There are a few different rules of thumb when it comes to analyzing a property to determine its potential cash flow, but the one that hasn’t failed me yet is known as “The 1% Rule.” It dictates that a rental property must fetch at least 1% of its purchase price in rent per month (which would be a 12% gross return annually). While 1% is the very least I will consider, it is a great initial filter to use that I can calculate in my head to see if a property is even worth looking at. All of my deals exceed the 1% rule by a healthy margin.
Many single family homes in metropolitan areas don’t meet the 1% rule, much less exceed it; hence, my focus on student and multifamily housing. When you account for the various expenses of maintaining a property such as HOA dues (for condos/town-homes), insurance, taxes, property management fees and saving for large capital expenditures such as a hot water heater or roof, it is pretty clear how your profit margin can be whittled down. Also, this is assuming you own the property in cash – it doesn’t even take into account the mortgage payment.
However, it’s important to also keep in mind that just because a property is renting for a certain amount, doesn’t mean that it it limited to renting for that amount. Sometimes, landlords don’t raise rent for years because they have good tenants. While that may save them in lowering turnover costs, it’s important to do a cost/benefit analysis to see which scenario would result in a larger profit.
There are also ways that you can creatively “juice” the returns, though if you have to do this to a <1% property to get it over the 1% threshold, it probably isn’t worth it. For example, in the case of student housing, if you offered individual leasing, you could likely get more in rent for the property compared to if you just rented the whole property out for one price. Similarly, if you had a multifamily property, you could add a coin-operated laundry machine or vending machine to generate more income without needing to add more space.
Something I think it’s also important to add is to make sure to keep a very healthy margin for error when calculating a property’s potential return. This means underestimating rent(s) and overestimating expenses, because there will always be unexpected repairs that need to be made and a tenant who will miss a payment or two (but hopefully they catch up). You don’t want a slight mishap to spell disaster for your investment.
When it comes down to it, real estate investors buy property because the cash flow from rent compared to the relative price of the property makes sense financially (aka meets or exceeds the 1% rule).