What a Rental Property Actually Earns

The sum everyone does, and the number it misses by

The first calculation a prospective landlord does is rent minus mortgage. On our case — a $300,000 property, 25 percent down, a $225,000 loan at 6.5 percent over 30 years, let at $2,750 a month — that is $33,000 minus $17,065.84, or $15,934.16 a year. It reads like a salary. The true answer, once every line that a landlord actually pays has been booked, is $1,392.56. The naive sum is out by $14,541.60, which is 44 percent of the gross rent and more than ten times the real figure.

The gap is not random noise and it is not bad luck. It has a structure, and the structure is the same everywhere: a handful of costs that are certain but irregular, a couple that are certain and regular, and one — the reserve for major works — that is certain in the long run and invisible in any single year. New landlords do not miss these because they are careless. They miss them because in the first twelve months most of them genuinely do not appear. The boiler does not fail in year one. The tenant does not leave in year one. The roof is fine in year one. The account only balances over the life of the holding, and a first-year statement that shows no vacancy and no repairs is not evidence that the model was wrong — it is the model, sampled at its most flattering point.

The profit-and-loss account, line by line

Start at the top with $33,000 of gross rent, which is the only line that is not a cost. Vacancy comes off first because it changes the base for everything charged as a percentage of what you collect. At 6 percent — an assumption, and the subject of the next article in this series — it removes $1,980 and leaves $31,020 actually banked. Management, if you use an agent, is usually quoted on rent collected rather than rent contracted, which is the correct convention: nobody should be paid a percentage of money that never arrived. At 8 percent that is $2,481.60.

Maintenance is the line people underestimate most confidently. It is not the big items — those come next — but the running cost of a building that has someone living in it: a tap, a lock, a blocked drain, a boiler service, a repaint between tenancies. Booked at 8 percent of gross rent it is $2,640 a year, or $220 a month. Many landlords will tell you they spent nothing this year. Very few will tell you what they averaged over ten. A useful cross-check is to run the figure against the building instead of the rent: on a modest home, a common rule of thumb is one percent of the property value a year, which on $300,000 would be $3,000 — the same order of magnitude, arrived at from the other direction.

Insurance and property tax finish the operating block. They are the two lines nobody forgets, because a bill arrives with a date on it. Here they are $1,200 and $3,600 — the tax computed as 1.2 percent of price, an assumption that would be roughly right in parts of the United States and roughly wrong almost everywhere else, since the base can be a market value, a cadastral value, a rateable value or a rental value depending on the country. What matters structurally is that both are fixed in the short run: they do not fall when the flat is empty, and they are the reason a void month costs more than one month's rent.

The capital-expenditure reserve nobody books until the roof goes

Maintenance keeps a building running. Capital expenditure replaces the parts of it that wear out on a schedule measured in decades: the roof, the boiler, the windows, the wiring, the kitchen, the bathroom. None of these is a repair. Each is a large single payment separated from the last one by fifteen or twenty-five years, which is precisely why a landlord who has owned for three years has never seen one and a landlord who has owned for thirty has seen them all.

The honest way to book them is to spread them. Take the components, divide each replacement cost by its expected life, and add up the annual slices. A $9,000 roof on a 25-year life is $360 a year. A $4,500 boiler on 15 years is $300. A $9,000 kitchen on 20 years is $450. Windows, bathroom, flooring and electrics on similar arithmetic will comfortably carry the total past $2,000, and the 8 percent of gross rent used in the table — $2,640 — is a shorthand for exactly that sum, not a number picked because it is round. On an older building it is low. On a new build with a warranty it is high for the first decade and then catches up.

The reserve is also the line that most changes how a purchase looks. Two flats with the same rent and the same price are not the same investment if one has a boiler installed last year and the other has one installed in 2004. A survey that costs a few hundred buys you the ages of those components, and the ages are what the reserve should be built from. Deciding not to hold a reserve does not remove the cost; it converts a predictable annual charge into an unpredictable demand for several thousand at a moment you did not choose.

Net operating income, debt service and cash-on-cash

Subtracting the whole operating block — $12,561.60 — from the $31,020 collected gives net operating income of $18,458.40. This is the property's own result, independent of how it was financed, and it is the only figure in the account that two different buyers looking at the same building would agree on. Divided by the price it gives the capitalisation rate: $18,458.40 ÷ $300,000 = 6.15 percent. That number, and not the rent, is what a valuer capitalises and what a lender stresses.

Debt service comes next and it is the only line that belongs to the buyer rather than to the building. The $225,000 loan at 6.5 percent over 30 years costs $1,422.15 a month, $17,065.84 a year. Net operating income minus debt service leaves $1,392.56 — the cash flow. Against the $84,000 actually put in ($75,000 deposit plus $9,000 of purchase costs) that is a cash-on-cash return of 1.66 percent. It is a small number and it is meant to be: at a 6.15 percent cap rate and a 6.5 percent borrowing rate, the loan is very nearly consuming the whole yield, which is what it means for leverage to be neutral.

Before any of this, most buyers screen with the gross rent multiplier — here $300,000 ÷ $33,000 = 9.09. That ratio is derived properly in our article on why the gross rent multiplier is not a yield, and the point it makes is exactly the point of this article seen from the other end: a multiplier compares deals, it does not measure a return, because it stops at the top line of the account you have just read. Use it to decide which three properties to underwrite. Use the account to decide which one to buy.

Four returns, not one — and cash flow is the smallest

Most analyses collapse everything a rental produces into one number and then argue about which number it should be. It is cleaner to keep them apart, because they have different units, different certainty and different tax treatment. The first is cash flow: $1,392.56 in year one, money you can spend, 1.66 percent of the $84,000 invested. The second is principal repayment: of the $17,065.84 of debt service, $14,550.95 is interest and $2,514.88 reduces the balance, which is 2.99 percent of the cash invested. The third is appreciation: at an assumed 3 percent, $9,000, or 10.71 percent of the cash invested, because the growth accrues on the whole $300,000 while your money is only a quarter of it. The fourth is the tax position, treated separately below.

Add the three that are real and the first year produced $12,907.45, or 15.37 percent of the money invested. Cash flow is 10.8 percent of that total, principal repayment 19.5 percent, and appreciation 69.7 percent. This is the shape that surprises people, and it should not be dismissed as an artefact of the assumptions: change the appreciation assumption to zero and the ranking still puts cash flow below principal repayment, because at a 6.5 percent rate on a 30-year schedule the first year's amortisation is small but the cash flow, after a full expense account, is smaller still.

The four are also not equally reliable, and ranking them by size gets the risk ordering exactly backwards. Cash flow is the smallest and the most certain — it is money that either arrived or did not. Principal repayment is second smallest and the most certain of all, because it is written into a contract. Appreciation is by far the largest and entirely hypothetical: it is a number you assumed, it can be negative, and you cannot spend it without selling or refinancing. Any presentation that adds the three together and quotes a single percentage is mixing a bank statement with a forecast.

Principal repayment is a forced saving, not a yield

The $2,514.88 of principal repaid in year one is real. It is not, however, a yield, and calling it one is the most common inflation of a rental's headline return. A yield is money the asset generates. Principal repayment is money you moved from your current account into your own balance sheet, using the tenant's rent as the transfer mechanism. If you paid the same $2,514.88 into a savings account you would not call it a return of 2.99 percent on your deposit; you would call it saving $2,514.88.

What makes it worth quantifying separately is that it grows, and it grows in a way nothing else in the account does. Because every euro of principal repaid removes its own future interest, the amortising portion of a level payment rises geometrically. On this loan it is $2,514.88 in year one, $3,259.34 in year five, $4,507.07 in year ten, $8,618.35 in year twenty and $16,479.86 in year thirty. Over the last decade of the schedule the tenant is repaying capital at a rate the first-year figure does not hint at, and this is the mechanism that turns a rental with almost no cash flow into a paid-off asset — slowly, and only if you hold it.

The practical consequence is that a rental is a poor source of income and a decent mechanism of accumulation, and the two are frequently confused by the same person on the same spreadsheet. If you need the money now, cash flow is your figure and it is 1.66 percent. If you are building equity to spend in twenty years, principal plus appreciation is your figure and it is very much larger. What you cannot do is claim the second while living off the first.

The fourth return is a tax position, and it is usually borrowed from the future

In the United States, residential rental buildings are depreciated over 27.5 years under a fixed statutory schedule. Assuming the building is 80 percent of the $300,000 price, that is $240,000 ÷ 27.5 = $8,727.27 of annual depreciation. Net operating income of $18,458.40, less mortgage interest of $14,550.95, less that depreciation, gives taxable income of −$4,819.83: a property producing positive cash flow and a taxable loss in the same year. At a 30 percent marginal rate the loss is worth $1,445.95 — subject to the passive-activity limits, which decide whether it can be used now or must be carried forward.

The important word in that paragraph is deferral. Depreciation does not make the building cheaper; it moves a deduction forward and reduces your tax basis by the same amount. When you sell, the reduced basis produces a larger taxable gain, and in the United States the depreciation taken is recaptured at its own rate. So the fourth return is real cash in the year it appears and a liability accruing quietly behind it. Counted as a return without counting the reversal, it flatters the analysis exactly as much as it helps the cash flow.

This is also the line of the account that travels worst. Every other line — vacancy, management, maintenance, reserve, insurance, tax, debt service — has the same meaning in every country, even if the numbers differ. The tax leg does not: the deduction that exists in one market is absent in the next, and a flat substitute tax on gross rent, where it exists, deletes the deduction question altogether. Any rental model you find online carries its author's tax code in it, usually invisibly, and that is the first thing to strip out before you reuse it.

Frequently asked questions

Is a 1.66 percent cash-on-cash return bad?

It is low, and it is a consequence of one input: a 6.5 percent borrowing rate against a 6.15 percent cap rate. When the loan costs more than the property yields, leverage subtracts from cash flow instead of adding to it, and the more you borrow the worse the cash flow gets even as the total return rises. The same building bought for cash would show a 6.15 percent return on $309,000, with no debt service and no principal repayment. Neither version is right or wrong; they are different trades, and the cash-on-cash figure is the one that tells you whether you can afford to hold the thing.

Should the capital-expenditure reserve be a percentage of rent or of value?

Neither, strictly. Both are shortcuts for the only defensible method, which is to list the components, price their replacement, divide each by its remaining life and add up. Percentages of rent break down where rents are very high relative to build cost — a small flat in an expensive city has a cheap roof and an expensive rent — and percentages of value break down where land is most of the price, since land does not need replacing. Use the component method for a property you are actually buying, and a percentage only to screen. Whichever you use, hold the money somewhere you will not spend it.

If I manage the property myself, can I delete the management line?

You can remove it from the cash account, and you should keep it in the analysis. The $2,481.60 is what the job costs; doing it yourself converts a cash expense into unpaid labour, which is a real decision with a real price. There are two practical reasons to keep the line visible. First, it tells you what you are earning per hour for the viewings, the paperwork and the 7 a.m. phone calls, and some people discover the answer is unattractive. Second, if you ever want to sell or to stop, the buyer or the agent will price the property with management in it — so a return that only exists because you work for free is not a return the asset can be sold with.

Why is appreciation counted on the whole property but cash flow on my deposit?

Because that is where each one lands. Price growth applies to the asset, and the lender's share of the asset is fixed in nominal terms — the bank is owed $225,000 whether the house is worth $200,000 or $400,000 — so the whole of the movement, up or down, accrues to the equity holder. Cash flow, by contrast, is what remains after the lender has been paid, so it is already net of the loan and belongs entirely to the capital you put in. The asymmetry is real, it is the reason leverage magnifies property returns, and it is also the reason it magnifies losses. Our article on appreciation works the multiplier out in both directions.

What single input changes this account the most?

The interest rate, because it hits the largest line. Debt service is $17,065.84, or 52 percent of gross rent; a one-point move on a $225,000 loan over 30 years changes the payment by roughly $150 a month, which is more than the entire annual cash flow. Vacancy is second: each extra percentage point removes $330 of rent and about $26 of management fee, so a rate of 10 percent instead of 6 would cost around $1,300 and wipe out the cash flow on its own. Appreciation moves the total return the most but the cash account not at all — which is the distinction this whole article exists to draw.