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How to analyze a property as an investment

How to analyze a property as an investment

Good morning! Today Brandon Turner from Bigger Pockets explains how to analyze a property to make sure you get a great deal. Enjoy!

I know you are busy.

However, just because you are busy – doesn’t mean you shouldn’t seek to find an amazing deal when shopping for a rental property. In fact – I believe it’s because of your busy life that finding the best deal is so important. You don’t want to be stuck with a property that drains your time, empties your wallet, and makes you want to throw your tenant’s belongings off a twelve-story building.

Shopping smart is key, but at the same time – smart shopping doesn’t need to take forever. There are several “quick and dirty” techniques you can use to look at an investment property and decide if it’s something worth pursuing. This post is going to share my method for finding the best needles in the real estate haystack.

What Metrics to Measure

For me, cash flow is king.

Cash flow, in it’s simplest definition, is the profit left over in my bank account after all the bills have been paid on arental property. For example, if a property rents for $500 per month and all my expenses for the month come to $400 – then I’ve just made $100 in cash flow.

Cash flow is important because it adds money to my bank account each month, rather than take money away. It helps me save more and gives me a scorecard for measuring my investment’s potential.

The other side of the coin is “appreciation,” which is the value gained when real estate prices rise. While appreciation is a welcome thing, (I love when my property values rise) I don’t use appreciation to determine a good deal. After all – there is no way of predicting the future since my crystal ball broke last year. Appreciation is simply the icing on the cake, but should not be used to determine an investment’s future value. Again – for me, it’s all about cash flow.

So how much cash flow is good? We’ll get to that in a minute, but first- let’s look at the quick and dirty way to calculate it.

Knowing Your Expenses: The 50% Rule

One of the most valuable “tools” to a real estate investor is known as the 50% rule. This “rule of thumb” states that for a real estate investment – the non-mortgage expenses will usually average out to about 50% of the rent.

Huh?

Let me explain. If you own a 4-plex that brings in $2,000 per month – you can probably assume that over the long run, this property is going to cost $1000 per month in vacancies, maintenance, and other charges (not counting the mortgage.)

Now, it’s easy to estimate your monthly cash flow by simply taking the amount of money you have left (known as the Net Operating Income) and subtracting out the monthly mortgage payment – which you can find using any online mortgage calculator. My favorite is this one.

For the example we’ll use in this post, let’s assume we bought the 4-plex for $140,000 and put a $28,000 down payment for a total loan amount of $112,000. At an interest rate of 5% for 30 years, the loan payment works out to approximately $600 per month. Additionally, this four plex rents for $500 per unit, per month, for a total of $2,000 per month in rental income.

Going back to that first example, here’s how it would look:

Monthly Rent: $2,000 per month

-$1,000 per month (50% Rule)

– $600 per month (Imaginary mortgage payment for this example)

———————————————————

= $400 per month in cash flow.

Now – you may be tempted to argue with me that 50% for expenses is high – and maybe you are right. However, this “rule of thumb” has been used by a lot of seasoned investors for many years for one reason: because it seems to just work. Maybe you’ll have no expenses for several months, and then be hit with a ton (like me, this month!) Maybe your roof will go bad and need to be replaced. Maybe the heating system will go out. Maybe you’ll have an eviction. The 50% rule allows you to look at cash flow over the long run, which is why I advocate using it. If it ended up being less – you win! But at least you won’t be tempted to buy a property that is actually going to cost you money to own (negative cash flow…bad.)

So, back to our example… is $400 per month in cash flow good? Well, maybe. Let me explain how I determine it.

How Much Cash Flow is Right?

For me – it comes down to 3 different methods:

  1. Return on Investment: Your return on investment is the tool used to calculate your investment’s use. If a $1,000 investment gave you $100 in profit over a full year, your ROI (return on investment) was 10%. So, let’s look back at that example of the four-plex. We determined that we could expect about $400 per month in cash flow with a $600 per month mortgage payment and a $28,000 investment (down payment.) $400 per month is $4,800 per year. $4,800/$28,000 = 17.14% return on investment. Also keep in mind that this ROI does not include any appreciation, tax benefits, or loan pay down (each month, the balance on the loan drops a little bit.) Officially, this number is known as your “cash on cash return on investment” and is a good way to compare your investment with other investments like stocks, bonds, or mutual funds.
  2. Per-Unit-Profit: Even more quick and dirty than the ROI measurements, sometimes it’s enough just to look at the “profit per unit.” This means – if I were to buy this property, would I clear a certain price per unit in cash flow? This is truly the “quick and dirty” way to analyze a property: begin with the total monthly income and use the 50% rule to take out the expenses. Next, subtract the mortgage amount. Using the example we discussed earlier, the fourplex supplied $400 per month in cash flow – or $100 per unit, per month – which is the minimum amount I’d ever generally accept though I like to see $200 per unit, per month.

The 1% Rule

Another “rule of thumb,” I should mention, and the fastest way to quickly decide if a property is worth pursuing, is known as the 1% rule. The 1% rule states that an investment property should rent for at least 1% of the purchase price. So, the fourplex we discussed earlier – which was bought for $140,000 – should bring in at least $1400 per month in total income (which, according to our example, it does meet.)

Some investors choose other ratios, such as the 1.5% rule or the 2% rule to achieve greater returns and greater cash flow. I typically won’t buy anything below 1.5% and try to aim for 2%, though your percentage may depend on your location and risk tolerance.

Conclusion

Did I lose you? Hopefully you stuck with me on these calculations!

The methods I mentioned above can be used to quickly analyze an investment property for further investigation. With thousands of properties listed for sale at any time, it’s simply impossible to do a thorough analysis of each. This is why these “quick and dirty” methods can be great for filtering properties and only looking at the best options.

One final disclaimer: never buy a property based entirely upon one of these methods. This is a way to filter out the 99% of properties that are not good deals and only focus on the best. Do your homework and learn what the actual expenses and income are, and buy amazing properties.

No matter how busy you are – I encourage you to spend some time trying out your new math skills to analyze some properties. Once you are good at it, you’ll be able to decide if a property is worth pursuing in just seconds – saving you time and helping you build wealth at the same time.

Do you have any questions about analyzing properties? Feel free to leave me a comment below and let’s chat!

brandon turner

 

Brandon Turner is the Senior Editor at BiggerPockets.com, the real estate investing social network. He can be found writing epic posts about real estate like the Ultimate Beginner’s Guide to Real Estate Investing or Tenant Screening: The Ultimate Guide.

 

 

 

This post was featured on the Carnival of Retirement, Satisfying Lifestyle Carnival, thank you!

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Lovely comments

  1. Thomas | Your Daily Finance says

    Hey Brandon nice example. I am a little confused on the returns. Should I expect more from a four plex verses a single family home? Or should it still work out to be the same? Also when you speak of the mortgage are we factoring in insurance and other expenses as well? And does this work with only a certain amount for the down payment? Thanks!
    Thomas | Your Daily Finance recently posted…Grocery Shopping List: How I Save Money on GroceriesMy Profile

    • Brandon Turner | BiggerPockets says

      Hey Thomas,

      It’s hard to say what you’d get better returns from, it largely depends on your area, the price, rents, etc. However, $2000 cash flow per year on a $10,000 investment is 20% cash on cash no matter what kind of property it is. Does that make sense?

      And when referring to the mortgage, in regards to the 50% rule, no – I’m only counting the principle and interest payment.

      And technically, it could work for any down payment amount – because the amount down will make the payment change. For example, if you find a house for $100,000 and put down $100,000 (so, no loan at all) then your cash flow projection would just be the 50% of the income minus $0. Or if you put down $0, your cash flow projection would be 50% of the expenses minus the monthly payment on $100,000. I have a feeling I’m just making this more confusing, huh?! Thoughts?
      Brandon Turner | BiggerPockets recently posted…5 Lessons Crazy Cat GIFS Can Teach Us About Entrepreneurship (Prepare to Smile…)My Profile

  2. Free Money Minute says

    Thank you for the explanation. I am looking at a property near my home and would prefer to pay cash for it. This would be my first rental, but probably a good move in our situation. Thanks for the tips on what to look out for.
    Free Money Minute recently posted…Run for Your Lives!My Profile

  3. Glen @ Monster Piggy Bank says

    In Australia property prices are so high that you would need to follow the 0.5% rule – I’m not even joking, affordability is so terrible over here. Most people end up buying properties and renting them at a loss for a few years just for the tax breaks the government gives to property investors.
    Glen @ Monster Piggy Bank recently posted…What is your 5 year plan?My Profile

  5. Rita P says

    Those were real quick tips to analyze investment on property. It is always good to do your homework before investing money. The 1% rule was something new for me to learn. Thanks for sharing those valuable tips Brandon
    Rita P recently posted…Become rich now or neverMy Profile

  7. Alexa says

    I LOVE these rules. I had previously heard of the 1% rule although I think I would sway closer to 2%. But the 50% rule is awesome. For me, 50% does seem a bit high but thats why I like it. It makes me feel safe. I definitely want to get into rental properties and I will keep these rules in mind when shopping. Fantastic advice!
    Alexa recently posted…5 Ways to Keep Preschool Aged Kids Entertained on the CheapMy Profile

  8. Mrs PoP @ Planting Our Pennies says

    I think your disclaimer should be in size 100 font. When people see us mention our duplex they all too often under estimate the costs we have associated with it by using rules of thumb. I was comparing insurance with someone else recently and realized at the time of our purchase, we paid about 9x the “Rule of thumb” estimate for insurance. Not for premium coverage, but for the insurer of last resort. You’ve got to run the actual numbers and make sure they make sense before pulling te trigger.
    Mrs PoP @ Planting Our Pennies recently posted…He Said She Said – The Banana Thief!My Profile

  9. Romona (@ Monasez) says

    Gret information in this article. I love to watch the show income property on HGTV and there were some things I was confused about as far as making money but this article kind of put the pieces together. It’s my goal to purchase a triplex in the city in the next two years, so this information has been very helpful.
    Romona (@ Monasez) recently posted…How to be eco-friendly affordablyMy Profile

  12. Brian @ Luke1428 says

    Rentals are a great investment and this is solid advice Brandon. The more an investor can put down initially the safer the investment becomes for them and a higher monthly cash flow they will see. We’ve bought our last several properties with cash which ends up removing many worries related to needing money to cover the mortgage, expenses, etc.
    Brian @ Luke1428 recently posted…A 15-Yr. Old Life Should Never End This TragicallyMy Profile

  14. Lindsey @ Sense & Sensibility says

    Thank you for this article. I think the 50% rule is perfect. Whenever I’ve thought about investing in real estate, I’ve wondered what I should set aside for maintenance and other unexpected costs. This gives me some more information to work with as we plan our first real estate purchase. Cheers.
    Lindsey @ Sense & Sensibility recently posted…Spend Less Money & Weekly ReviewMy Profile

  17. Mr. Utopia @ Personal Finance Utopia says

    These are solid tips and were explained in a clear, concise manner. Investment properties have always been something I’ve been interested in, but I’ve never had the funds in place to ever really consider. I’ll be incorporating these rules when that time comes to seriously look into rental properties. I think my main concern over investment properties would be the time it takes to manage them. They’re supposed to be “passive” income, but there sure seems to be a need to spend time collecting rent, paying the bills, making sure repairs are done, finding renters, evicting, etc.
    Mr. Utopia @ Personal Finance Utopia recently posted…Are Paid Vacations Really a Job Benefit?My Profile

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  27. Dave says

    I’m late to the party here, and new the this real estate thing (just learning for now), but I have a questions about the “cash on cash return on investment”. Is the value of the home not included in there anywhere?

    And doesn’t that mean that this would incentivize putting less down on a rental property?

    As a quick example (I’m just making up numbers, not sure if they are realistic), let’s say there are two indentical homes that are $200,000 and each generates $500 per month.

    Person A buys home A and puts down $50,000, leaving $150,000 left.
    Person B buys home B and puts down $20,000, leaving $180,000 left.

    $500/month would be $6000. Person a has made 12% (6k/50k) and person B has made 30% (6k/20k).

    Person B has done better, but this seems backwards to my normal line of thinking that it’s better to put more down on a home than less. What is different here?

    Anyway, I’m new to all of this and my math could be off, but is there something I am missing?

    Cheers!

  29. tony says

    I’m amazed at your 1% rule and totally gobsmacked by you and others aiming more for 2%. In any part of Australia in the last 25 years that I know of, the best you can hope for is about 0.1% per week, which is about 0.4% per month in your method. And these days houses mostly don’t even get this. 0.3% per month would typically be more like it.

  30. Gerald Vonberger says

    You mentioned some very interesting principles that I hadn’t heard of before. I’m new to property investing, so this is all very foreign to me. I bought a couple of properties around a lake nearby, and I’m about ready to start renting them out. I think the “50% rule” that you explained is a great thing to know so that I can plan on general expenses over the next few years.

  31. Loms says

    Hi Brandon
    I’m Loms from Christchurch NZ
    Thanks for the tips, I have learnt a lot from your bigger pockets YouTube clips.

    Would u recommend for starting out, looking for investment properties in your own hometown first before the wider country?

    I really want to break thru in buying investment properties with OPM for a number of reasons, first being I don’t have much of my own, second being I want to push myself out of my mindset that having little money is an obstacle, so I can overcome that.

    Would u recommend that I find the deal first and put together a summary before I find a lender, knowing that my bank will say no so looking for alternate options?

    Thanks for your time
    Loms

  32. Buying real estate says

    Much thanks to you for the clarification. I am taking a gander at a property close to my home and would like to pay money for it. This would be my first rental, yet most likely a decent move in our circumstance. A debt of gratitude is in order for the tips on what to pay special mind to.

  33. Buying real estate says

    Much thanks to you for this article. I think the 50% tenet is great. At whatever point I’ve contemplated putting resources into land, I’ve pondered what I ought to set aside for support and other startling expenses. This gives me some more data to work with as we plan our first land buy. Here’s to you

  34. hafiz. malik says

    so far all articles i read does not address sinking fund or capital recovery factor. some how it is tied to mortgage payment , what about down payment , depreciation , ( land generally over keeps up with inflation ) tax break at the end I want my capital investment back in “present worth” amount . My rental investment should not be ” similar to some kind of annuity ” I am not account nor tax lawyer .

  36. shantanu sinha says

    Hello Pauline,

    These are some great tips. Very useful.
    It is always good to do little bit of homework, before one is planning for
    their investments.

    Got to learn about the 1% rule, that was something new here.
    I would love to implement these points when I go for something new rental properties.

    Thank you for sharing this among us.
    Shantanu sinha
    shantanu sinha recently posted…Top 15 Sites to Search Property ListingsMy Profile

  37. Donald says

    Quite helpful information shared here!!

    But do always remember that:

    Home decoration is not counted anywhere in property appraisal, Property appraiser is concerned about heating & air conditioning system, security system, smoke detector, fireplaces, windows, doors and so on.

  38. Mangrove Realty says

    Woo this is something great..
    While different sized properties require more or less analysis, but still you need to follow the steps.

    Larger investment properties are priced/valued differently. The value of larger investment properties is directly related to how much income/profit it produces for its owner.

  39. Catherine says

    Hi there, I am looking to buy my first rental property and need help analyzing whether it’s going to give me enough cash flow.
    The house is a natural 3 bedroom and I plan on turning a livingroom into a 4th bedroom just by adding a door. It is 300k, putting down 60k and projected monthly income is $2400 for student rentals. I’m new at this so I’m not sure if my resulting numbers are correct. It’s generating some cash flow but is it enough in your opinion?

  40. David Barney says

    I Love these standards. I had already known about the 1% principle in spite of the fact that I think I would influence more like 2%. However, the half run is great. For me, half seems somewhat high yet thats why I like it. It makes me feel safe. I certainly need to get into investment properties and I will remember these guidelines when shopping. Fabulous exhortation!

  41. linda Prin says

    It is good to find out that we should plan for 50% of our rental to go to expense and up-keep of the place. My husband and I have been wanting to turn a part of our home into a rental and I will have to crunch some #’s to make sure that it would be a benefit to us. I will consider the investment and post later what I decide, but thank you for your expert opinion.

  42. MA says

    Hi Brandon, like the rules and standards but I need more help. Looking at a one-bedrm condo for $460,000, putting 25% down, mortgage of $345,000 for 30 years at approx 4.02% interest rate. Estimated rental $3,000………… is this a good investment?

  44. Adam says

    Good post share. This would be my first rental, but probably a good move in our situation. Thanks for the tips on what to look out for.

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