One of the things I love about investing in rental property is the return on investment (ROI). I still remember the first bit of advice I ever received on rental properties and ROI. Becky and I were planning to move and were thinking about transitioning the house to rental property. I knew that positive cash flow (monthly rent minus principle, interest, taxes and insurance) would be vital for this endeavor. But I didn’t know how to tell if the house would be a good rental property.
I asked the realtor how to tell if a property would be good to rent out. She gave the typical response: “If you can put 20% down on the purchase and the interest rate on the loan is 9% (this was in the mid 1980’s, remember), then you should be able to cash flow approximately $100 per month. That would be a really good rental property.” What she didn’t tell me was that since I was moving, I had to pay a 10% monthly management fee. In the end, there was no positive cash flow.
Having positive cash flow is foundational to building wealth through real estate. The formula that I now start with in any real estate investment consideration is a 1.5% gross monthly return on the full acquisition and rehab of the property. So if I buy a property for $85,000 and spend $15,000 on rehab then I now have $100,000 invested. A 1.5% gross monthly return for that investment would be $1,500 per month in rental income!
For some of you, $100,000 single-family properties are renting for $750-$800 per month, so this seems too high. In that case, you may have to focus on 2-4 unit properties to get close to this return. In other parts of the country, a median rental single-family property will cost $250,000-$300,000. Some areas are even higher! The point is that then the rents should be higher in order to reflect the true value of the properties. Rent should reflect the true value of the property.
It all boils down to this: What a rental property costs is not what is important. What a rental property will rent for is the important factor. Most of the time I can tell you within five minutes if a property will be a good investment. This is because I ask the first and by far most important question that should be asked on any property—including the one you would live in as your personal home! How much will it rent for?
In stock investing, we are always concerned about the price-to-earnings ratio, or the P/E ratio. We should be focused on the same thing in real estate investing. With rental property, rents are the earnings and the cost of the house is the price. That’s what you need to look at when determining if a property will serve as a rental property. It needs to have positive cash flow. So start with a 1.5% gross monthly return. It is possible to go as low as .8% gross monthly return in today’s low interest rate environment. But, if you go this low, the property should be a little nicer and rental demand should be above average for that kind of property in your area.
Have any questions about rental properties? Let me know in the comment section!
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