Method and definitions
How we analyze a rental property.
Definitions first, then a worked example you can check with a pocket calculator.
- Applies to
- Single-family houses, duplexes, triplexes, fourplexes and ADUs in Washington
- Prepared by
- Austin Hellickson, Managing Broker, LPT Realty
- Status
- Illustrative. Not a projection for any property.
1. What a rental analysis answers
Statement
No rental income, return, or appreciation is guaranteed. Examples are illustrative only. This is not investment, tax, or legal advice.
A rental is a small business with one product. Its income is rent. Most of its costs are predictable, and a few of them are large and arrive without warning. The analysis on this page is the one a careful lender or an experienced small landlord would run. None of it is complicated.
It is easy to do carelessly, though, and the careless version is almost always too optimistic. It skips vacancy and management, and it treats repairs as an afterthought. A listing that says a duplex “cash flows” has usually been run that way.
The short answer to “is this a good rental” is a single figure: cash flow after every cost, including the mortgage. The longer answer is how much that figure moves when the rent comes in lower or the interest rate comes in higher. Both belong in the analysis.
2. Definitions
What rent comparables are
Rent comparables are recently leased units that sit close to the subject property and resemble it in size and condition. They set the gross rent in the analysis. Leases that were actually signed count for more than asking rents. Each comparable is adjusted for differences that tenants pay for, such as a garage, in-unit laundry, a fenced yard or a third bedroom, and the analysis uses the middle of the adjusted range. On a duplex or larger building, each unit is estimated on its own.
How vacancy is estimated
Vacancy is the rent you do not collect, either because a unit sits empty while it is cleaned and re-leased or because a tenant has stopped paying. It is entered as a percentage of gross rent. Even a well-run house loses some time between leases. On a single-family rental, one empty month is a large share of the year, which is why a small vacancy line still matters.
Repairs versus capital reserves
Repairs are the routine fixes, like a dripping faucet or a gate that no longer latches. Capital reserves are money set aside for components with a long life and a large bill, such as a roof, a furnace, a water heater, exterior paint or a side sewer. Both are budgeted, separately, and more is budgeted for older buildings. A 1920s house in Tacoma’s North End and a 2018 townhouse in Kennewick do not age the same way, and the analysis should not pretend they do.
Property management
A professional manager usually charges a share of collected rent, plus fees when a vacant unit is leased. Management is included as a cost even when you plan to manage the property yourself. If you move away or buy a second rental, the numbers still need to work with a manager in place. If they only work with your unpaid time, the property is really a part-time job.
Taxes and insurance
Property tax comes from the county assessor’s record (Pierce, King, Spokane, Benton or Franklin County, depending on the address). It is also checked for anything that ends when the property sells, such as a senior exemption held by the current owner. Landlord insurance is a different policy from a homeowner’s policy, and it usually costs more. The analysis uses an actual quote for the building whenever one is available. Utilities the owner pays, common on multi-unit buildings where water, sewer and garbage are billed to the property, go in this group too.
What net operating income means
Net operating income, or NOI, is effective gross income minus operating expenses. It is what the property earns before any financing. It is the most useful single figure for comparing two buildings, because it ignores how each buyer chooses to pay for them.
How cap rate is calculated
Cap rate, short for capitalization rate, is NOI divided by the purchase price. A property with $30,000 of NOI bought for $500,000 has a 6 percent cap rate. It is a quick way to compare buildings of different sizes. It says nothing about your loan or your cash flow.
What cash flow means
Cash flow is NOI minus the year’s mortgage payments (principal and interest). It is the money left in the account at the end of the year, before income tax. A property can show a respectable cap rate and still lose money every month when the loan is large or the rate is high. The example below shows exactly that.
How cash on cash return works
Cash on cash return is annual cash flow divided by the total cash you put in: the down payment and closing costs, plus any money spent on repairs before the first tenant moves in. It most directly answers how hard your own money is working. It does not include loan paydown or appreciation, both of which are real and neither of which is certain.
3. A worked example
Illustrative example. Not a real property. Not a projection.
The schedule follows one made-up duplex through the method at two purchase prices. The rent, tax, insurance and interest figures are round assumptions picked to make the arithmetic easy to follow. They are not estimates for any Washington city, and they are not a forecast of anything.
| Line item | At $500,000 | At $450,000 |
|---|---|---|
| Cash invested | ||
| Down payment, 25 percent | 125,000 | 112,500 |
| Closing costs, assumed 2 percent | 10,000 | 9,000 |
| Total cash invested | 135,000 | 121,500 |
| Income, annual | ||
| Gross scheduled rent, two units at $2,000 a month | 48,000 | 48,000 |
| Vacancy and credit loss, 5 percent | (2,400) | (2,400) |
| Effective gross income | 45,600 | 45,600 |
| Operating expenses, annual | ||
| Property tax | (5,000) | (4,500) |
| Landlord insurance | (2,000) | (2,000) |
| Repairs | (2,400) | (2,400) |
| Capital reserves | (2,400) | (2,400) |
| Management, 8 percent of collected rent | (3,650) | (3,650) |
| Owner-paid water, sewer, garbage | (2,400) | (2,400) |
| Total operating expenses | (17,850) | (17,350) |
| Net operating income | 27,750 | 28,250 |
| Cap rate | 5.55% | 6.28% |
| Financing | ||
| Loan amount, 75 percent of price | 375,000 | 337,500 |
| Debt service, 30-year fixed at 7.00% | (29,940) | (26,940) |
| Annual cash flow | (2,190) | 1,310 |
| Per month, rounded | (183) | 109 |
| Cash on cash return | (1.62%) | 1.08% |
Figures in dollars unless marked. Parentheses show a cost or a loss. Debt service rounded to the nearest $10.
4. What the example shows
At the higher price, the building loses money every month, even with two paying tenants and a cap rate that looks respectable on paper. At the lower price, it produces a small positive cash flow. Same building and the same rents. The only differences are the price paid and the size of the loan that follows from it.
That is why the analysis comes before the offer. Once you are under contract, the price is set, and the only remaining question is how much of the shortfall you are willing to cover each month.
How a marginal deal can improve
Usually in one of a few ways. A lower price. A larger down payment, which shrinks the loan but also lowers cash on cash, because more of your money is tied up. A value-add plan, such as legalizing a basement unit or adding an ADU, that raises rent enough to justify its cost. Each of those has a trade-off, and the analysis puts it in writing.
5. What the analysis leaves out
Appreciation
Property values can rise and they can fall. No analysis on this site counts on appreciation, and you should be skeptical of any pitch that needs it to make the numbers work.
Income tax
Depreciation and the tax treatment of an eventual sale matter a great deal, and they depend on your own situation. A CPA should answer those questions. I am glad to send the analysis to yours.
Loan paydown
Each mortgage payment reduces the balance and builds equity. You can reach that equity only by selling or refinancing, so it stays out of cash flow.
Your time
Managing a rental yourself saves the fee and costs hours: showings, a late-night call about a water heater, rent that arrives a week late, the move-out inspection. The analysis prices management in so that choice stays yours.
Send me a property and I will run it exactly this way.
You will get the same schedule, filled in with the property’s real tax record, a rent estimate from nearby leases, and the financing you expect to use. Every assumption is visible, and you are welcome to argue with any of them.
Request an analysis206.940.0942Austin.Hellickson@homexa.com
Austin HellicksonManaging Broker, LPT Realty