I often have clients ask me whether a certain property would be a good investment property. Because we're in California, many properties turn out to be good investments over time because of the continually rising housing market. However, markets can be fickle and as we saw during the crisis a few years ago, determining when the market will crash is almost impossible to pinpoint. Fear not, appreciation investing is not the only way to make money off a property. Here in Davis, the student population continues to increase each year along with rental prices. Thus, finding a property that can produce cash flow each month can be a very sound investment.
How Do You Determine Cash Flow?
Simply speaking, cash flow = the Total Income and the Total Expenses. If you can rent out your property for more money than all your expenses each month you have a positive cash flow. However, most buyers I meet with find it hard to determine all their hypothetical monthly expenses for their potential rental property, let alone their mortgage and interest payments.
Fear not, the 50% rule provides a quick rule of thumb for buyers to gauge whether their potential rental property would provide cash flow. This rule of thumb states that a rental property’s expenses tend to be about 50% of the income, not including the mortgage principal and interest (P&I) payment. The formula would look like this:
Cash Flow = (Total Income x .5) – Mortgage P&I
Keep in mind the 50% rule is only a rule of thumb and is generally not as accurate as using the actual expected numbers. In this example, Carl determined using the 50% rule that he could expect $130 per month in expenses, but the actual numbers we did earlier showed only $89 per month.
Therefore, the 50% rule is a good tool to use to quickly analyze a rental property, but should never take the place of a thorough analysis of a property. Think of the 50% rule as a “quick filter” that allows you to estimate cash flow in under a minute, enabling you to analyze dozens of properties looking for a deal with the potential that you can run a more thorough analysis on.
