How Do I Evaluate a Rental Property?

Choosing the right house to buy as a rental property can be a daunting decision and can put you in a financial hole if done willy-nilly. We’re here to help inform that decision before you just send it like Leeroy Jenkins.

Real estate investing can be a great investment option for those who prefer more control over their investments compared to stock market investing. Rental property investing isn't nearly as passive or straightforward as index fund investing, but it can be highly lucrative (if done wisely).

Not every house would make a great rental property. In fact, very few homes make a great rental property, when looking strictly at the numbers. At the end of the day, you’ll want to find a rental property that will turn a decent profit after accounting for all operating expenses.

We’ll talk about two common methods of screening a house to determine if it’ll make a good rental property: the 1% rule and 50% rule.

The 1% Rule

The 1% rule is the simplest and least detailed way to screen a property, helping you quickly determine if the property is worth digging into further.

To determine if a property passes the 1% rule, simply divide the estimated monthly rental income of the property by the estimated purchase price. If the resulting number is 0.01 (1%) or greater, the property passes the 1% rule. If a house is selling for $150,000, it would have to rent for $1,500 a month to pass the 1% rule.

The 1% rule is good for quickly picking out the potential winners in a sea full of losers, but don’t stop your scrutiny here.

The 50% Rule

The 50% rule suggests that a house’s total operating expenses (the things you’ll need to pay for as the landlord to sustain the property) will total 50% of the house’s monthly rental income. If a home is expected to rent for $2,000, this rule suggests estimating $1,000 in monthly expenses. Like the 1% rule, this can help you quickly decide if a property is worth pursuing.

However, also like the 1% rule, this is only a rule of thumb. These “rules” alone are not enough to convince you to throw your money at a house. They’re simply screening criteria to weed out the obviously bad investment properties.

Cash-on-Cash Return

If you’re satisfied with your initial screening of a prospective rental property, it’s time to get into the weeds.

The cash-on-cash return is a calculation of your potential return in relation to the amount of money you’ve personally invested in the property

As a formula, cash-on-cash return is calculated like this:

Cash-On-Cash Return = Annual Pre-Tax Cash Flow ÷ Total Cash Invested In The Property

If your net income (rent minus all expenses) over a year is $1,200 and your total down payment, closing costs, and home renovations total $12,000, your cash-on-cash return is 10% ($1,200 ÷ $12,000).

The higher the cash-on-cash return, the more bang for your buck you’re getting. But also the more leverage (debt) you’re probably using. If you find a way to snag a rental property while putting $0 down between your down payment and closing costs, your cash-on-cash return is technically infinity.

Your target cash-on-cash return will be dependent on your goals. Some real estate investors aim for 8% or more, while others will settle for nothing less than 12%. Personally, I wouldn’t want to invest my money, time, energy, and remaining hair into a house that earns me equal to or less than my sweet, sweet index funds (~8% annually).

Side note: to determine how much a house could rent for, pull rental comps (short for comparisons), talk to an investor-friendly realtor or other investors in the area you’re looking to purchase in, or do both. To look at rental comps, check out Zillow, Realtor, Redfin, or Rentometer.

One important thing to note is that if you get paid $1,000 a month in rent from a tenant, you aren’t keeping all $1,000 as profit. Rental properties can be needy, and you’ll want to set money aside each month to cover four major expenses:

Maintenance: Routine maintenance tasks on your house, such as toilet repairs, air filter replacements, etc. (set aside ~5% of your rental income each month)

Vacancy: Regardless of whether or not there’s a tenant living in your property, you are still responsible for covering the bills every month. When you don’t have a tenant, you are responsible for paying your entire mortgage, utilities, etc. Putting money aside each month can lessen the pain of any vacancies (set aside ~5% of your rental income each month).

Capital Expenditures: These are the big, infrequent, but costly expenses you make on a property, such as a roof replacement, HVAC replacement, etc. (set aside ~5% of your rental income each month)

Property Management: If you don’t manage your property yourself, you’ll need to pay a property manager to do it on your behalf. Most property managers charge you 10% of the monthly rental income for their services.

In total, that’s 25% of your expected rental income that you’ll need to factor in when running the numbers on a property. These numbers per expense can increase or decrease as you see fit, depending on the home’s condition, your risk tolerance, management fees, and the average vacancy of similar homes within your local housing market.

On top of these expenses, you’ll want to factor in any HOA fees, whether you or the tenant will pay utilities (this is mostly relevant for multi-family properties with shared utilities), any lawn care fees (unless you plan on having the tenant handle it), and more.

If after accounting for all expenses a property meets your desired cash flow (that is, your net profit each month after expenses) and cash-on-cash return numbers, you have the means/desire to buy it, and it won’t derail your other financial goals, go for it.

BiggerPockets has an awesome rental property calculator to help you crunch the numbers on a property. It’s highly customizable and you can run a number of free reports before having to upgrade to a pro account.

To be clear, I don’t think everyone should invest in real estate. It requires planning, analysis, patience, and organization to truly crush it, although you can develop systems along the way to ease the process.

Call to Action

Pull up your real estate app of choice (Zillow, Realtor, Redfin, etc.) and find a property listed for sale in your area that you think may make a good rental property. Run it through this calculator to see if your eyes deceived you (spoiler: they probably did).

What We’re Reading/Listening To:

If you’re interested in real estate investing, read BiggerPockets and listen to the Afford Anything Podcast. BiggerPockets is an online community of real estate investors with forums, tools, and networking opportunities that can help you learn and get your foot in the door with real estate. Paula from Afford Anything is a wealth of knowledge on all things real estate.

Debrief on Deck

Next week, Wilson will come back from the woods to talk about the Federal Reserve. Who are they, what do they do, and are they the Illuminati? Guess we’ll find out next week.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

Disclaimer