80
Net Operating Income:
NOI = GOI – Total Expenses (excluding debt services)
= $1520 – $710
Cash Flow = NOI – Debt Services
= $810 – $408
Cash on Cash Return:
CCR = Annual Cash Flow / Initial Capital Investment
= ($402 x 12) / ($22000 + $2500 + $5000)
= 0.1635 = 16%
Cap Rate = NOI x 12 / Purchase Price
= ($810 x 12) / $110000
= 0.08836 = 9%
From the above calculations, this deal will net a 16% CCR with a $402 cash flow per month. And that’s already considering Vacancy allowance, maintenance, and CapEx!
It’s definitely worth looking at.
In general, please keep in mind that even when the numbers look good to you, it doesn’t mean the property is indeed a good deal. Never buy a property mindlessly.
Now that we got the example out of the way, note down what was confusing to you and move your way down to the rest of the post for further explanations. 🙂
RENTAL PROPERTY ANALYSIS FORMULAS & CALCULATIONS
Here are all the formulas and calculations that I find useful when I analyze a rental property to see if it’s a good deal or not.
1 % Rule
Definition: The 1% rule states that the rental income collected from a property must be at least 1% of the entire purchase price for the property to be a good deal.
Formula: 1% Rule = 0.01 x Monthly Rental Income
If you buy a property for $100,000, then the monthly rental income must be at least $1000.
If you buy a property for $300,000, then the monthly rental income must be at least $3000.
Definition: Similar to the 1% rule. The 2% rule states that the rental income collected from a property must be at least 2% of the entire purchase price for the property to be a good deal.
Formula: 2% Rule = 0.02 x Monthly Rental Income
If you buy a property for $150,000, then the monthly rental income must be at least $3000.
If you buy a property for $300,000, then the monthly rental income must be at least $6000.
Definition: The 50% rule states the monthly expenses will be at least 50% of your rental income.
Formula: 50% Rule = 0.50 x Monthly Rental Income
If the monthly rental income is $1000, then your monthly expenses will be $500.
If the monthly rental income is $3000, then your monthly expenses will be $1500.
Capitalization Rate (Cap Rate)
Definition: The ratio of a property’s annual Net Operating Income and its purchase price.
Formula: Cap Rate = Net Operating Income x 12 / Purchase Price
Cap rate will vary depending on where you’re investing. Do a research of the are that you’re looking at or ask an experienced realtor for the average cap rate.
Definition: The amount of money left over from your rental income, after subtracting all expenses, to maintain the property in rentable condition.
Formula: Cash Flow = Income – Expenses
Or if you want to speak technical and talk “real estate investor” to me then…
Cash Flow = Net Operating Income (NOI) – Debt Services
If you don’t know what NOI is, don’t worry, I’ll explain it more in detail later on in the post.
For now, just think of your monthly cash flow as your income minus expenses.
Keep in mind that, when I say expenses, it’s not just debt services, property taxes, strata fees (if any) and insurance.
Expenses are everything that is costing you each month to maintain the property.
You always want to make sure that you obtain a positive cash flow after expenses.
Cash on Cash Return (CCR)
Definition: The ratio % between annual cash flow and the cash initially invested. Some would consider CCR to be Cash ROI, but to avoid confusion we’ll call it Cash on Cash Return.
Formula: Cash on Cash Return (CCR) = Annual Cash Flow / Initial Capital Investment
Where Annual Cash Flow = Monthy Cash Flow x 12.
Initial Capital Investment = Down Payment + Closing Costs + Improvement Costs (money that you put into the property to get it ready for rent.)
If you’re wondering what kind of CCR you should be looking for, then find out the average return you’re currently getting from your other investment vehicles.
That average return is the amount of return that you want to beat when you look for a rental property to buy.
Gross Operating Income (GOI)
Definition: The total monthly income minus vacancy allowance.
Formula: Gross Operating Income (GOI ) = Monthly Rent income – Vacancy Allowance
Gross Rent Multiplier (GRM)
Definition: The ratio of purchase price to gross annual rental income.
Formula: Gross Rent Multiplier (GRM) = Purchase Price / Annual Rental Income
Another quick way for you to tell if a property is a good deal or not. Personally, I don’t use this calculation often, but when I do I look for GRM less than 8.
Net Operating Income (NOI)
Definition: The net income amount after subtracting all operating expenses (without considering debt services) from rental income.
Formula: Net Operating Income (NOI) = Gross Operating Income – Total Expenses
Total Return On Investment (Total ROI)
Definition: The % of how much annual cash flow + principal pay down + principal appreciation earned based on the cash initially invested.
Formula: Total Return On Investment (Total ROI) = (Annual Cash Flow + Principal Pay Down + Principal Appreciation) / Initial Captial Investment
This formula considers the following wealth generators to calculate the return:
- Principal Pay Down
- Principal Appreciation
- Annual Cash Flow
Personally, I focus on CCR before I look at Total ROI since the appreciation is based on the current market value; it is unpredictable and I don’t like to bet my money on that.
With that being said, the only time I would look at this value is after I purchase the property for at least a year and see the changes it has done to my net worth.
Definition: The money that your tenant pays you periodically for using your property.
You could either rent your place furnished or unfurnished.
I prefer to rent my properties unfurnished since these suites attract tenants who stay for a longer period.
This creates less work and a smaller turnover rate throughout the year, thus creating a more passive income stream.
Alternatively, you could rent your unit furnished or host an Airbnb suite and get a higher rent than unfurnished suites.
In addition, there are other ways that you could maximize your income from renting things such as:
- Coin-operated laundry
- Vending machine
- Maintenance services
- and more
Be creative! If there is a demand for it, someone will want to rent it. 😀
Definition: The value of your property that increases over time.
From what I hear, most people buy into real estate betting on appreciation first.
While appreciation can grow your wealth, it is equally important to understand that your property value could also go down. This is why you should look at cash flow first and treat principal appreciation as a bonus when buying rental properties.
The goal is to make money when you buy. Buy property below market value to gain instant equity while it gives you positive cash flow as passive income.
Principal Pay Down / Principal Recapture
Definition: The equity that you gain as you pay down your loan.
You may think of this as extra savings within your loan.
While the property is rented, your tenants will be the ones paying down the debt while you watch your net worth grow.
Definition: The ability to make tax deductions on qualifying rental related expenses to decrease the amount of taxes you pay on your rental income.
Here are some examples of what you may be able to expense:
- Loan interest
- Property Management Fee
- HOA or Strata Cost
- Maintenance and Repair Costs
- Property Taxes
- Legal Fees
- Dwelling Insurance
- and more
Please note that I am not an accountant. Always hire and seek help from a certified accountant to maximize the most amount of tax benefits that you can get from your rental property.
Capital Expenditures (CapEx)
Definition: The cost to replace big items on your rental property, such as the roof, appliances, hot water tanks, furnace, windows, plumbing, etc.
CapEx is one of those expenses that a lot of newbie investors don’t consider in their calculation.
I was definitely guilty of that too when I first started!
To do a rough estimate of this, you can put aside 5-10% of your rental income per month as your CapEx allowance. Personally, I put aside 10% because I’m a worry wart. 😛
In general, when you buy a property, you need to consider when the last time these big ticket items were serviced or installed and set aside some money so you can be prepared to replace them when necessary.
Definition: The payment that you pay towards your loan.
Obviously, if you’re using cash to pay for your rental properties, then this doesn’t apply to you.
When looking for a loan, make sure you shop around to get the best rate and a loan that fits best for your situation and goals.
Depending on your debt agreement, you’ll need to make payments periodically towards your debt service provider.
If you’re wondering where to get this value for your rental property analysis, use an online debt calculator first to give you the monthly debt payment for a quick estimate.
Play around with the estimate and stress test to make sure that you will be cash flowing, even with a higher interest rate.
Definition: This is sometimes referred to as “hazard insurance”. As homeowners, you will need to cover for potential unfortunate events that might happen at your property. Such as your tenants accidentally burning down your house, or a tornado comes by and shreds your house into pieces, etc.
What is covered under dwelling insurance will vary from one policy to another. Make sure you talk to a licensed broker in the property’s area to get options and estimates between different companies.
Home Owner Association (HOA) / Strata Fee (If Any)
Definition: A mandatory fee paid towards common expenses and shared amenities for strata managed dwellings.
If you live in a condominium, townhouse or multi-family dwelling, most of the time you’ll need to pay a strata fee. This money will be used to do maintenance on the premise and keeping common areas in order.
Depending on the type, age, structure of the building and type of amenities, the strata fee can go up or down over the years. Which is why when you buy a rental property, a concrete building is going to be a better choice in terms of durability.
Generally, you can find this cost stated on the property listing; if not, ask your realtor to obtain this information.
Maintenance / Repairs
Definition: The monthly cost to keep your rental property in normal living condition for your tenants.
To give you an idea of the kind of expenses to expect, here are examples of maintenance and repair costs:
- Lawn cutting
- Snow plowing
- Pest control
- Garbage removal
- Appliance repairs
- Sending your PM to deal with irresponsible neighbours
- and more.
Trust me, one of those things will happen. 🙂
Some of those maintenance tasks can probably be done by the tenants. However, you should still be prepared to deal with it just in case it isn’t.
When analyzing a property, make sure to budget some money to cover maintenance and repair costs.
If you’re unsure how much to set aside each month, then 10% of your rental income is a good amount.
Definition: A company that represents and manages your property for you.
Hiring a property management company to look after your property is essential if you’re investing out of province. If something goes wrong at your rentals, you don’t want to be the one that the tenants call at 3 am.
Adding to my previous point, I also think that it’s a good idea to keep a healthy distance between you and your tenants. It helps to keep the emotions out so you can make logical decisions.
Now, I’m not saying to go out there and be a robot landlord; what I’m simply saying is that when you know your tenant, it’s easier to become friends with them.
Let’s say one day they missed a rent payment or paid late, they might keep doing it and take advantage of you because of the friendship that you have with them.
Definition: The amount that is paid by the owner to the city, based on the value of their dwelling and land.
If you’re unsure where to find this amount, you can look online through the city’s website or call the city directly to get the information.
Or you can contact a realtor to find the property taxes paid the previous year as an estimate for when you do your calculation.
Definition: The additional costs to have water, electricity, and gas running through the property for the tenants.
- When you see $xxx (+ utilities), it means that utilities are paid by the tenants
- When you see $xxx (inclusive), it means that utilities are paid by the landlord
If you rent your property all inclusive, keep in mind that it will be harder to predict the monthly utility costs, unless you put a cap on them.
With this being said, putting a cap on utilities may lead to difficulties in collecting a variable amount, especially since the utilities are technically under the homeowner’s name.
For me, I find it easier to have the tenants pay for utilities. It’s one less thing to deal with. 🙂 Always be conservative with your numbers. When in doubt, analyze with a higher amount.
Vacancy Allowance (VA) / Vacancy Rate
Definition: The amount of money that you put aside each month to pay for your rental expenses when the unit becomes vacant.
Formula: Vacancy Allowance = Vacancy Rate % x Monthly Rental Income
When looking to buy a rental property, it is always smart to be prepared for when the unit is vacant.
If you don’t have any money set aside, then be ready take out money from of your personal account to subsidize for the lack of rental income during those vacant months.
To calculate the vacancy allowance to put aside each month for your rental property, you’ll need to first find out the vacancy rate of the area that you’re buying in.
You can search online for city data to find the vacancy rate or you can ask an experienced realtor in the area for that number.
TERMS AND DEFINITIONS
Definition: The final costs, in addition to the purchase price, to complete the property so that the title can be transferred to the new owner.
This will be considered as a part of the initial capital investment when purchasing the property.
So, if you are trying to figure out what this value might be, then calculate 5% of your purchase price as your closing costs for a quick estimate.
Keep in mind, similar to any estimates, always confirm the final cost with a certified professional.
Days On Market (DOM)
Definition: The number of days that the listing has been on the market for.
This one is pretty straightforward. It is useful to find out the DOM of a property because desperate times call for desperate measures.
When you find a property that has been on a market for too long, most of the time you’ll be able to negotiate a better deal; the owner is probably tired of listing their property and wants to get rid of it.
Plus, DOM just sounds cooler than saying Days on Market, doesn’t it? 😛
Definition: The initial amount of cash that you put down to purchase the property if you’re getting a loan.
The amount that you need to put down varies depending on your qualifications and what kind of loan you’re trying to get. It could range from 0% to 35%.
Talk to your mortgage broker or mortgage adviser at your local bank.
Definition: The reserve bank account where your money is kept fairly liquid so that you can use it when you’re dealing with your worst landlord nightmare. Or in other words… when sh*t happens.
A good rule of thumb is to keep between 3 – 6 months of your expenses for each rental unit. Again, when I say expenses, it means everything that your rental property is costing you per month. I can’t stress this enough.
But in all honesty, if you want to keep more money in your reserve, it doesn’t hurt either.
Personally, I keep at least 6-9 months in my emergency fund account for each of my rental units, including the one that I live in.
Security Deposit / Damage Deposit
Definition: A legally allowable amount of money that the landlord can request from the tenant to use against damages to the property if occurred.
I’m not going to go into details as to how much a landlord can collect from their tenants for deposit since every province or state has their own rules.
Check with your residential tenancy branch to find out what that allowable amount is.
When analyzing a rental property to see if it’s a good deal or not, always be conservative with your numbers.
You’d rather be in a situation where you’ve overestimated an expense than underestimated it.
While there are many formulas that you can use to assist your cash flow analysis, use them with a grain of salt.
Do the math and make sure the numbers work for you first, before jumping into it.
Give yourself a minimum cash flow amount per unit that you must meet, and stick with it.
If the numbers don’t work, then learn to walk away and keep searching.
Most of the deals that you analyze aren’t going to be a good deal, but the goal is to not give up until you find the right one.
What are your thoughts on this? Do you have any other questions?