Napkin calculation method

Cash flow, rental income, expenses, ROI, Cap Rate? What do all of these mean and which are important?

We get asked all the time, how do I know if this is a good deal, or what numbers should I care about or use to investigate if a property is a good investment.

Here are the steps to take to estimate potential cash flow and return on investment. It's also best to plan for any unexpected expenses that could occur.

#1. Figure out the monthly income (gross income)

Income should include all rent, laundry income, parking income, etc. Rent is calculated by using the current tenants are paying, potential market rent (which a property manager like Simply Managed or realtor can help offer advice)

Make sure the rent you are using is realistic especially if the property is advertised as 'currently below market rent rates'. This is commong for a lot of investment properties we come across.

#2. Calculate the monthly operating expenses

These may include property taxes, insurance, property management fees, mortgage or financing costs, and homeowners association (HOA) fees.

Most importantly, don’t forget to estimate vacancy and repairs! They are a real part of any property investment, and they can dramatically affect the cash flow. Still, many people don’t think to include them in the expenses.

Here’s how to estimate your total expenses.

Property taxes

Look for a local area tax rate calculator from the city, county or state and use the selling price. Most of the time taxes adjust after a sale to a new higher rate!

Insurance

Get a quote from an insurance provider.

Property management company fee

Simply Managed offers a tiered fee structure between 8% and 12% around 10% of the monthly rent.

Utilities

Ask the previous owner for bill estimates to get a rough idea of your expected monthly spend.Or, if tenants will pay utilities, you don’t need to include this in your equation.

Financing

Talk to a lender or use an online mortgage calculator to calculate the monthly mortgage payment for your debt service.Most financers do require 25% down payments for strictly investment properties so it's best to check with a lender. If you are looking at a multi family and possibly living in one of the units this can change the lender requirements.

HOA

HOA fees are another thing to consider as they can dramatically change the expenses for a property. Have your agent double check if there are any pending special assessments, or if there may be something in the future. Special assessments can be quite costly.

Vacancy

A good rule of thumb is to conservatively estimate 10% of the monthly rent toward vacancy expenses. In situations where you have a property manager, like Simply Managed, the actual percentage could be much less. I still use 10% no matter what as a conservative margin.

Repairs

This is an estimate, but it should not be left out. Just like with vacancy, it's best to be on the conservative side. If a house is recently rehabbed or passes an inspection with flying colors, maybe 5% of the monthly rent is ok. If the property is not in top shape or aging, conservative could mean closer to 25%.

#3. Subtract the monthly expenses from the monthly rent

This is your net income—your monthly cash flow. You did it! Hopefully it’s positive. If it’s not positive, run and find another deal!

#4. Calculate the returns

Two numbers typically used are the cap rate and the cash-on-cash (COC) return.

#5.Capitalization rate (cap rate)

This gives you an idea of whether the property is a good deal. It basically compares the return on investment (ROI) to the purchase price. Here’s the cap rate equation:

Net operating income (NOI) ÷ purchase price (or market value, if you already own the property) = cap rate

*Note: mortgage rates are typically used in the cap rate calculation

#6.Cash-on-cash return

This number indicates how much return you are getting on the money you invest. If you pay all cash for a property, this number will be the same as the cap rate. If you are financing, this number is the most accurate way to see the actual return you are getting on your cash-in and the leverage. Here is the equation—and remember to include the mortgage payment, since this one is focused on financing:

Net annual income ÷ total cash invested = cash-on-cash return

Understand the difference? One measures how good a deal you are getting on the purchase price, and the other tells you the exact return on your money you are getting. They are the same for an all-cash buy but can be very different for a leveraged purchase.

If you have any questions or want help running numbers please give us a call! Our team is here to help guide you to finding a great investment.