Before you buy a rental, learn the three numbers investors use to decide whether a property will actually produce income. Plain-English formulas and a worked example.
Owning a rental property sounds like an easy way to earn passive income: buy a place, find a tenant, collect rent. But plenty of rentals quietly lose money because the buyer never ran the numbers. The difference between a property that pays you and one that drains you often comes down to a few simple calculations you can do on the back of an envelope.
This guide explains three of the most common ones, the 1% rule, the cap rate, and cash-on-cash return, in plain language. You don't need a finance degree, just a calculator and a willingness to be skeptical.
Rental income feels simple, but the real picture includes a mortgage, property taxes, insurance, repairs, vacancies, and sometimes a property manager. A place that rents for $1,800 a month isn't putting $1,800 in your pocket. Often it's not even close.
Running the numbers before you buy is how you avoid falling in love with a property that looks great but loses $200 a month. Think of these formulas as quick filters: they won't tell you everything, but they help you rule out bad deals fast.
The 1% rule says a property's monthly rent should be at least 1 percent of its purchase price. So a $200,000 property should rent for around $2,000 a month.
It's a rough screening tool, not a guarantee. In expensive cities, almost no property meets it, and in cheaper markets, many exceed it. Still, it helps you quickly spot listings that are wildly out of line. If a $300,000 home would rent for only $1,500 a month, that's 0.5 percent, which is a warning sign that costs may outrun income.
Treat the 1% rule like a metal detector at an airport: it flags things worth a closer look, but it can't tell you what's inside the bag.
Cap rate, short for capitalization rate, measures a property's income relative to its price, ignoring how you finance it. The formula is:
Cap rate = Net operating income divided by purchase price
Net operating income (NOI) is your yearly rent minus operating expenses like taxes, insurance, repairs, property management, and vacancy. It does not include mortgage payments.
For example, if a property earns $24,000 a year in rent, has $9,000 in operating expenses, and costs $250,000, then NOI is $15,000 and the cap rate is 6 percent.
Cap rate lets you compare properties on equal footing, even if they're different sizes. Higher cap rates generally mean higher income relative to price, but often higher risk too. A very high cap rate might point to a rough neighborhood or a property needing heavy repairs.
Cap rate ignores financing, but most investors use a mortgage. Cash-on-cash return fills that gap. The formula:
Cash-on-cash return = Annual cash flow after mortgage divided by total cash invested
Total cash invested includes your down payment, closing costs, and any upfront repairs. Annual cash flow is rent minus operating expenses minus mortgage payments.
This number tells you how hard your own dollars are working. If you put $60,000 into a deal and it nets $4,200 a year after everything, that's a 7 percent cash-on-cash return. You can compare that with other places your money could go, like a high-yield savings account, an index fund, or a fractional real estate investing app. Our investing hub is a good place to explore those alternatives.
Meet Andre and Simone, who are considering a duplex listed at $280,000.
Both units would rent for $1,350 a month, so total rent is $2,700 a month, or $32,400 a year. That's about 0.96 percent of the price, so the 1% rule is nearly satisfied.
Now they estimate operating expenses for a year:
Property taxes: $3,800
Insurance: $1,500
Repairs and maintenance (about 8 percent of rent): $2,600
Vacancy allowance (5 percent): $1,620
Property management (8 percent): $2,600
Total operating expenses: $12,120. Their net operating income is $32,400 minus $12,120, or $20,280. The cap rate is $20,280 divided by $280,000, which is about 7.2 percent.
They plan a 25 percent down payment of $70,000, plus $8,000 in closing costs and $7,000 in repairs, for $85,000 total cash invested. Their loan is $210,000 at 6.5 percent over 30 years, which costs roughly $1,327 a month, or $15,924 a year.
Annual cash flow after the mortgage: $20,280 minus $15,924, which equals $4,356. Cash-on-cash return: $4,356 divided by $85,000, or about 5.1 percent.
Is that good? It's decent but not spectacular. If they could earn around 4 to 5 percent in a safe savings account, taking on tenants, repairs, and risk for 5.1 percent might not seem worth it. But the picture improves over time: rents can rise, the mortgage balance falls, and the property may appreciate. They decide to negotiate the price down to $265,000, which lifts their cash-on-cash return above 6 percent. Running the numbers gave them a negotiating target.
The most common mistake is underestimating expenses. New investors often forget maintenance, vacancies, and capital expenses like a new roof or water heater. A good habit is to set aside a percentage of rent for repairs every month. Our guide on the true cost of homeownership shows how quickly those costs add up.
Another mistake is using the listing's rent estimate without checking comparable rentals. Look at what similar units nearby are actually renting for, not what the seller hopes to get.
A third is relying on a single metric. The 1% rule, cap rate, and cash-on-cash return each show a different angle. Use all three together.
A fourth is forgetting that leverage cuts both ways. A mortgage can boost your return, but a higher interest rate eats cash flow. If rates are high, the same property may look much worse than it did a few years ago.
Finally, many beginners skip a cash cushion. If a tenant moves out and the furnace dies in the same month, you need reserves to cover the mortgage. Six months of expenses is a common target.
If you want a lower-effort way to start, you might also consider house hacking, where you live in one part of the property and rent the rest.
Screen listings with the 1% rule to cut obvious losers.
List every expense, including vacancy, repairs, taxes, insurance, and management.
Calculate NOI and cap rate to compare properties.
Calculate cash-on-cash return using your real down payment and closing costs.
Stress-test the deal: what if rent drops 10 percent or the interest rate is a point higher?
Keep a cash reserve before you buy, and compare the expected return with simpler options in low-cost investing.
Rental property can be a solid source of income, but only if the numbers work. The 1% rule screens quickly, the cap rate compares properties, and cash-on-cash return shows how your own money performs.
Run all three, be honest about expenses, and keep a cash cushion. If the math doesn't work on paper, it won't magically work once the tenant moves in.
This article is for general educational purposes only and is not financial, tax, or investment advice. Real estate investing involves risk, including loss of principal. Figures in examples are illustrative, so consult a qualified professional before making decisions.
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