The 10% Rule
Simply take the annual gross rent and divide it by the purchase price. If the result is 10% or better, you have found a potentially attractive investment property. Such a find could deliver levered cash-on-cash yearly dividends in the teens, which is not a bad investment in today’s world. This rule works today because of the relationship between financing, rents, and expenses.
Today, one can obtain financing for single-family and 1-4 rental properties with interest rates from 3.5-4.2%, depending on the loan type. Rates this low require a 20% down payment. The interest rate is key because in order to benefit from the magic of positive leverage, the cap rate must exceed the interest rate.
Understanding the Cap Rate
The cap rate is one accounting term all real estate professionals should know. Starting with gross rent, subtract expenses such as vacancy allowance, utilities, taxes, insurance, and maintenance. For a typical single-family home, these expenses will consume about 25% of the gross rent. Do not consider a loan payment or taxes at this time.
Subtracting these expenses from gross rental returns the net operating income or NOI. Dividing NOI by the purchase price delivers the cap rate. In the typical case where gross rent is 10% of the purchase price and the expenses consume about 25% of the gross rent, the cap rate will be 7.5%. Notice how the cap rate of 7.5% exceeds the loan interest rate of 3.5%? This is positive leverage.
Making Money on the Bank’s Money
It only makes sense to borrow money if you can achieve positive leverage. When you do so, you are making money on the money you borrow. In other words, you are getting paid to borrow money. In this example, if you borrow 80% of the purchase price at 3.5% and employ it in an investment that yields 7.5%, you can achieve a levered return in the low teens.
Performing much more detailed and thorough analysis is necessary to truly judge the risks and benefits of an investment property. Those skills will be a subject of a future blog. However, using the 10% Rule can help you quickly find the potential investment opportunities.