Rental property, run as a business
An investment property is not a home you happen to rent out. It is a small business with a balance sheet, and it either pencils or it does not. The difference between investors who build portfolios and investors who quietly sell at a loss three years later is almost always that the first group ran the numbers honestly before they bought.
Here are the numbers, with worked examples — including one deal that does not work, because that is the one you need to be able to recognize.
Cap rate: what the property earns, before financing
The capitalization rate is the property's net operating income divided by its price. It deliberately ignores your mortgage — which is what makes it useful, because it lets you compare two properties on their own merits regardless of how each one happens to be financed.
Cap rate = NOI ÷ Purchase price
Operating expenses do not include your mortgage payment, and they do not include depreciation. They include taxes, insurance, maintenance, reserves, management, utilities you pay, and HOA dues.
Worked example — Property A: $420,000, rents for $3,200/month
| Line | Annual |
|---|---|
| Gross scheduled rent ($3,200 × 12) | $38,400 |
| Less vacancy allowance (5%) | −$1,920 |
| Effective gross income | $36,480 |
| Property taxes | −$5,200 |
| Insurance | −$1,600 |
| Maintenance & capital reserves | −$2,400 |
| Property management (8% of EGI) | −$2,918 |
| Other (licensing, turnover, misc.) | −$600 |
| Net operating income (NOI) | $23,762 |
| Cap rate ($23,762 ÷ $420,000) | 5.66% |
A 5.66% cap rate is not inherently good or bad. It is only meaningful against what comparable properties in the same market are trading at, and against what you could earn elsewhere at similar risk. Cap rates run lower in expensive, high-demand markets and higher in cheaper ones — that spread is the market pricing growth expectations and risk, not a free lunch.
Cash-on-cash: what you actually earn
Cap rate ignores your loan. Cash-on-cash does not — it measures the annual pre-tax cash flow you keep, against the cash you actually put in. This is the number that tells you whether the deal is worth doing with your money.
Cash-on-cash = Annual cash flow ÷ Total cash invested
Property A, financed
25% down on $420,000 is $105,000, plus roughly $8,400 in closing costs and $6,000 of make-ready work — call it $119,400 of cash in. The $315,000 loan at 7.0% on a 30-year amortization costs about $2,096 per month, or $25,152 a year.
Cash-on-cash = −$1,390 ÷ $119,400 = −1.2%
Property A is cash-flow negative. It is not a catastrophe — the loan is still being paid down by the tenant, and appreciation may bail it out — but you would be feeding it about $116 a month before the first repair bill, and that is a decision you should make on purpose, with reserves, not by accident.
Property B: $260,000, rents for $2,600/month
| Line | Annual |
|---|---|
| Gross scheduled rent ($2,600 × 12) | $31,200 |
| Less vacancy allowance (6%) | −$1,872 |
| Effective gross income | $29,328 |
| Property taxes | −$3,400 |
| Insurance | −$1,400 |
| Maintenance & capital reserves | −$2,600 |
| Property management (8% of EGI) | −$2,346 |
| Other | −$500 |
| Net operating income (NOI) | $19,082 |
| Cap rate ($19,082 ÷ $260,000) | 7.34% |
Financed the same way: 25% down is $65,000, plus about $5,200 in closing costs and $4,000 of make-ready — $74,200 of cash in. The $195,000 loan at 7.0% costs about $1,298 per month, or $15,570 a year.
Cash-on-cash = $3,512 ÷ $74,200 = 4.7%
Property B cash-flows. It is not spectacular — 4.7% before tax benefits, principal paydown, and any appreciation — but it is positive, and it survives a bad month. Property A does not. Same investor, same financing, same market. The property is the difference.
The 1% rule: a screen, not a verdict
The 1% rule says monthly rent should be at least 1% of the purchase price. It exists so you can reject obviously-bad deals in five seconds without building a spreadsheet.
- Property A: $3,200 ÷ $420,000 = 0.76% — fails the screen. And, when we ran it fully, it did in fact come out negative.
- Property B: $2,600 ÷ $260,000 = 1.00% — passes. And it did in fact cash-flow.
Do not treat the 1% rule as gospel. It is a crude filter that ignores property taxes, insurance, HOA dues, condition, vacancy, and appreciation potential entirely. In many high-cost markets almost nothing hits 1%, and disciplined investors buy there anyway on a different thesis. In some low-cost markets a property clears 1.5% and is still a bad deal because the taxes are punishing, the roof is done, or it will sit vacant.
Use it to decide what is worth underwriting. Never use it to decide what is worth buying.
Investor financing is a different animal
An investment-property loan is not a primary-residence loan with a different address on it. Expect:
- A larger down payment. Typically 20–25% minimum on a conventional loan, and often more for multi-unit properties.
- A higher rate. Investment properties carry loan-level pricing adjustments; the rate you were quoted on your own home is not the rate you will get.
- Reserve requirements. Lenders want to see months of payments in the bank after closing — and the requirement grows as you add properties.
- No government-backed shortcuts. FHA, VA, and USDA are for owner-occupants. The one legitimate overlap is house hacking: buying a two- to four-unit property, living in one unit, and renting the rest — that can qualify for owner-occupant financing, with the occupancy requirement taken seriously.
- Property-count limits. Conventional financing caps how many financed properties you can hold, after which you move to portfolio, commercial, or DSCR products.
- DSCR loans. These underwrite the property's income rather than your personal income — useful for self-employed investors and for scaling past the conventional caps, at the cost of a higher rate.
Talk to a lender who actually does investor lending before you write an offer. Their guidelines will shape which property you can even pursue.
Depreciation and the 1031 exchange
Two of the largest advantages in real estate are federal, and they apply the same way in every state.
Depreciation
The IRS lets you depreciate the building portion of a residential rental — not the land — on a straight-line basis over 27.5 years. That is a paper deduction that reduces taxable income without costing you cash. The catch is depreciation recapture: when you sell, the IRS wants some of that benefit back. Model it before you sell, not after.
The 1031 like-kind exchange
Under Internal Revenue Code §1031, you can defer capital gains tax by exchanging one investment property for another instead of simply selling. The mechanics are federal, strict, and unforgiving:
- The property must be held for investment or productive use in a trade or business. Not your primary residence.
- You have 45 days from closing your sale to formally identify replacement properties, in writing.
- You must close on the replacement within 180 days of the sale (or by your tax-filing due date, if earlier).
- A qualified intermediary must hold the proceeds. If the money touches your hands, the exchange is dead.
- To fully defer, you generally must trade equal-or-up in both value and debt.
Set the exchange up before you list, not after you close. The single most common and most expensive 1031 mistake is selling first and asking about it second. By then it is too late — there is no retroactive fix.
And note: while §1031 itself is federal, the state tax treatment is not uniform. Some states have their own rules, withholding requirements on sales, or clawback provisions if you exchange into property in another state. Talk to a CPA who knows the states involved — both the one you are selling in and the one you are buying in. Nothing on this page is tax advice.
Being a landlord: obligations you cannot opt out of
Landlord-tenant law is state law, and often city law on top of that. Security deposit limits, the deadline to return a deposit and itemize deductions, how much notice you must give before entering, how notices must be served, what the eviction process is and how long it takes, whether rent increases are capped, whether just-cause protections apply, the exact habitability standard, and required lease disclosures — all of it varies, and sometimes it varies between two cities in the same state.
Do not carry a rule over from another state, and do not rely on a template lease you found online. Before you rent a unit, confirm the actual requirements where the property sits — and for anything consequential, use a local attorney. Nothing on this page is legal advice.
What is federal, and applies to you everywhere
- The Fair Housing Act. As a landlord you may not discriminate on the basis of race, color, religion, sex, national origin, familial status, or disability. In practice this means: publish your screening criteria, apply them identically to every applicant, keep records of your decisions, and never advertise in a way that signals a preference for or against any protected class. It also means you must consider reasonable accommodations and modifications for applicants and tenants with disabilities. Many states and cities add further protected classes on top of the federal list — check yours.
- Lead-based paint disclosure. For housing built before 1978, federal law requires you to disclose known lead hazards and provide the approved pamphlet to tenants.
- Fair Credit Reporting Act. If you deny an applicant based on a consumer report, you owe them an adverse action notice.
The expenses new investors forget
- Capital reserves. Roofs, HVAC systems, and water heaters die on their own schedule. Budget for them monthly or you will finance them on a credit card.
- Vacancy and turnover. Not just the lost rent — the paint, the cleaning, the carpet, and the marketing.
- Management. Whether you pay a manager 8–10% or do it yourself, it is not free. Your time has a price.
- The bad month. A tenant stops paying and the legal process takes as long as it takes. Have the reserves to survive it without selling.
Let's underwrite a real deal
Send me a property you are considering — or tell me what you are looking for — and I will run the actual numbers with you: the real tax bill, a real insurance quote, realistic rent comparables, and what it does to your cash-on-cash. If it does not pencil, I will tell you that.
- A full underwrite on any property you are considering
- Realistic rent comps — not the seller's pro forma
- Introductions to investor lenders, and to a 1031 intermediary before you sell
- Off-market and pre-market opportunities in your local market