Listing remarks
- Net operating income is rent collected minus operating expenses, before the mortgage; cash flow is what is left after the mortgage payment.
- The IRS treats repairs as deductible expenses but requires improvements such as a new roof to be capitalized and depreciated.
- Fannie Mae counts reserves in months of the full mortgage payment, including taxes, insurance and association dues.
Most bad rental purchases look fine on the listing sheet. The trouble shows up later, when the real costs arrive. You do not need a finance degree to avoid that, only a few formulas and the discipline to use honest inputs. This guide explains each one and then works through a single hypothetical example. The numbers in the example are round figures chosen to show the arithmetic, not typical rents or prices for any market.
Start with gross rent, then subtract reality
Gross scheduled rent is what the property would bring in if every unit were rented all year at the asking rent. No property achieves that every year. Units turn over, tenants leave, and some rent goes unpaid. Investors usually subtract a vacancy and collection allowance to get effective gross income. Use the real history of the building if the seller can document it, and be conservative if not.
Operating expenses: the list people shorten
Operating expenses are the costs of running the property, not of financing it. A realistic list usually includes:
- property taxes and insurance;
- repairs and routine maintenance;
- property management, even if you plan to do it yourself, because your time has value;
- utilities the owner pays, such as water or common-area electricity;
- landscaping, snow removal, trash and pest control;
- accounting, legal and licensing fees;
- a reserve for big items that wear out: roof, furnace, water heater, flooring.
That last line is the one most often left out. The IRS distinguishes ordinary repairs, which can generally be deducted in the year paid, from improvements such as a new roof or furnace, which must be capitalized and depreciated. Either way the cash leaves your account, so plan for it. See Rental Property Taxes: Income, Deductions, Depreciation and Losses for the tax side.
Net operating income (NOI)
NOI = effective gross income minus operating expenses. It deliberately ignores the mortgage. That makes it useful for comparing buildings regardless of how each buyer finances them.
Cap rate
Capitalization rate = NOI divided by purchase price. A building with higher NOI relative to its price has a higher cap rate. Cap rates are a quick comparison tool, not a verdict: a high cap rate can reflect higher risk, such as an older building or a weaker location, and the figure is only as good as the NOI behind it.
Cash flow
Cash flow = NOI minus the annual mortgage payment (principal and interest). This is the money that actually reaches you, before income tax. Negative cash flow means you feed the property from your own pocket every month.
Cash-on-cash return
Cash-on-cash return = annual cash flow divided by the cash you put in: down payment, closing costs and any money spent on repairs before the first tenant moves in. It answers a simple question: what is my cash earning?
A worked example
Imagine a hypothetical duplex bought for $300,000. Each unit rents for $1,500 a month. All figures below are invented for the illustration.
| Line | Calculation | Annual amount |
|---|---|---|
| Gross scheduled rent | 2 units x $1,500 x 12 | $36,000 |
| Vacancy and collection allowance | 5% of gross, an assumption | -$1,800 |
| Effective gross income | $34,200 | |
| Operating expenses | taxes, insurance, repairs, management, reserves | -$13,000 |
| Net operating income | $21,200 | |
| Cap rate | $21,200 / $300,000 | about 7.1% |
| Mortgage payments | principal and interest, assumed | -$17,000 |
| Cash flow | $21,200 – $17,000 | $4,200 |
| Cash invested | down payment, closing, repairs, assumed | $80,000 |
| Cash-on-cash return | $4,200 / $80,000 | about 5.3% |
Now change one input. If a furnace replacement adds $6,000 of costs in a year, cash flow for that year turns negative. If rent falls short of the estimate by $100 a unit, cash flow drops by $2,400. This is why the inputs matter more than the formulas.
Tip: Run every deal three times: with your expected numbers, with rent 10 percent lower, and with one major repair. If the property only works in the first case, it does not really work.
Don’t forget reserves
Lenders build caution into the math too. Fannie Mae measures reserves in months of the full payment of principal, interest, taxes, insurance and association dues, and it generally requires six months of reserves for an investment property loan. Even if your lender does not require that, a cash cushion is what keeps a bad month from becoming a forced sale. More in Financing an Investment Property: What Lenders Look For.
What the formulas leave out
- Appreciation. None of these numbers include a change in the property’s value. Treat appreciation as a possible bonus, not as the plan.
- Income tax. Depreciation can lower the tax on rental income, but the deduction is recaptured when you sell.
- Your time. Self-management saves the fee but costs evenings and weekends.
- Local rules. Rent control, licensing and inspection fees change the expense line in some cities.
The bottom line
NOI tells you what the building earns, cap rate lets you compare buildings, cash flow tells you what you keep and cash-on-cash tells you what your money earns. Use conservative inputs, test bad cases, and walk away from deals that only work on the seller’s numbers. Next: Buying Your First Rental Property: From Search to First Tenant.