The Harton Team is working with a nice handful of investors at any given time, some looking for “flips” that can bought, renovated and re-sold quickly for a decent return, and other looks to build their portfolio with rental properties they hold onto for the longer term. Evaluating both of those options involves completely different metrics, of course, and the latter is generally the more complicated.
There are, in fact, at least three different ways to calculate returns on rental properties, but once you get the hang of them you can often do the math in your head (or on a short spreadsheet stored on your iPhone, like we do!)
The rent ratio is calculated by dividing the monthly rent by total cost of the property (purchase price + financing costs + rehab costs):
rent ratio = monthly rent / cost of the property
For example, if the total cost of a property were $100,000 and monthly rent were $1,000, the property would have a rent ratio of exactly 1%.
Generally, we look for a ratio of at least 1%. Some investors we work with look for ratios as high as 2%. Obviously the higher the ratio the better, all other things being equal. What we’ve found, however, is that for a single family home in a good school district in central Virginia, 2% is a hard mark to hit.
Note that this ratio does not factor in expenses. This is important to understand. Most rental investors won’t buy properties with HOA (homeowners association) fees but with rates as low as they have been recently interest doesn’t add a heavy load to the P&L. As a result, we area often comfortable using this as an initial assessment, without expenses, of a property.
The next two ratios, however, do factor in costs.
Short for capitalization rate, the cap rate enables you to evaluate and compare properties without factoring in financing. The formula is simple:
Cap Rate = Net Operating Income / Total Cost
Net Operating Income, or NOI for short, is based on annual numbers and is gross rents minus all expenses, but excluding the P&I portion of a mortgage payment. For many properties, expense include taxes, insurance, repairs and vacancy (these last two are often overlooked by investors, much to their eventual woe!)
Generally, a cap rate of at least 6% or better is a must. While our investors don’t always calculate a cap rate for their investments (the rent ratio is enough), properties fall in the 8 to 10% range.
Note that the cap rate does not factor in the cost of financing. Our third and final ratio does.
Cash on Cash Return
The final ratio is the cash on cash return. You calculate this ratio by dividing your cash flow by the cash you have invested in the property:
Cash on Cash Return = Pre-Tax Cash Flow / Total Cash Invested
Pre-tax cash flow is simply annual rents less all cash outflows (including the P&I of the mortgage payment.
Most look for a ratio of between 15 and 25%. For most, the actual ratio is meaningless. As you can tell, the more leveraged you are, the higher the ratio but this alone wouldn’t make an investment a reasonable one. We absolutely look at the actual cash flow we believe a property will generate. A positive cash flow is a must. But calculating a cash on cash return ratio is of little value to our investors in most cases.
Make sense? Let us tell you more about how we help our investors search for, evaluate, negotiate for and ultimately make money on their real estate purchases!