Everybody interested in real estate investing wants to know: how much cashflow is enough cashflow? Today I’ll tell you how to look at a property that you want to purchase and determine if it’s going to have enough cashflow to make it worth it.
What’s so funny about this question is that everyone wants to know what cashflow their particular property should have. They are asking the wrong question. Some people will try to quantify it by throwing out a sum like $200 or $400 per unit. The reality is that there are so many other factors that come into play when determining how much your property should cashflow.
It’s a question that should be asked, but in a more detailed way. You need your scenario, with your specific return, and with your specific property. I’ll go over everything that you need to be looking at that will help you determine how much cashflow is going to be enough.
Let’s start off with an example. There was a criteria floating around that $200 is the ideal cashflow per unit of rental property. Here’s the problem with that. If you do the math on the $200/unit, that ends up being $2,400 per year. That would be incredible if you spent $50,000 for a unit in a duplex that cost you $100,000. However, if you purchased an $800,000 single family home and it’s only cashflowing $200 per month, you just get $2,400 a year. On an $800,000 property, that’s an atrocious return and a terrible investment.
On top of that, you have to look at what current interest rates are. You also need to consider how much of a down payment you put on the property. Are you using leverage or buying cash? You’ve got all of these different factors to consider. Asking how much a property should cashflow is a trick question because sometimes $500 per unit is an incredible monthly return and sometimes it’s horrible.
Cashflow does matter, it just matters based on a myriad of other things. The number one thing that I look at when determining if I should buy a property is the cash on cash return. However, even the cash on cash return, if manipulated, can be a bad thing to look at. In order to break down these numbers, I’m going to use my free property rental calculator app. I want you to use this app so you can see the benefits of analyzing a property properly and picking one for yourself. If you want to use my free app, just go to the app store and search for “CDS Rental Calculator.” That will help you follow along to see these numbers.
Go to the rental calculator and plug in:
$100,000 purchase price
5% down (assuming this is a duplex where you live in half)
1.5% closing costs
30 years to pay off
3.5% interest rate
I am making these numbers up but they are based on a property that I bought a couple years ago. Don’t worry too much about whether they are realistic for you; I am just plugging them in to show you how it works.
If we run these numbers, we’ll get a 35.87% return, which is astronomical. That’s an incredible return on your investment. That would be just shy of $200/month in cash flow, or $23,000 a year.
Let’s go back and put in 25% down. Anytime I analyze a property, I run the numbers with 25% down, even if I’m not actually going to put in 25% down. When you run the numbers again, it puts you in at a 12.95% cash on cash return. This meets my criteria, and gives you a great return of $3,382. That’s more cashflow because you put more down, which means you have a smaller mortgage to pay every month.
I would buy this property in either scenario because my criteria is above a 12% cash on cash return with a 25% down payment.
Now I’ll show you how the cash on cash return can put you in a bad place with a different example. We’ll do 5% down again. This time we’re going to drop the rents to only $850. If we run the numbers with this, we’ll get a 14.8% cash on cash return, which looks great.
But when you look at your cashflow, it’s only $951 for the entire year. This has now devastated your cashflow to where you’re not even getting $100 per month.
If we plug in a 25% down payment and run the numbers, your cash on cash return drops to 7.7%. The smaller down payment confuses people. Putting in a smaller down payment increases your return through the power of leverage. That’s the power of low interest and how you can meet the criteria of 12% cash on cash return with only 5% down. If you had put a full 25% down, you’d only get 7.7% cash on cash return.
This is why with all of my properties, whether I’m putting 5% down or 25% down, I run the numbers as if I’m putting 25% down. Then I know I’m going to have enough cashflow to protect myself. Even this rule can get finicky, but this is the best standardized way for me to determine if it’s a good deal. Here’s why: with a 25% down you can see this does not meet my criteria. With a 5% down it would have, but with 5% you might have a good cash on cash return. You would not have a strong enough cash flow to bail you out if the water heater goes out or something else that costs you. For me, that $951 in cash flow on 5% down is not strong enough to purchase a property that big and take on that form of risk, because you’re not making enough to cover a big expense.
You have to determine what that amount is for you, but for me it is 25% down and 12% (or higher) cash on cash return. That’s what I need to feel comfortable that it’s still worth it even if rents drop or if I have a major expense on the property. If you’re putting 3.5% down or 5.5% down, the reason I like to still run the numbers at 25%, is that I know that it will be a good deal and still be a good buy. It will leave me enough cashflow to protect myself.
I also like this rule because there are people who will say they only need $200 a month in cashflow or a 12% cash on cash return. You can lower your down payment enough to where you get that but it’s still not a good buy. When you have the right things in place where you’re running the numbers with 25% down, and still getting 12% cash on cash return, that’s where I feel comfortable buying.
The only caveat is on the 5% scenario. Let’s say we plug in a 5% down payment. Make the rents $1,000 again, and run the numbers. Your cash flow is $2,300. You need to determine whether you know your market well enough that you’ve got expenses, vacancies, all of these factors in the right place so that you never lose money every month.
Even if rents drop, you have to feel comfortable that your cashflow is strong enough. You need to at least cover your basis so that you don’t have to put money into the property. Can you set aside six months or a year’s worth of reserves. I do a year if I’m doing a smaller down payment, because I will have less cashflow. A smaller down payment is a more vulnerable place.
So to summarize: if I can get a 12% cash on cash return, and run the numbers as if I’ve got 25% down, even if I buy the property with 0% or 5% down, that to me is a good deal. I’ve got my criteria refined to where I feel good with that deal.
Let’s say this is going to be your first deal, and you’re looking at living in one unit and renting the other. You may be worried about your risk. Don’t bail on buying a property, just set your criteria stiff enough so that you’re comfortable with the risk that you’re taking on.
If the $2,300 margins look tight, maybe your criteria needs to be a 20% cash on cash return with a 25% down. Then, if you only put 3.5% or 5% down, your return and cashflow will be astronomical. You need to be comfortable with it. Some people will add the additional rule of per unit having at least $200 per month in cashflow.
I analyze deals because I feel like it puts me in a very comfortable place where I’ve got reserves for the worst case scenario and enough cashflow to make it make sense. You may be comfortable getting a 12% cash on cash return with 5% down because you have a lot of reserves and just want to get into an investment property. That’s what you have to figure out for yourself. There is no bulletproof, one size fits all, perfect criteria. Some people hold to a 20% cash on cash return, some hold to 6% regardless of how much they’re putting down.
I personally feel like my criteria is perfect for me to have enough in case my cashflow gets eaten up, I’m still going to be in the positive. I think it’s a great criteria for a new investor. If you want to be more aggressive, that’s ok. If you’ve got a lot of other money put away in reserves or you’ve put down a large down payment and you want to be less aggressive, that’s ok too. All of these can be right answers depending on your scenario.
I hope seeing my scenario and my criteria helps you determine your scenario and your criteria so that you can buy properly. Don’t say “I only need $200 per unit” because if you buy a massive unit that could be a terrible investment that could put you in the negative if things go south.
It’s also a bad idea to make it just purely based on cash on cash return and then manipulate your down payment because you could buy a bad investment and still show a 12% cash on cash return. You could get an infinite return if you buy a deal with 0% down. Your losses could be infinite too if things go south. That’s why I want to make sure I’ve got big enough cash flow to protect me if they do.