At least once a week on our physician communities, someone asks a question about whether or not they should buy a rental property, or whether they should rent out or sell their existing home when they move. The answer we almost always give is, “Will it cashflow?” You don’t want to get stuck with a real estate property that is a liability. What this means is that the net operating income, or money coming in after expenses are paid, is positive. Of course, ideally it’s not just breaking even, but actually bringing in significant profit, but what significant means is different to everyone, and can change from market cycle to market cycle.
This article will cover how to determine whether your property will cashflow, whether it’s a short term rental, a midterm rental, or a long term rental. Of course, these are all estimates, and real estate investments can always throw curveballs your way, so we recommend being as conservative as possible and thinking about worst case scenarios when plugging numbers into your cash-on-cash calculators.
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Real estate investing is attractive to our members for many reasons (see our article on 5 reasons why physicians invest in real estate here). It’s often cited on the groups as a route to financial freedom. While real estate can be an amazing investment, it’s not without risks. One of the biggest risks is the possibility that the property turns into a money pit where the expenses outweigh the money coming in, and instead of creating monthly income for you, you find yourself paying out of pocket to have that property. When you’re looking at an investment property, you want to try your best to ensure that doesn’t happen.
Buying a property for investment purposes is very different than buying a primary house. Most people don’t view their primary house as an investment, but rather a place for them to come home to that should feel like home (and we believe this is the right way to look at it!). What this means though, is that decisions aren’t necessarily made on what’s going to get them the best return on investment financially but rather on general happiness.
When you buy an investment property, though, you just want to look at the numbers. Does it cashflow? What are the liabilities? How am I leveraging debt effectively to maximize return? Where can I add value to the investment asset to make it appreciate for a higher price at sale?
Assessing Potential Rental Property Investment Opportunities: Does it Cashflow?
When you decide that you’re going to get started with active real estate investing in properties, one of the first things you’ll likely do is get an investor agent (or a few) in the market that you’re looking to invest in. If you don't have an investor agent in the market that you want, you can use a resource like Bigger Pockets to find one. They’re going to send you potential investment opportunities, likely along with their projections on what that property should net you.
Remember, although a good investor agent is going to want you to invest with them time after time and therefore should be incentivized to make sure you have a good experience, at the end of the day, they make their money when you buy a property. So while you should look at their projections, you’re also going to want to run your own and ensure that you believe their assumptions and that they underwrote them conservatively enough for your level of risk. Assuming the property doesn't have any obvious major dealbreakers, the first thing you're going to want to ask yourself is if the rental property cashflows.
The 1% Rule
Before you get too into the numbers, one quick way to screen whether or not something even warrants a further deep dive is by using the 1% rule, where you essentially divide the monthly rent by the purchase price. If that number isn't >0.01, chances are that it's not worth your time to dig into. This becomes important in markets where you're seeing properties coming onto the market daily. In slower markets, you may have more time to look at some of the pros and cons of each property before it flies off the market.
What is Cash On Cash Return?
A cash-on-cash return basically gives you a way of taking the business plan of a property and projecting out the cash distributions while you’re holding that investment. This is different from the total ROI of a project, which will also take into account what you make on the property at the time of sale for a total return on investment for the original amount you’ve invested. Because you don’t know what you’ll sell the property at and when that will be, the key to a good long term rental investment is knowing that while you’re holding the property, it will not be a liability that is taking money out of your pocket.
Enter the cash-on-cash calculator, which will take into account the expenses of the property (paying back mortgage, insurance, maintenance, property management fees if applicable, etc) and the income of the property (rental income) on an annual basis, and calculate how much of a return you’re getting on the money you put into that project.
Cash on Cash Return = Total Cash Invested / Annual Pre Tax Cash Flow
The Cash On Cash Calculator
If you google ‘cash on cash calculator’, you’ll find many results where you can plug numbers in, often with different ones depending on the type of investment opportunity. While each is slightly different and varies in how complex they get, they will focus on a few basic big picture things.
Inputs Into the Cash on Cash Calculator
As a general rule, when you're thinking about what numbers to plug in here, overestimate rather than underestimate. You'd rather be pleasantly surprised with a good return over what you expected than find you underestimated costs and the property is actually not profitable.
Total Cash Invested
Initial Costs (repairs, renovations, if you’re doing furnished rentals, furniture, legal, accounting, etc)
The Monthly Ongoing Costs of Debt (Principal and Interest Payment on the Mortgage)
Calculated based on the amount of the mortgage, interest rate, and the term
The Ongoing Expenses
Property Management Fees, if applicable
A Reasonable Maintenance Budget for Ongoing Maintenance and Things that Could Go Wrong
HOA or condo fees, if applicable
Other fees that may be applicable depending on your contract
Services such as landscaping, shoveling snow, etc
If a midterm or short term rental, additional expenses
Website/Marketing for the property
Booking or Platform fees for things like AirBNB, VRBO, other listing services
Taxes for lodging, etc
Subscriptions (Internet, Streaming Services)
For long term rentals, this will be straightforward as the amount of rent per month
For short and midterm rentals, you will have to include
Average daily rate
If you don't know where to find the information about what the property would likely rent for, you can look at online sources for similar properties and what they're renting for or talk to your realtor/investor agent to get an idea of what numbers to plug in. For short term rentals, you can use tools such as AirDNA (PSG affiliate link) to figure this out.
Outputs of the Cash on Cash Calculator
Monthly Net Operating Income
This is a simple equation. Note, most people don’t include mortgage payments in this number.
Net Operating Income = Monthly Income - the Ongoing Monthly Expenses
Annual Cashflow = (Monthly Net Operating Income - Monthly Principal and Interest) x 12
Cash on Cash Return
Cash on Cash Return = Annual Cashflow / Total Cash Invested
What is A Good Cash On Cash Return on a Rental Property?
This is a harder question to answer, unfortunately. For a long term rental, we generally have quoted 10% as a good cash on cash return. In today's market, that may be harder to find, and you may find yourself taking on properties that provide slightly less return because you believe in the other benefits you'll get from them such as the long term appreciation potential of the property. For short term rentals, we'd like to see higher returns given that the work involved in them is generally higher with turnover of tenants and the business of marketing.
If your cash on cash return is calculated as positive, you are at least fairly confident that the property won’t be a liability. From there, you can then compare this against other things you might do with that same amount of money, such as investing in a three fund portfolio or short-term investment. That gives you the tools to decide if this particular investment is ‘worth it’ for you. Remember, of course, that even if two investments give you the same cash-on-cash return, there may be other benefits to investing in real estate that give real estate the edge, such as the tax benefits and the potential for appreciation for additional returns. Just remember, don't get emotional about real estate investments - it doesn't matter how beautiful the property is or if it's located in an area you want to invest in. The numbers have to make sense. If they don't, move on and wait for an investment opportunity where the numbers do make sense.