Real estate rental property investments represent one of the most powerful tools available to young professionals hoping to accelerate wealth creation, but the analytical process can feel overwhelming to many. This post provides a streamlined framework that will help you analyze real estate rental investments in seconds.
Introduction to Real Estate Investing in Your 20s
I first discovered the power of real estate when I tore through a handful of books that fundamentally shifted my investing mindset. These included Rich Dad, Poor Dad by Robert Kiyosaki, Rental Property Investing by Brandon Turner, The Real Estate Game by William Poorvu and many others. Soon after, I found the BiggerPockets forums.
I was sold. Today, I’m convinced that real estate represents one the quickest ways for young professionals to radically transform their financial futures. Specifically, buy and hold rental property investing.
There are countless other real estate investment strategies out there such as house flipping, BRRRR, or even passive syndication deals. While these alternative methodologies can prove lucrative, they tend to require greater risk-tolerance, capital, experience, or all of the above. For the purposes of this post, I will focus exclusively on how to analyze real estate investments classified as small (1-4 unit) buy and hold rental properties. Recognize, however, that this exposes just the tip of the proverbial iceberg.
Challenges of Real Estate Investing in Your 20s
I won’t lie. While the framework that I present allows you to analyze real estate deals in seconds, the process of investing in real estate takes hard work. It requires a commitment to save, network, build a supporting team, and analyze deals until your head spins. These challenges are magnified for young professionals who lack the credibility, experience, and capital reserves that more seasoned investors enjoy. On the positive side, technological advancements continue to shrink this gap. It’s never been easier for real estate investors to connect, analyze, learn and grow. Younger tech-savvy real estate investors can use this trend to their advantage.
Most new investors must overcome a period of “analysis paralysis.” There’s an incredible amount of information and wisdom to absorb when embarking on the real estate investment journey. It requires an entirely different mindset and approach than passive index investing.
For many this can feel quite overwhelming. I should know. I’m currently in the midst of landing my first real estate deal. I’ve moved beyond the analysis paralysis stage, but it took a good 3-4 months. I consumed a ridiculous amount of real estate literature, podcasts, and webinars. The action that ultimately propelled me through my paralysis was religiously analyzing at least one deal every day. This brute repetition provided me with the comfort necessary to move forward.
I know this sounds daunting at first. How can busy young professionals like us carve out additional time from our day jobs, social commitments, workout classes, etc.? Luckily, the simple shortcuts presented below will allow you to screen and analyze small residential real estate deals rapidly.
I use these same two shortcuts when I personally analyze real estate deals. I know they work. And they eliminate 85-90% of opportunities immediately. This frees me up to dig deeper into the select real estate investments that meet my criteria.
A Word of Caution About Analyzing Real Estate
A quick word of caution before I present these shortcuts. Just because a property generates rental income that is greater than the monthly mortgage payment, this does NOT make it a good deal. While the notion might sound correct to novice investors, this line of thought will almost certainly lead to a negative financial outcome. Investors must account for many additional expenses including taxes, insurance, maintenance/repairs, vacancies, utilities and more. Do not fall victim to this common beginner trap! Use the shortcuts below instead.
Analyze Real Estate Investments with the 1% Rule
This first rule of thumb indicates that a rental property will often cashflow when the monthly gross rent to price ratio equals more than 1%. In other words, take the projected monthly rental income from the property and divide it by the purchase price. If the resulting figure is larger than 1%, you potentially found yourself a deal. Typically, the higher the rent to price ratio, the higher the expected cash flow. And the higher the cash flow, the more quickly it will help an investor build wealth.
Don’t worry if this last paragraph confused you. The real estate industry is full of fancy jargon, but we’ll break the 1% Rule into pieces. Once we do that, it becomes nothing more than the application of middle school math.
Numerator – Gross Rent
Gross rent is simply the total income that an investor anticipates collecting from a tenant’s monthly rental payments. For instance, if you’re evaluating a duplex and believe that each unit will rent for $800 then your gross rent for the property is $1,600/month.
But how does an investor estimate rental income? If you’re lucky, the figures might be included in the online listing at sites such as Zillow, Trulia or Redfin. For more updated and precise information, you can leverage the services of a realtor. A real estate agent will set you up with access to the MLS (a highly regulated database of all the “on-market” property listings in a region). Whether using a site like Zillow or the MLS, remember that you can’t necessarily accept rental figures at face value. Sellers and their agents want to paint the rosiest picture possible to entice buyers to submit offers.
To validate the optimistic rental income figures provided by sellers, conduct your own independent research. A few helpful sites for this include Rentometer, Apartments and Craigslist. These platforms allow users to filter by neighborhood, zip code and other property characteristics to help project more accurate rental prices. A rock-star property manager or real estate agent can also prove invaluable here. They can offer additional context and a qualitative perspectives informed by years of experience.
Denominator – Purchase Price
This is quite literally the total purchase price of the property. It can be ripped directly from the listing. And unlike the rental figures in the numerator, every listing will include a price. Now just because a property is listed for a certain price doesn’t mean it will sell for that price. Investors can always offer below asking depending upon market conditions and the unique situation.
I prefer, however, to simply use the listing price for the purposes of the 1% Rule. If I run the numbers and they show that the listing price is $200-300K too high to meet the 1% Rule, I know it’s an easy pass. Alternatively, if the listing price is only only $10-20K above a price that would meet the 1% threshold, I might pursue it further even though it doesn’t technically pass the 1% Rule. Real estate analysis often turns into more of an art than science. There are individual factors and nuances to consider on each deal, but the 1% Rule helps to quickly eliminate many subpar opportunities. Let’s put it all together with an example below.
Illustrative Example of the 1% Rule
Deal Facts:
- Buy and hold rental investment opportunity
- $200,000 duplex in Nashville, TN
- Unit A Rent = $850
- Unit B Rent = $1,000
Calculating the Gross Rent to Price Ratio:
- Gross Monthly Rent = Unit A Rent + Unit B Rent = $1,850
- Purchase Price = $200,000
- Gross Rent to Price Ratio = $1,850 / $200,000 = 0.9%
So the deal didn’t quite meet the 1% Rule, but it’s close. While it’s not a slam dunk, it could warrant further investigation depending on market conditions in a given area.
Analyze Real Estate Investments with the 50% Rule
The 1% Rule taught us that a higher rent to price ratio is beneficial to an investor since it typically implies higher cash flow. But what about estimating the expected cash flow itself? This is a crucial consideration since cash flow represents the money that investors pocket on a monthly basis.
The 50% Rule is here to help. It holds that roughly 50% of gross monthly rental income will go towards “operating expenses.” These include all expenses associated with a real estate investment outside of the mortgage payment. We already know how to estimate rental income based upon our discussion of the 1% Rule. If we cut the monthly rental income in half, the 50% Rule says that this number represents our monthly operating expenses. The remaining 50% can be used to cover the mortgage payment, and any excess cash becomes profit for the investor. But how do you quickly estimate the mortgage payment? Let’s take a look.
Mortgage Payments
Most mortgages feature fixed monthly payments made over the life of the loan. The primary variables driving this payment amount include interest rate, purchase price, loan term and down payment percentage. If you wanted to get extremely precise, you could call up a mortgage broker or bank to receive quotes based on current interest rates and your credit score.
But the point of these rules is to allow quick and dirty analysis. So make some simplifying assumptions and run with it. I recommend assuming a conventional 20% down payment and using the interest rates shown on sites like Trulia. In fact, Trulia includes a mortgage calculator right on its listing pages. As you can see below, the tool allows users to manipulate the key variables we mentioned.
Note that for the purposes of the 50% rule, a mortgage payment strictly refers to the “principal and interest” payment shown in row 1 of the screenshot. The remainder of these costs are included in operating expenses. We accounted for those when we assumed 50% of gross income would cover all expenses outside of the mortgage. Let’s put the 50% Rule into action with an example.
Illustrative Example of the 50% Rule
Deal Facts (Same as 1% Rule Example):
- Buy and hold rental investment opportunity
- $200,000 duplex in Nashville, TN
- Unit A Rent = $850
- Unit B Rent = $1,000
Financing Assumptions
- Downpayment = 20% of Purchase Price
- Interest Rate = 3.0%
- Monthly Mortgage Payment = ~$960 (estimate per online mortgage calculator)
Applying 50% Rule:
- Gross Monthly Rent = Unit A Rent + Unit B Rent = $1,850
- Operating Expenses = 50% of Gross Rent = $1,850 * 0.5 = $925
- Investor Cash Flow = Gross Rent – Operating Expenses – Mortgage Payment
- Investor Cash Flow = $1,850 – $925 – $960 = -$35 / month
In this case, the 50% Rule suggests that an investor might actually lose money on the deal. My cash flow target for properties in my target market is about $100 / unit per month. So in the case of the Nashville, TN example above, I would want to see total expected cash flow of $200 / month (since a duplex has two units). Note that some investors are willing to sacrifice cash flow in the hopes of investing in a rapidly appreciating location. While this can generate massive upside, I prefer to screen rental deals with a primary focus on cash flow. Appreciation might still occur, but it’s a bonus.
Key Takeaways to Ensure You Analyze Real Estate Successfully
The 1% Rule and 50% Rule are useful in helping investors quickly evaluate a high volume of potential deals. They are particularly beneficial for new investors seeking exposure, validation, and confidence. These rules might even help inspire you to move beyond the inevitable rookie analysis paralysis and into the game.
Overreliance on these shortcuts, however, is dangerous. Never make an offer decision based solely on these rules. They represent step 1 of a much larger and more complex process. Once you’ve used the rules to quickly identify a handful of deals worth pursuing, then the real fun (work) begins.
This is where it’s useful to remember that real estate is a team game. You’ll want to rely on a thoroughly vetted team to provide a more holistic picture. Your agent can run a comparative pricing analysis and help you craft a compelling offer. Meanwhile, your lender can structure a financing package around your goals, and your contractor can provide repair cost estimates. When you establish a team that operates with this sort of harmony, chasing a deal becomes exhilarating.
But you’ll struggle to reach this exciting stage of the process if you waste all of your time going deep on every deal that crosses your desk. Use shortcuts to sort through the noise. Then hone in on your best targets and unleash your team’s full potential.