I am no real estate investment expert. I have used tried and tested ways to evaluate an investment before going down the road of deeper evaluation and due diligence. In order to evaluate a property’s income potential, I always start with the One Percent Rule: Does the monthly rent equal one percent of the purchase price or more? If the answer is yes, I continue with my diligence. If not, I move on to the next investment property.
Is the monthly rent greater than, or less than, $1,000?
In other words: for every $100,000 in price, I look for $1,000 in rental income. If a house costs $250,000, it needs to rent for $2,500 per month or more.
One percent is the minimum level of return I’d accept. But keep in mind, there’s usually a trade off between risk and reward.
If a house passes the One Percent Test, I look at a measure called the capitalization rate or Cap Rate. The “cap rate,” measures the return on the property value. Cap rate equals annual net income divided by the home price.
Here is an example.
Rent = $1,200 per month Mortgage, Insurance, Taxes, Hydro, Repairs, etc. = $950 per month “Net income” (your income after expenses) = $1,200 – $950 = $250 per month.
Multiply by 12 to find your annual net income: $250 * 12 = $3,000 In order to find the cap rate, divide $3,000 (annual net income) by the price of the house.
Let’s assume your house cost $200,000. $3,000 / $200,000 = 0.015
Multiply your answer by 100 to convert it into a percentage. The $3,000 in cash flow you are receiving translates to a 1.5 percent return on your property value. Definitely not exciting enough to pursue.
Finally, I scope out my cash-on-cash return: An equation that shows how far my cash will carry me.
The formula for this is annual net income divided by down payment. Using the same example as above:
I buy a house for $100,000. I put 20 percent down, or $20,000. The annual net income is $3,000.
$3,000 / $20,000 = 0.15, or 15 percent! Really good!