When purchasing income property, there are many ways of looking at it to see if it is a good investment. It’s probably a good idea to look at more than just one formula before deciding to purchase a property. One formula you should at least take a look at is the Cash on Cash Return. This compares your net cash flow to the total amount of cash you have invested in the property: NET CASH FLOW / TOTAL $ INVESTED. Some Cash on Cash formulas say to compare cash flow to the down payment, but I think it is wise to include your closing costs and initial repairs/maintenance to this Cash on Cash formula. So “Total $ Invested” is the Down Payment, Closing Costs, and initial Maintenance/Repairs.
Generally speaking, the return on investment for the stock market is about 10% per year on average over the past 20 years. And mutual funds are about 2 points below, near 8%. So you want your Cash on Cash Return to to be in that 8-10% if possible. Due to the capital appreciation of real estate (4-5% per year on average), it would probably be okay to have a Cash on Cash Return even a little lower than 8-10%. Obviously the higher the better!
For example, let’s say you are looking at a property that will have purchase price of $180,000. A 25% down payment for that property would be $45,000. With closings costs and a little maintenance, let’s say total investment is $50,000. The next thing to look at would be net cash flow. Let’s say this particular property will cash flow $350/month…or $4,200/year. $4,200/$50,000 = 8.4%. That is very similar to stocks & mutual funds, and means that it might be a good investment!