Let’s travel back for a moment to the world of spreadsheets that I quite enjoy. Away from the sea of social media cheese where you can easily get distracted from the cells and formulas that truly make the world turn.Curious about how to evaluate rental properties? Look no further…
If being a landlord or vacation rental owner is something you’ve considered, this post will cover off some on how I use the cash on cash method to evaluate rental property returns.
Philip, a reader of the blog, emailed me a few weeks back asking how each of our properties generates cash flow. He went on to ask how real estate supports our financial independence goals.
How to Evaluate Rental Properties: Let’s start with the basics
- Our properties generate cash flow because we’re able to fetch a rent that’s substantially higher than the cost of mortgage, insurance, taxes, and maintenance
- You cannot forget to account for the “stealth cash flow” that rentals generate via your tax returns. Remember that depreciation on the structure, and all maintenance and property management costs are business deductions.
- Financial independence is much easier to achieve when you break out of your comfort zone to learn about and apply ways to make more cash outside of your day job. Fantasy Football leagues don’t count.
There are two basic methods I’ve learned of for figuring the value of a property as a rental. One is cap rate, where you take the estimated net annual income of the property and divide it by the purchase price.
Each of our rentals nets roughly $1,100 a month, after maintenance, insurance, and taxes. That’s $13,200 a year. (NOTE: You do not factor in mortgage/financing with cap rate.) Next, take the average purchase price of each home, or $150,000, and divide that into the $13,200 numerator.
Hence, our portfolio cap rate is roughly 9%. Ideally, you should aim for 8% or higher if you’re relying solely on the cap rate method to evaluate a rental property.
What! No one told me there was going to be math in this blog today!
You might be asking, “what then is cash-on-cash, and why should I use that method instead?” The reason I like the “CoC” method is that it reveals for you the expected return on your invested dollars. Basically, is plunking down $30,000 for a down payment on a rental property mortgage a better bet than plunking down $30K into the stock market? Cap rate does this for you initially, but requires you to re-factor with changes in property value.
Cash-on-cash is the preferred method to use for figuring where to put that $30K, when you finance a rental property. For 99% of us real estate investors who believe in using other people’s money (or “OPM”, which you enunciate like “opium”, for effect), CoC is the best method for determining return on value.
My good friend who got me into real estate rentals nearly five years back shared a spreadsheet that looked pretty much just like this snippet below. Only, I updated the numbers to reflect the average rental home in our portfolio.
How to Evaluate Rental Properties: Let’s dive in!
A couple of points to make here. The cash on cash output is pretty strong with this house. At 16.15%, that means so long as you have zero vacancies, your rental house will probably outperform the stock market (7%?) by a healthy margin, year over year. There are variables to watch out for, that’ll quickly sink your cash on cash return.
- Get a good interest rates on your rental mortgage. It’s important to maintain a good credit score, find a good lender, and watch those rates! We’ve been fortunate to acquire our properties during a period of super low-interest rates, and it makes a big difference. Note that the borrower’s rate for rental buyers is generally 0.5% higher than for homestead borrowers.
- Avoid the temptation to put down more than 20% to get a better interest rate. This may sound contradictory to #1 above, but the margins are the key here. Your lender may offer you a quarter point reduction, say from 4.5% to 4.25% in exchange for a 25% down payment. Look what that does to your cash on cash:
All of the sudden, despite the good intent of reducing your monthly payment and scoring a lower interest rate, you’ve somehow landed a lower cash-on-cash return? What gives?!?
Well, again, you’re throwing more up-front money into the rental that could instead go towards investments (other rentals, stocks, etc.) Avoid the temptation to color all debt as bad debt. With rental properties, it’s all GOOD DEBT. OPM! OPM!
How to Evaluate Rental Properties with Cash on Cash – The Rest of the Story
This spreadsheet has a fun little section as you scroll to the bottom. The other reason I prefer to use CoC is hinted at above. You’re not required to re-factor every time your rental property appreciates in value. CoC will do the work for you, so long as you set a realistic appreciation target. Check out this snippet of the true “bottom-line CoC”:
That last line there brings it all home. A modest return of 16.2% all of the sudden becomes 29.8%, when you factor in the appreciation of the home over time. For my rentals, I use 2% as the annual appreciation target. At some point I may cut this to 1% to reflect a more tame housing market.
In Minneapolis these past several years, values have shot up crazily, and I don’t feel it’s sustainable by any means. Our $150,000 rentals could sell for $180,000 if put on the market today. That’s a 20% increase over the five years since we started. Realistically, I believe these properties will top out at $200,000 within the next decade or so.
This is the power of finding real estate in up-and-coming population centers. I.e., areas that have good urban renewal and infrastructure improvements going on. Remember that land is a finite resource. As long as our population continues to grow and migrates to cities, the demand for single family homes will rise, and supply will become constrained.
If you have the itch?
Let me know in the comments if you’d like to get your hands on this spreadsheet. I’m happy to share. You can play with the numbers and pose questions on any of it.
Down the road, I’ll share more about how I’m using cash on cash to evaluate rental returns on the Airbnb Experiment. Lots of variability with that thing. With it being a vacation rental you just can’t bank on rent rolls too much, until you’ve put a full year or two behind you.
Author’s note: This week’s publishing schedule is off by a day, but for a couple of very good reasons. One, we partied hard until 11PM (crazy!) on Saturday night, which required me to sleep in on Sunday. No blog work for me that day. Second, I have a fun guest post lined up this Friday over at 1500 Days to Freedom. I hope you’ll check it out, and then proceed to give me lots of crap for sleeping in on Sunday. 😉