Real Estate Investment Basics

The numbers every first-time investor needs, from NOI and cap rates to cash-on-cash return, financing and the reserves that keep a deal alive.

Four ways a property makes money

A rental property can pay you in four ways:

  • Cash flow: rent left over after expenses and the mortgage
  • Appreciation: the property becoming worth more
  • Loan paydown: tenants' rent paying down your mortgage principal
  • Tax benefits: mainly depreciation, which reduces taxable income

    • Different strategies lean on different sources. A high-yield property in a flat market is mostly cash flow; a low-yield property in a growing market is mostly appreciation.

    Net operating income

    Net operating income (NOI) is the rent you actually collect minus operating expenses: property tax, insurance, repairs, management, and an allowance for vacancy. It is calculated before mortgage payments.

    NOI is the foundation of almost every other number, so estimate each expense from real quotes and records rather than rules of thumb once a deal gets serious.

    Cap rate

    The capitalization rate is NOI divided by the property's price. A $300,000 property producing $18,000 of NOI has a 6% cap rate.

    A higher cap rate means more income per dollar invested, but often more risk or less expected growth. Residential cap rates commonly range from about 4% to 10% depending on the market. Comparing a property's cap rate with similar properties nearby shows whether its price is in line.

    Cash-on-cash return

    Cap rate ignores financing. Cash-on-cash return measures what you earn on the money you actually put in: annual pre-tax cash flow after the mortgage, divided by your cash invested.

    If you put $75,000 into a property (down payment plus closing costs) and it produces $4,500 a year after all expenses and loan payments, your cash-on-cash return is 6%.

    Quick screening rules

    Two rules of thumb help filter listings quickly:

  • The 1% rule: monthly rent of at least 1% of the price suggests the property may cash-flow. A $200,000 home should rent for about $2,000 a month.
  • The 50% rule: over time, operating expenses excluding the mortgage tend to run near half of rent.

    • Both are screens, not analysis. In expensive markets few properties pass the 1% rule, and real expenses vary widely.

    Financing

    Loans for investment properties usually need a larger down payment than a home you live in, commonly 15% to 25%, and carry higher rates. Some lenders offer DSCR loans, which qualify you on the property's income: the debt service coverage ratio is NOI divided by the annual loan payments, and lenders typically want it at or above about 1.0 to 1.25.

    If you live in one unit, FHA loans allow as little as 3.5% down on properties of up to four units.

    Reserves and risk

    Most deals that fail do so because of cash, not because of the market. Keep reserves for vacancy and repairs; several months of expenses is common advice. Get insurance quotes before you make an offer, and model what happens if the unit sits empty for two months or the roof needs replacing.

    Leverage multiplies both gains and losses. A deal that only works if everything goes right is not a good deal.