Thinking About Buying a Rental Property? Let’s Break Down the Numbers!

One of the questions I get asked fairly often is how I determine whether a rental property is a good investment.

I’ve bought and sold quite a few rental properties over the years, from small duplexes to larger apartment buildings, and one thing I’ve learned is that just because a property brings in a lot of rent doesn’t necessarily mean it’s a good investment.

In fact, sometimes the numbers can be downright disappointing once you start digging into them.

This week, we had a fourplex listed for sale in our Southeast Iowa market at approximately $300,000. I thought it would be a great opportunity to walk through how I look at an investment like this and explain some of the things buyers should consider before jumping in.

At first glance, four apartments collecting rent every month sounds pretty attractive, doesn’t it?

But let’s dig a little deeper.

First, there are a few terms I think every real estate investor should understand.

Net Operating Income (NOI) is the income a property generates after subtracting its normal operating expenses, but before mortgage payments, income taxes, and depreciation.

Capitalization Rate (CAP Rate) is a way of comparing a property’s operating income to its purchase price. You calculate it by dividing the NOI by the property’s value or purchase price. It’s especially useful when comparing investment opportunities without considering their financing.

Return on Investment (ROI) measures how much you’re earning relative to what you’ve invested. There are different ways to calculate ROI depending on whether you’re measuring cash flow, appreciation, equity buildup, or the total return.

Cash-on-Cash Return is one of my favorite metrics. It measures the annual cash flow you receive compared to the actual cash you’ve invested. If you invest $100,000 and the property generates $8,000 in annual cash flow, that’s an 8% cash-on-cash return.

Now that we’ve got those terms out of the way, let’s look at our example.

For simplicity, let’s assume the fourplex is priced at $300,000 and all four units rent for $850 per month. These are hypothetical numbers for our analysis, not a representation of the actual property’s financial statements.

That’s $3,400 per month, or $40,800 per year in potential rental income.

Not bad, right?

But here’s where I see a lot of first-time investors make a mistake.

They look at the rent, subtract the mortgage payment, and assume everything left over is profit.

Unfortunately, it doesn’t quite work that way.

We need to account for property taxes, insurance, maintenance, utilities, vacancy, property management, and something called capital expenditures, or CapEx.

CapEx is money we need to set aside for bigger expenses that don’t necessarily happen every year. Think replacing a roof, installing a new furnace, repairing a parking lot, or replacing windows.

Just because you didn’t have to replace a furnace this year doesn’t mean you won’t need to replace one next year!

And while you might plan to manage the property yourself, I still think it’s important to account for a management expense. Your time has value, and if you eventually want to step away from managing the building, that expense becomes very real.

Let’s break down our hypothetical fourplex.

We’ve gone from collecting over $40,000 a year in rent to having less than $19,000 available for our mortgage payments after setting aside money for future repairs and replacements.

At a $300,000 purchase price, the property has a CAP rate of approximately 7.1% based on its traditional NOI. After accounting for our additional CapEx reserve, that yield drops to about 6.3%.

Now let’s talk about financing, because this is where things get interesting.

Borrowing money is expensive right now.

For our example, let’s assume we put 25% down, finance the remaining $225,000 at 7.5% interest, and amortize the loan over 25 years.

That’s $75,000 out of pocket for the down payment, plus closing costs and any initial repairs.

Our mortgage payments would be approximately $1,663 per month, or nearly $20,000 per year.

Remember that $18,859 we had available after expenses and reserves?

Well, we’ve now got almost $20,000 in annual mortgage payments.

That leaves us with approximately negative $91 per month in cash flow.

Wait a minute. We’re putting $75,000 down on a $300,000 property, taking on all the responsibilities of owning four rental units, and we’re actually losing a little money every month?

That’s exactly why running the numbers is so important!

Now, this doesn’t automatically make it a terrible investment. There can be other benefits to owning real estate, including mortgage principal reduction, potential appreciation, and tax advantages. But none of those should be used as an excuse to ignore negative cash flow.

Personally, I like properties that can pay their own way from the beginning.

So what could we do to make this deal more attractive?

This is where real estate investing gets interesting, because there are several levers we can potentially pull.

1. Negotiate a better purchase price.

What if instead of paying $300,000, we could purchase the property for $260,000?

Assuming the same rents and operating expenses, with 25% down and the same financing terms, our cash flow improves to approximately $131 per month.

That’s certainly better, although I still wouldn’t call it a home run.

2. Find opportunities to increase rental income.

What if the existing rents are below market value?

Maybe the apartments are currently renting for $850 per month, but comparable units in good condition could reasonably command $950.

That’s another $400 per month in potential gross rental income across the building.

After adjusting for vacancy and management, that increases annual income available for debt service by approximately $4,195.

At the original $300,000 purchase price, our estimated cash flow improves to approximately $258 per month.

Of course, we’d need to verify those market rents, account for any improvements needed to achieve them, and consider existing lease agreements.

3. Put more money down.

Another option is increasing our down payment.

If we put 40% down instead of 25%, we’d borrow less money and lower our monthly mortgage payment.

That improves the cash flow to approximately $241 per month at the original asking price.

But here’s the catch: we’ve also tied up an additional $45,000 of our own money.

And that brings us right back to cash-on-cash return. Just because we’re generating more monthly cash flow doesn’t necessarily mean we’re earning a better return on our investment.

4. Get creative with the deal.

This is probably my favorite part of real estate investing.

Maybe the seller would consider seller financing at a more attractive interest rate. Maybe there’s an opportunity to shift certain utility costs to tenants where appropriate, or make improvements that justify higher rents.

Or maybe we negotiate a lower purchase price AND identify an opportunity to increase the rents.

For example, buying this property for $260,000 and eventually bringing rents to $950 per unit would increase our projected cash flow to approximately $480 per month under the same assumptions.

Now we’re starting to see a more interesting opportunity.

Of course, not every property has these possibilities. Sometimes the seller won’t negotiate, the rents are already at market value, or the repairs needed to increase income simply cost too much.

And that’s okay.

One of the most important lessons I’ve learned investing in real estate is that you don’t have to buy every property you look at.

I’ve passed on plenty of deals over the years because the numbers just didn’t make sense.

Sometimes the best investment decision is knowing when to walk away.

But I also believe there are opportunities right here in Southeast Iowa for people who are willing to do their homework, understand the numbers, and think creatively.

Whether you’re looking at your first duplex, a fourplex, or a larger apartment building, the fundamentals are pretty much the same.

Understand your income, accurately account for your expenses, evaluate your financing, and make sure you’re getting a return that justifies the money and effort you’re putting into the investment.

And don’t forget to account for the unexpected. Because trust me, if you own rental properties long enough, the unexpected WILL happen!

If you’ve ever thought about getting started in real estate investing, or you’re already an investor looking for your next opportunity, I’d love to have that conversation.

At Thrive Realty, we can help you identify investment properties, evaluate potential returns, explore financing options with local lenders, and look for opportunities that other buyers might overlook.

Sometimes a great deal isn’t immediately obvious. You just have to know how to look at it.

Don’t just live. Thrive.

John Mercer
Broker/Owner, Thrive Realty