Rental Property ROI Guide

Metric 1: Cap Rate (Capitalization Rate)

Cap rate measures unlevered annual return — what the property would yield if purchased all-cash:

Cap rate = Net Operating Income (NOI) ÷ Property Price

NOI = Annual rental income MINUS operating expenses (taxes, insurance, maintenance, vacancy, property management). Does NOT include mortgage payment.

Example: $300,000 property generating $24,000/yr rent, $9,000 in operating expenses. NOI = $15,000. Cap rate = 5.0%.

Healthy cap rates vary by market: 4-6% for prime metros (LA, NYC, SF), 7-10% for mid-tier cities, 10%+ for declining or risky areas.

Metric 2: Cash-on-Cash Return

Cash-on-cash measures actual return on YOUR cash invested (after financing):

Cash-on-cash = Annual Pre-Tax Cash Flow ÷ Total Cash Invested

Annual pre-tax cash flow = NOI minus mortgage payment. Total cash invested = down payment + closing costs + initial repairs.

Example: $300K property, $60K down, $12K closing/repairs ($72K total cash). NOI $15K, mortgage $1,500/mo = $18,000/yr (loan exceeds NOI). Cash flow = -$3,000. Cash-on-cash = -4.2%. THIS IS A LOSING INVESTMENT despite "decent" cap rate.

Metric 3: GRM (Gross Rent Multiplier)

Quick comparison metric:

GRM = Property Price ÷ Annual Gross Rent

Example: $300K property, $24K annual rent. GRM = 12.5.

Lower GRM is better. Healthy markets: 8-12. High-cost markets: 15-25 (often poor cash flow). Useful for screening properties quickly before doing deeper analysis.

Metric 4: IRR (Internal Rate of Return)

IRR includes ALL cash flows over the holding period AND the eventual sale proceeds:

Difficult to calculate by hand; use a spreadsheet (=IRR function) or specialized real estate calculator.

Captures: initial investment (negative), annual cash flows (positive or negative), tax benefits (depreciation deductions), eventual sale proceeds (after selling costs and capital gains tax).

Healthy long-term IRR for rental property: 12-18%. Higher than stock market average (10%) but with substantially more work and risk.

The 1% rule (screening tool)

Rule of thumb: monthly rent should be at least 1% of purchase price.

Example: $200,000 property should rent for at least $2,000/mo.

Properties meeting the 1% rule typically have positive cash flow with normal financing. Properties below the 1% rule rarely cash flow with leverage.

1% rule rarely works in expensive metros (CA, NY, MA, Hawaii). It does work in many midwest and southeast markets. The 0.7-0.8% rule is more realistic in most metros today.

The 50% rule (operating expense estimate)

Rule of thumb: operating expenses (excluding mortgage) typically run 50% of gross rent over the long term:

• Property tax: ~10-15%
• Insurance: ~3-5%
• Maintenance reserves: ~5-10%
• Vacancy reserves: ~5-8%
• Property management (if used): ~8-10%
• Utilities (if landlord pays): varies
• HOA fees: varies
• Capital expenses (roof, HVAC, etc.): ~5%

50% rule prevents the common new-investor mistake of overestimating cash flow.

Hidden costs that wreck rental ROI

• Vacancy: 5-10% lost rent per year is normal; higher in declining markets
• Eviction: $3,000-$10,000 + 2-4 months lost rent
• Major capex: roof ($8K-$15K), HVAC ($5K-$10K), water heater ($1K-$2K), windows ($500-$1K each)
• Bad tenants: property damage costs $5K-$25K to repair
• Compliance: tenant rights laws (eviction moratoriums, rent control, lead paint disclosure)
• Property management: 8-12% of rent if you don't self-manage

Frequently Asked Questions

What's a good cap rate for rental property?

Depends on market. Tier 1 metros: 4-6% acceptable. Tier 2 cities: 7-9% target. Tier 3 / declining: 10%+ to compensate for risk.

Should I use leverage on rental property?

Most successful rental investors use moderate leverage (60-80% LTV). Lowers cash invested and amplifies returns IF property cash flows. Don't over-leverage — properties with negative cash flow plus low equity become forced sales in downturns.

Is rental property better than stocks?

Different risk/return profiles. Rentals: higher work, more leverage potential, illiquid, tax advantages, inflation hedge. Stocks: liquid, no work, no leverage tax advantages, easier diversification. Many investors hold both.

How do I depreciate rental property?

Residential rental: 27.5-year straight-line depreciation on the building (NOT the land). Commercial: 39 years. Provides annual deduction even though no cash leaves your pocket. Recaptured at sale (taxed at 25%).

Should I buy in my own name or LLC?

LLC provides liability protection but mortgages on LLC-owned properties are often more expensive. Common compromise: own in personal name, then deed to LLC after mortgage closes (review with attorney first — could trigger due-on-sale clause).