Analytics and Portfolio Growth

Successful real estate investing is not about emotions, luck, or secrets. It’s about understanding numbers and following proven strategies. This guide provides key concepts and metrics to help you assess and compare properties effectively while recognizing their limitations.

Topics covered:

Prices and Rents
Inflation and Rents
Maintenance Cost Provision
Vacancy Cost Provision
Depreciation
Combining Maintenance, Vacancy, and Depreciation
Analyzing Investment Properties

Prices and Rents

What determines price and rent?

Prices: Real estate prices are driven by supply and demand. When buyers outnumber sellers, prices rise until equilibrium is reached. Conversely, when sellers outnumber buyers, prices fall.
Rents: Rental rates are tied to property prices. High prices reduce homeownership affordability, increasing rental demand and driving up rents. Low prices increase homeownership, reducing rental demand and lowering rents.
Takeaway: Rental rates typically lag 2–5 years behind property prices, primarily due to existing lease terms. By watching current price trends, you can anticipate future rental trends.

See this paper for specifics on estimating future rent growth for a specific zip code.

Inflation and Rents

Financial freedom isn't a single event. Financial freedom requires an income that enables you to sustain your standard of living throughout your lifetime despite inflation.

Inflation erodes purchasing power, so your rental income must grow faster than inflation to maintain financial freedom. Here’s how inflation and rent growth interact:

The formula for calculating the future value in today's dollars (buying power) is:

FV = PV x (1 + g)^n / (1 + i)^n

FV: Future value in today’s dollars
PV: is the current (starting) rent
g: is the annual rent growth
i: is the annual inflation rate
n: is the number of years into the future.

Example 1: $1,000/month, 5% inflation rate, 2% rent growth.

After 5 years: $1,000 x (1 + 2%)^5 / (1 + 5%)^5 ≈ $865
After 10 years: $1,000 x (1 + 2%)^10 / (1 + 5%)^10 ≈ $748
After 15 years: $1,000 x (1 + 2%)^15 / (1 + 5%)^15 ≈ $647

The takeaway is that even though rent increased by 2% per year, inflation decreased the buying power by 5% per year. This is why you can never achieve financial freedom if you buy properties in a city where rents do not outpace inflation.

Example 2: $1,000/month, 5% inflation rate, 7% rent growth.

After 5 years: $1,000 x (1 + 7%)^5 / (1 + 5%)^5 ≈ $1,099
After 10 years: $1,000 x (1 + 7%)^10 / (1 + 5%)^10 ≈ $1,208
After 15 years: $1,000 x (1 + 7%)^15 / (1 + 5%)^15 ≈ $1,327

Rent growth exceeding inflation preserves and increases buying power.

Maintenance Cost Provision

Investors want to factor in future maintenance costs when calculating cash flow or ROI. Many popular real estate websites suggest using 5% of annual rent to estimate maintenance costs. However, this approach is invalid since maintenance costs have no relationship to rental income.

For example, below are two properties. Property A rents for $1,050/month, and Property B rents for $2,000/month.

According to the property manager, Property A's annual maintenance cost exceeds $2,000/Yr. Property B has an average maintenance cost of around $350/Yr.

How does the rent multiplier method compare to actual data?

Property A: The average maintenance cost is about $2,000/Yr. The 5% “Rule” is $630/Yr, which is too low and completely wrong.
Property B: The average maintenance cost is about $350/Yr. The 5% “Rule” is $1,200/Yr, which is too high and completely wrong.

Our recommended properties are similar in type and condition, resulting in similar maintenance costs. Historical data shows the average annual maintenance cost is about $450, representing roughly 1.5% of gross annual rent.

Vacancy Cost Provision

Several popular real estate websites claim that vacancy costs can be estimated as 5% of annual rent. Like maintenance, this method is invalid because the amount of rent has nothing to do with vacancy cost.

Below is data on the three major tenant segments in Las Vegas.

Segment Handle	Transient Tenants	Permanent Tenants	Transitional Tenants
Property class typically occupied	C and -B Class	-A and A Class	A Class
Average length of stay	<=1 Yr	>5 Yrs	<2 Yrs
Typical rent	$800 to $1,000	$1,700 to $2,500	>$3,000
Typical Annual vacancy cost	~$3,200	~$450	~$3,500

Comparing the 5% multiplier with historical data.

Transient Tenants: (Rent = $950/month): Actual Vacancy Cost ≈ $3,200/year, 5% “Rule” = $570/year
Permanent Tenants: (Rent = $2,000/month): Actual Vacancy Cost ≈ $400/year, 5% “Rule” = $1,200/year

Takeaway: Vacancy costs depend on tenant performance and other factors, not the amount of rent. For the tenant segment we target, vacancy costs average $400/year, or 1.5% of annual gross rent.

Depreciation

Depreciation is an accounting prceedure that measures the decline in value of a property or its components over time. The concept is straightforward.

Depreciation is an accounting concept that enables businesses to deduct the cost of an asset over its useful life. It reflects the wear and tear, obsolescence, or decline in utility of an asset as it is used over time. By systematically recording depreciation, businesses can match the cost of an asset with the revenue it generates, providing a more accurate picture of profitability. Where this falls down is most real estate increases in value.

The IRS defined process:

Determine what percentage of the purchase price is attributable to land (which is not depreciable) and what percentage is improvements (which are depreciable).
Divide the depreciable amount by the IRS-dictate useful life of residential real estate which is 27.5 years,

For example, suppose you buy a $400,000 property, and 80% is improvements, and 20% is the land cost. The annual depreciation is calculated as follows:

($400,000 x 80%) / 27.5 ≈ $11,636/yr

This deduction reduces your taxable rental income. For most investors, it shelters rental and possibly other income, depending on their tax situation. Depreciation typically increases an investor's effective return by 3% to 6%, which depends on your specific tax situation.

Combining Maintenance, Vacancy, and Depreciation

Faced with three unknowns—maintenance, vacancy, and tax savings, I decided to offset maintenance and vacancy costs with tax savings.

Based on client surveys, tax savings have consistently exceeded the combined costs of vacancy and maintenance. Therefore, we do not include maintenance or vacancy costs or tax savings in our calculations. You will see how this affects our return calculation formula later in the guide.

Analyzing Investment Properties

This section examines popular investment metrics and their limitations.

Cash Flow

Cash flow is the difference between income (rent) and expenses. The basic formula is:

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - MaintenanceCost - VacancyCost) x (1 - IncomeTaxRate)

However, we do not include the following in our calculations:

MaintenanceCost: As you previously read, there is no way to estimate maintenance cost, so we exclude this cost.
Vacancy Cost: As you previously read, the vacancy cost cannot be estimated, so we exclude it.
IncomeTaxRate: Every individual will be different, so we exclude taxes.
Insurance: The cost of landlord insurance varies widely depending on the deductible you choose and other factors. With a $1,000 deductible or higher, landlord insurance typically costs around $800 per year, which we use in the calculations.

Based on the above, the cash flow calculation we use is:

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees)

ROI (Return on Investment)

ROI is (Cash Flow)/(Acquisition Cost). The general formula is below.

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - ~~MaintenanceCost~~ - ~~VacancyCost~~) x (1 - ~~IncomeTaxRate~~) / (DownPayment + ClosingCosts + ~~RenovationCosts~~)

However, we do not include the following in our calculations:

MaintenanceCost: As you previously read, there is no way to estimate this cost.
VacancyCost: As you previously read, there is no way to estimate this cost.
IncomeTaxRate: Nevada has no state income tax so this is not included.
RenovationCosts: Although we provide a renovation cost estimate early in the evaluation process, the final amount isn't determined until the due diligence period. Since renovation is a one-time expense, it affects ROI less than recurring costs.
ClosingCosts: Based on research, actual closing costs range between 1.5% and 1.7% of the gross purchase price. Until interest rates exploded, we estimated closing costs as 2% of the gross purchase price. Today, people tend to buy down the interest rate, so we added 1% to cover these costs. In summary, we estimate closing costs to be 3% of the gross sale price.
Insurance: The cost of landlord insurance varies widely depending on the deductible you choose and other factors. With a $1,000 deductible or higher, landlord insurance typically costs around $800 per year, which we use in the calculations.

So, the formula we use for ROI is:

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees) / (DownPayment + ClosingCosts)

Cash flow and ROI limitations.

Cash flow and ROI only predict how a property will likely perform on the first day of ownership under ideal conditions.
Cash flow and return on investment (ROI) do not fully reflect your actual return due to taxes. However, this doesn't mean they're useless. They can be quite valuable when comparing properties within the same area. For instance, these metrics can be very useful if the properties are located in the same city and have comparable appreciation rates, rent growth rates, property taxes, and rental regulations. In this situation, cash flow and ROI are useful for comparing properties.

Rent-to-Price Ratio

While popular, this calculation is invalid. I will demonstrate the problem by comparing two properties.

	Property A	Property B
Price	$400,000	$350,000
Rent (Mo)	$2,200	$2,200
Taxes (Yr)	$2,000	$8,000
Insurance (Yr)	$800	$2,800

Calculating the rent-to-price ratio for the two properties:

Property A: ($2,200 x 12)/$400,000 x 100 ≈ 6.6%
property B: ($2,200 x 12)/$350,000 x 100 ≈ 7.5%

Property B is the clear winner. Or is it? Let’s estimate cash flow.

Property A: ($2,200 x 12) - $2,000 - $800 = $23,600
property B: ($2,200 x 12) - $8,000 - $2,800 ≈ $15,600

Property A outperforms Property B due to lower operating costs. Since the rent-to-price ratio ignores operating costs, it should never be used for making investment decisions.

Cash Flow and ROI Are Misleading

In most cases, you'll hold onto investment properties for many years. While cash flow and ROI are handy for initial comparisons, they don't give insight into future performance. I'll illustrate this by comparing Property A and Property B. Here's the basic information.

	Property A	Property B
Purchase Price	$350,000	$400,000
Initial Rent (Mo)	$2,000	$2,000
Expenses (Mo)	$1,600	$1,800
Property Taxes (Yr)	$2,450	$2,800
Insurance (Yr)	$700	$800
Rent Growth (Yr)	2%	7%
Inflation (Yr)	5%	5%

Calculating Initial monthly cash flow:

Property A: $2,000 - $1,600 - $2,450/12 - $700 /12 ≈ $137.50
Property B: $2,000 - $1,800 - $2,800/12 - $800/12 ≈ -$100.00

This is a no-brainer; property A is the better investment. Or is it? Over ten years, let’s look at buying power (what you live on).

After Year #	Present Value Net Cash Flow	Present Value Net Cash Flow
1	1943	2038
2	1887	2077
3	1833	2116
4	1781	2157
5	1730	2198
6	1681	2240
7	1633	2282
8	1586	2326
9	1541	2370
10	1497	2415

As you can see, Property A's buying power (present value) declines yearly, while Property B's (present value) cash flow increases yearly. So, Property A is a bad investment despite its strong first-year performance. This demonstrates why you must look at probable price and rent growth.

Growing A Portfolio

To achieve income replacement, you'll need multiple investment properties. How much capital you'll need depends on property appreciation rates in the investment city. Cities with high appreciation rates require less capital, while those with low appreciation rates demand more. To demonstrate this, I will compare two markets: one with little to no appreciation and another with significant appreciation, showing how each affects your total capital requirements.

Suppose you need $5,000/Mo to replace your current income, and the cash flow from each property is $300/Mo. How many properties will you need?

$5,000 / $300 ≈ 17 properties

If your only acquisition cost is a 25% down payment, and each property costs $250,000, how much capital will you need from your savings?

17 x 25% x $250,000 ≈ $1,062,500. This is an unobtainable amount for most people.

Note: The following is a simplified example that doesn't account for inflation, but the core concept remains valid.

What if you invested in a city with significant rent growth?

If the initial rent is $2,000/month, with expenses remaining constant at $1,700/month, how many properties will you need to generate $5,000/Mo if rents increase by 8% annually?

Year 0: Cash flow: $2,000 - $1,700 = $300/Mo = 17 properties
Year 1: Cash flow: $2,000 x (1 + 8%)^1 - $1,700 ≈ $460/Mo. Properties needed: $5,000/$460 = 11 properties
Year 2: Cash flow: $2,000 x (1 + 8%)^2 - $1,700 ≈ $633/Mo. Properties needed: $5,000/$633 = 8 properties
Year 3: Cash flow: $2,000 x (1 + 8%)^3 - $1,700 ≈ $819/Mo. Properties needed: $5,000/$819 = 6 properties
Year 4: Cash flow: $2,000 x (1 + 8%)^4 - $1,700 ≈ $1,021/Mo. Properties needed: $5,000/$1,021 = 5 properties
Year 5: Cash flow: $2,000 x (1 + 8%)^5 - $1,700 ≈ $1,239/Mo. Properties needed: $5,000/$1,239 = 4 properties

The takeaway is that if you invest in a city where rents increase rapidly, you will need fewer total properties to meet your $5,000/Mo requirement.

How much capital would you need to acquire 17 properties in a city where properties appreciate at 10% annually?

Cash-out refinancing allows you to replace your current loan with a new loan once you've accumulated enough equity, allowing you to use a portion of the accumulated equity to purchase another investment property.

In this example, I will assume that property costs $400,000, and the only acquisition cost is a 25% down payment. The future investment property will cost $475,000, requiring a 25% down payment of $118,750. How long will it take to accumulate $118,750 for the down payment using a 75% cash-out refinance? To simplify, I will assume there's no principal paydown on the initial $300,000 loan.

After one year: $400,000 x (1 + 10%)^1 x 75% - $300,000 ≈ $30,000 investable cash.
After two years : $400,000 x (1 + 10%)^2 x 75% - $300,000 ≈ $63,000
After three years: $400,000 x (1 + 10%)^3 x 75% - $300,000 ≈ $99,300
After four years: $400,000 x (1 + 10%)^4 x 75% - $300,000 ≈ $139,230

So, after three years, a 75% cash-out refinance will provide enough cash for the down payment on the $475,000 property. See this article for a real world example.

Buying in a city with rapid and sustained appreciation lets you use accumulated equity to purchase additional properties, minimizing the capital needed from your savings. As your property portfolio grows, your total equity accumulates faster—creating a snowball effect that accelerates your ability to add new properties. See the illustration below, which shows the geometric progression of property acquisition.

Summary

I covered a lot of topics in this guide. We always seek ways to improve our material, so I welcome your feedback on how this, or any other guide we provide, can be improved.

Review Questions

Cash Flow

What is the formula for calculating cash flow, and which costs are excluded in the guide's calculations?
Why are maintenance costs, vacancy costs, and income taxes excluded from the cash flow calculation?

ROI (Return on Investment)

What is the formula for calculating ROI, and which costs are excluded in the guide's calculations?
Why are renovation costs excluded from the ROI calculation?
What are the limitations of cash flow and ROI when analyzing investment properties?

Rent-to-Price Ratio

Why is the rent-to-price ratio invalid for making investment decisions?
Using the example of Property A and Property B, explain why Property A outperforms Property B despite having a lower rent-to-price ratio.

Cash Flow and ROI Are Misleading

Why are cash flow and ROI insufficient for predicting long-term property performance?
In comparing Property A and Property B, which property has better initial cash flow, and why does this not make it the better investment?
How does rent growth impact the long-term buying power of Property B compared to Property A?

Growing a Portfolio

Why do cities with high appreciation rates require less capital to grow a portfolio than cities with low appreciation rates?
How many properties would you need if you require $5,500 monthly cash flow and each property generates $300 per month?
How does rapid rent growth reduce the number of properties needed to achieve a $5,000/month cash flow goal?
What is cash-out refinancing, and how can it help investors grow their portfolios?
For example, if a $400,000 property appreciates 8% annually, how much investable cash can be generated after three years through a 75% cash-out refinance?
How does investing in a city with rapid appreciation create a snowball effect for property acquisition?