How it's calculated
NOI = collected rent − operating expenses (tax, insurance, maintenance, management, HOA, other)
Cash flow = NOI − mortgage payment
Cap rate = yearly NOI ÷ price
Cash-on-cash = yearly cash flow ÷ cash invested
DSCR = NOI ÷ mortgage payment
Maintenance is a percent of the full rent, since repairs happen whether or not the unit is let. Management is a percent of the rent actually collected, which is how most managers charge. The mortgage payment is principal and interest only; it isn't an operating expense, which is why NOI comes before it.
Worked example
A $250,000 house with 25% down ($62,500) and $7,500 of closing and repair costs: $70,000 invested. The $187,500 loan at 7% for 30 years costs $1,247.44 a month.
Rent is $2,200. With 5% vacancy you collect $2,090. Expenses are $250 tax, $125 insurance, $176 maintenance (8% of rent) and $167.20 management (8% of $2,090): $718.20. NOI is $1,371.80 a month, or $16,461.60 a year.
Cap rate = 16,461.60 ÷ 250,000 = 6.58%
Cash-on-cash = 1,492.29 ÷ 70,000 = 2.13%
Rent is 0.88% of the price, so it fails the 1% rule, and the slim cash flow shows why.
The 1% rule
A quick screen used by many investors: monthly rent should be at least 1% of the purchase price. It's a rule of thumb for spotting deals worth a closer look, not a test of a good investment. In high-priced areas few properties pass, and taxes and insurance vary too much for any single rule to fit everywhere.
Limitations
- This is a first-year snapshot. Rent increases, rising costs and the loan paydown aren't projected.
- Appreciation and principal paydown add to your total return but aren't in cash flow or cash-on-cash.
- Income tax isn't included. Rental income is taxable, and depreciation and expenses can offset it; see IRS Publication 527.
- Big repairs like a roof or HVAC (capital expenditures) are lumpy. Many investors set aside 5% to 10% of rent for them on top of maintenance; add it to Other.