Am I making a good return on rental properties?

Earlier this month, I wrote a couple of articles on real estate investing and it seemed to elicit a lot of responses and questions. Thank you for all of those by the way. One of the questions that I had promised to write an article on that it appears had some questions and debates on, is the one around how to analyze rental property returns. The most common phrase I have heard from multiple folks is – “I can cover my mortgage and expenses and the underlying property will appreciate. So this should be a good investment. Right?” Unfortunately that is not right. Not if you are looking at this as a true investment in comparison to your other investments. Today I am going to talk about two different fundamental calculations real estate investors do to assess a property’s return. There are probably other ways to do this but these 2 are the most popular and fundamental in real estate analysis. 

Location impacts returns 

Before we jump into the calculations though, I do want to introduce the idea of location as it impacts the returns. Location can be looked at in 2 perspectives. 

• The first perspective at a high level is which city you are going to invest in. There are many ways to analyze and think about this but I won’t go into that today. I am not an expert on this because pretty much all my investments are in one city (All my investments are in a mid-sized city in the Midwest of the US) so I don’t have the experience to talk about this. But I will say this – investing in High Cost of Living areas like major cities like New York, San Francisco typically means it will be much harder to find properties that will meet your minimum expected returns. This is simply a function of the price to rent ratio. The rents you can hope to get normally won’t be commensurate to the cost of the property. Now, this is a broad generalization and there are many investors who invest in these types of cities and make great returns but for the average investor, this is harder. 
• The second perspective is once you decide the city you are going to invest in – which neighborhoods are you going to invest in? In real estate parlance, there are typically 3 classes of neighborhoods. Class A, B and C. Class A neighborhoods are affluent neighborhoods with great school districts, shopping etc. You will see a lot of high end homes, condos and generally the property values will be much higher. Typically the kind of tenant profile you will attract will be higher income earning professionals. This is a generalization of course. At the other end, Class C neighborhoods tend to be typically lower income neighborhoods and the tenant profile is almost always lower income wage earners. Class C properties tend to be much lower priced. Class B is somewhere in between. There is a Class D as well which is really even worse than Class C and generally very few people ever invest in those. So why is this important? Well, I have learnt through my own process and what is common knowledge that you can expect higher returns in Class C neighborhoods (10% or greater CAP Rates) and much lower returns in Class A neighborhoods (4% – 6%). FYI – these rates are broad generalizations and just to illustrate my point and don’t take them as gospel. They will vary by city and a number of other factors. If the reason is not obvious, it is because of the price to rent ratio again. As we dig into CAP Rates, I will revisit this. 

CAP Rate (Capitalization Rate)

The CAP Rate is the most common and in my opinion, the most important and effective way to measure the returns of a rental property. There are criticisms about it but talk to any real estate investor and he/she will know what the CAP rate is and will tell you this a key measure they use. 

The CAP Rate is a calculation of the unleveraged returns from a property. What it simply means is this – assume you are going to buy the entire property in cash and don’t have a mortgage (I know, I know – most people are not going to buy it in cash but just bear with me here) – then it’s simply a calculation of what are the returns through cash flow with respect to the original investment. So it goes through a series of numbers – let’s look at them: 

1. Expected income – this is the first and important line. What rent do you expect from this property? You may get rent for the house and additional income/rent for renting out the garage or anything else on the property. This is the gross income. 
2. Estimated costs. Below are the all the costs you will need:
   • Property taxes and insurance – so a mortgage typically has 4 components – PITI (Principal, Interest, Taxes, Insurance). So for calculating the CAP Rate, i want you to forget about the Principal and Interest. So even if don’t have a mortgage, you still need to pay property taxes and insurance. So that is an ongoing expense. 
   • Any HOA (Home Owners Association) fees if the property is governed by an HOA
   • Property management expenses – even if you plan to manage this by yourself, you should always run your numbers with this. Typically this will be around 8% – 10% of the monthly rent or it may be a fixed fee around that number. 
   • Repairs and maintenance – even the best of properties will require repairs and maintenance over time and usage. Honestly, there is no one right number to estimate. This really depends on how old the property is and what condition the property is in. If the property is in great condition and if a lot of the structure, interiors, appliances etc. are newer then you can estimate a lower amount for maintenance. If the opposite is true, then you estimate higher expenses. I have seen different rules of thumbs being used – people will normally estimate between 5% – 10% but again that is a very broad generalization and you should be careful about that. 
   • Capital replacements – Taking it forward from the previous bullet, if you know the age of items like the roof, siding, appliances etc., you can get a good idea as to when you can expect to replace those and you should simply budget for it each month. If this is a HOA property that covers the building exterior, then you typically don’t have to worry about budgeting for this separately because your HOA already covers that. 
   • Vacancy – this is the one thing people tend to forget. As you have tenants turn over, you will have vacancy. But this again depends on the state of the market and the location/neighborhood you are in. Normally people estimate 5% which is roughly around 2 weeks in a year. It can obviously be more or can be nothing if you have long term tenants. 
   • The above are the most common costs to consider. So as you can see, your costs are not simply the mortgage but there are a bunch of different costs to look at. 

3. After you estimate all this, you subtract the costs from the rent to get what is called the Net Operating Income (NOI). 
4. Finally you need your original full purchase price of the property + closing costs + any up front investments you made for any repairs etc. to get your initial investment. Now you are probably asking the question – hey, I bought this on a mortgage so my initial investment was only the down payment. For CAP Rate calculations remember, we said you assume you just bought it in cash? So assume the full price of the house. 
5. You then divide the Net Operating Income (3) by the Initial investment (4) to get the CAP Rate. 

Below is how the calculation would shake out with a hypothetical example: 

Purchase price: $150,000 ; Closing costs: $3,750

CAP RATE (ANNUALIZED) = 5.2% [$7980 / ($150,000 + $3750)]

So let me answer the obvious question you probably have – why am I excluding mortgage in this? The simple answer is that the CAP Rate is the purest form of evaluating an underlying asset independent of your financing terms. So if you have a poor credit score and you end up getting a very high interest mortgage, the returns will look very poor simply because your financing terms were poor. But that does not give you the true picture of the value of the underlying asset. So for the finance geeks, this hits at the heart of another concept. The CAP Rate is also a way of valuing an asset. When investors invest in a property, they start with an expected CAP Rate and work backwards to see how much they would be willing to pay for the property. For multi-family properties which typically have only investor buyers, this is pretty much the way properties tend to get valued. For single family homes though, since there are a lot of regular home buyers, this is not the only consideration when a property is valued a certain way. 

So what is a good CAP Rate? 

Well, the answer is obviously – it depends! 🙂 It depends on when you are investing, which location you are investing in and last and most importantly, it also depends on what you are comparing these returns to. Let’s talk about each of these:

• When you are investing – I don’t like talking about this much because this is a market timing type question. Most people tend to get very obsessed about this – a common question is whether the market is too hot to invest now? So for eg, if you invested in properties in the 2010 – 2012 era when prices of properties hit rock bottom, then almost every one made a killing and could expect ridiculously high CAP Rates. But hindsight is 20/20. When prices were crashing, everyone was fearful and at that time did not feel comfortable investing. On the other hand in 2021 at the time of writing this article, the market is really hot and feels over-priced. But I don’t worry about this because I focus only on the next 2 criteria. Irrespective of the time I buy it, I will always figure out whether the underlying investment is sound based on the next 2 criteria. 
• Where you are investing – remember I started off this article talking about location? So depending on which cities or types of neighborhoods you invest in, you can expect a certain CAP Rate. And then compare those CAP Rates to other properties within the same neighborhoods to see if it makes sense. 
• What are you comparing these returns to? So this is the opportunity cost. If you have $X and want to invest it in either real estate, or the stock market or maybe cryptocurrency, you have to understand the risk adjusted returns and see if it makes sense from that perspective. However, remember in my earlier article I talked about comparing these to Bonds. So I expect in the long run to make 7% – 8% returns on the stock market but I don’t expect to make the same kind of return on my real estate portfolio because I invest only in Class A Neighborhoods and expect to get around 5%-6% returns on my properties. Most people would look at that and say that’s terrible. But I am OK with that because I almost view it as a bond portfolio and hence compare it to Bond returns. So my risk adjusted returns look very good actually. (Note: CAP Rates will increase over time as you increase rents slowly over your costs). Now you may feel like you have better use for your money and can earn much higher returns if you were to invest it in other vehicles. That’s a decision for you to make. 

You can google CAP Rates in different cities to help you get some sort of an idea of what to expect But again those are very general for the reasons I mention. If you start talking to other investors in a location, they will give you a very good idea of what they consider as expected and good CAP Rates. 

Cash on Cash Return 

So this is the other way to measure your returns. It’s the more intuitive way of measuring your returns. I like to measure both ways just to understand the differences. But given my style and type of real estate investments, they both tend to be pretty close. So let me explain the Cash on Cash return. 

Cash on Cash return simply does all the same things that CAP Rate does but with 2 key differences – 1) we include the principal and interest portion of the mortgage and 2) We call the upfront investment as the down payment instead of the full value of the property. Of course, you still include your closing costs and other upfront costs. So in effect, this is a true return for today based on what you actually invested in. Here is the math:

1. Calculate rent and all expenses like you would in the CAP Rate
2. Include the Principal and Interest in your expenses
3. The difference between 2 and 1 is your Net Income (NI). So your Net income now subtracts your entire monthly mortgage payment. 
4. For the initial investment, include your down payment (20% , 25% whatever you put) , closing and other upfront costs.
5. Finally, the cash on cash return is essentially the Net annual Income divided by your initial investment. 

It sounds very similar to CAP rate as I mentioned but more intuitive as a return on investment calculation. The only reason why I caution people on getting carried away with this calculation is this – there are a lot of real estate investors who will invest with zero money down and so this inflates the rate of return to a ridiculous number because your up front investment is almost nothing. The other point is what i mentioned earlier – depending on your credit worthiness, you are going to get a certain interest rate for borrowing cash. While that tells you how savvy or not savvy you are at leveraging cash, it does not tell you the true value of the investment like the CAP Rate does. Don’t worry if this is all too confusing – ultimately, run both the calculations and see what you find. I have created a standard excel template for you to download and use. Its nothing fancy but should get you started. Use this link to download the file.

Hopefully that was not too complicated. As you get into your real estate journey, I hope I managed to equip you with more information on how to analyze deals. Thank you for reading and I wish you success in your financial journey. 

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.