Cash Flow is King: Estimating Whether a Rental Property Will Give You a Good ROI

Thanks to HGTV, we all think we could be homeowners and house-flippers. But in reality, it takes some forethought to decide if a rental property is really worth the time and effort. 

You may have spent your pandemic days lulled into a Zillow daydream, scrolling through properties in low-cost-of-living areas and writing up future Airbnb descriptions to use when you list your home.

While there are no doubt benefits to buying a second property—whether for leasing long-term or as a vacation rental—real estate investing can be all hands on deck compared to investing in a real estate investment trust, or REIT. You’ll want to do some upfront research and calculations before buying a second home, starting with identifying the right kind of mortgage.

According to Robert Heck, VP of Mortgage at online brokerage Morty, you have to know the ins and outs of your financing before you can estimate the ROI on your rental property.

“Investment properties and different property types have eligibility nuances behind them,” says Heck.

Details like your monthly payment, interest rate, and down payment start with the type of mortgage you get. Rental property loans work differently from mortgages for primary residences. They often require larger down payments (at least 20% to 25%, compared to 3.5% for some qualifying FHA loans), come with higher interest rates, have stricter credit score and debt-to-income ratio (DTI) requirements, and won’t allow private mortgage insurance (PMI).

There are also different loans for multi-family units, like if you were to buy a condo building versus a single-family house at the beach. Other options exist for buying multiple residences, such as a blanket mortgage loan, where you can finance multiple rental properties under a single loan.

Since special mortgages exist for investment properties and rental properties only (compared to someone’s primary residence), prepare to have good proof of income and a solid credit score before you apply.

Once you have the details of your mortgage hammered out, calculate your potential return on investment (ROI) before you commit to buying the property. Start by looking at comparable units or homes in the same area and arrive at a reasonable median rent you think you could charge.

Then, compare the estimated monthly rental income to what your monthly mortgage payment would be. If you follow real estate trends and invest accordingly, now may be a good time to consider investing in a rental property, since mortgage interest rates are so low, says Florida-based certified financial planner Mac Gardner.

“With the interest rate environment we're in right now, if you have a good credit score you can get a 2% mortgage or 3% mortgage,” Gardner says.

The formal ROI calculation is this: 

Net profit / Cost of investment

So, for instance, if you charged tenants $1,500 in rent to live in a house with an $800 mortgage payment, your ROI would be $700 / $800, or an 87.5% ROI. All this means is that you are able to charge rent that’s 87.5% higher than the cost to own the house every month.

But don’t over-simplify: To get the true ROI on a rental property, you also have to factor in maintenance costs (usually spread out over years, but averaged into a monthly expense), taxes, and the opportunity cost during any months your rental sits empty without tenants.

So, assuming you budget $200 per month for maintenance costs and another $50 per month for taxes, and you have one empty month per year after every tenant’s lease expires (this is kind of on the high end, but it’s good to be over-prepared), you’ll need to average these costs into the equation as well. One month’s rent is $1,500, so letting your house sit empty is a $1,500 opportunity cost, or about $125 in losses per month on average.

That $125, plus $250 for maintenance and taxes, means you’re actually paying a monthly average of $1,175 to own the house. 

Therefore the true ROI would be more like $325 / $1,175, or 27.7%.

So, is owning a rental property worth it to you for a $325 cash flow increase every month?

Gardner uses one single question to cut through the allure of being a homeowner and get down to his clients’ deeper motivations: Do you want to own that dirt?

By this he means, do you actually want to own a physical house and land, or simply use other vehicles like REITs to benefit from additional cash flow? 

“The other path is you can purchase REITs, which are fairly liquid and act a lot like real estate from a long-term growth perspective,” Gardner says. However, if owning a second property—so that you can use it one day, or perhaps pass it down to your kids—is important to you, then the potential surprises and ongoing costs of homeownership are likely going to be worth it. Not to mention, the long-term appreciation on an investment property can be worth more than the added cash flow, which can sometimes seem nominal compared to the level of responsibility and maintenance that’s required. 

If all you’re looking for is higher cash flow, then REITs may be your best bet—most REITs pay dividends, so you're still getting passive income. Platforms such as Concreit and Streitwise have helped investors benefit from regular yields from real estate—mostly commercial and corporate office properties.

The biggest challenge of owning a rental property is being a landlord. Getting those golden tenants isn’t always a sure thing. Sometimes your property sits unoccupied unless you’re on the ball with marketing it or paying for a property management company to fill it. You’ll also have to be ready to manage any potential issues that come from your tenants having personal, issues, complaints, or concerns.  

There’s no guarantee you’ll have stable, long-term tenants who treat the house with respect, but there are some solutions popping up to this.

Founded in 2015, Roofstock lists properties for sale that are already occupied by tenants, and users can purchase and rent out the properties remotely through the online platform starting at $20,000. 

This model eliminates the awkward lag between purchasing a property and finding people to live there. Investors can start earning a return as soon as they close on a property.

Another lower-barrier-to-entry platform for real estate investing is Fund That Flip, which lets you invest in pre-vetted real estate projects in $5,000 increments alongside owners who want to renovate, or “flip,” the house.