Buying a rental property without running the numbers is gambling. Real estate investing is a business, and like any business, profitability depends on understanding your inputs and outputs. Here are the key metrics every rental property investor must calculate before making an offer.
Gross Rental Income
This is the total rent you collect if the property is always occupied. For a duplex with two units at $1,200 per month each, gross rental income is $28,800 per year. This is your starting point, but it is not your profit.
Vacancy Rate
Always budget for vacancies. A standard assumption is 5 to 10 percent of gross rents, depending on the local market. Subtract this from gross income. A realistic vacancy allowance on the duplex above would reduce income by $1,440 to $2,880 per year.
Operating Expenses
Operating expenses include property taxes, insurance, maintenance and repairs (budget 5 to 10 percent of gross rents), property management fees (typically 8 to 12 percent of collected rents), and utilities you pay as the landlord. These are all costs before your mortgage payment.
Net Operating Income (NOI)
NOI equals gross rental income minus vacancies minus operating expenses. It does not include mortgage payments. NOI is the number used to compare properties regardless of financing.
Formula: NOI = Gross Rents – Vacancies – Operating Expenses
Cap Rate
The capitalization rate tells you the annual return on a property if you paid all cash. It is calculated by dividing NOI by the purchase price.
Formula: Cap Rate = NOI divided by Purchase Price
A cap rate of 6 to 8 percent is generally considered solid in most markets. High cap rates often come with higher risk. Very low cap rates may indicate the property is overpriced or in a market with very low rental income relative to prices.
Cash-on-Cash Return
This is the most practical metric for leveraged investors. It measures your annual cash flow as a percentage of the actual cash you invested (down payment plus closing costs).
Formula: Cash-on-Cash Return = Annual Cash Flow divided by Total Cash Invested
A cash-on-cash return of 8 to 12 percent is considered strong. Anything under 5 percent deserves a hard look before committing.
The 1 Percent Rule
A quick screening tool: the monthly rent should equal at least 1 percent of the purchase price. A $200,000 property should rent for at least $2,000 per month. This rule is not a guarantee of profitability, but it filters out obvious losers quickly.
Debt Service Coverage Ratio (DSCR)
If you are financing, lenders will look at your DSCR, which compares NOI to annual debt payments. A DSCR above 1.25 means the property generates 25 percent more income than needed to cover the mortgage, which is what most lenders want to see.
Always Run Realistic Numbers
New investors often use optimistic assumptions: low vacancy, low maintenance, high rents. Run conservative numbers, and the deal still has to work. If it only works in the best-case scenario, move on.