How much profit should you make on a rental property?
There is possibly an infinite number of ways to answer this question if the goal is to be subjective. However, in this post, my goal is to give somewhat of an objective answer. In order to do this, I need to bring another party into the equation: the lender.
Now, it could be that you’re looking to buy a rental property (or properties) with cash and never secure long-term financing, but I don’t imagine that’s true for the average person reading this post.
So, going with the assumption that you’ll be working with a lender, we must consider profitability from the lenders’ perspective as well in order to answer the question before us.
You see, if the lender doesn’t think your rental property will be profitable enough, then they will be less likely to extend financing to you. Furthermore, keeping the numbers looking good for a lender becomes especially important if you’re looking to grow your rental portfolio.
When determining a property’s profitability, lenders focus heavily on a number called Debt Service Coverage Ratio (DSCR).
Before we discuss DSCR further, download Zilculator’s DSCR spreadsheet by visiting this page, and scrolling to the bottom.
The formula for calculating DSCR is the following:
Net Operating Income (NOI) / Total Debt Service
To calculate NOI, you simply add up your annual rent, or projected annual rent, and subtract your operating expenses and vacancy loss. Operating expenses, in this case, are the costs of owning a rental property. Here are the costs you should consider:
Unless you know the average vacancy loss for your property, assume that it will be 10%. So, multiply your annual rent by .1 or 10% get your vacancy loss.
Now, go to Ziculator’s DSCR spreadsheet, and enter the numbers you have so far in cells c8, c9, and c10.
Next, you’ll need to enter your estimated mortgage payment in cell c11. If you don’t know your mortgage payment, use this calculator, and enter the amount you’re planning on borrowing, the loan term, and the anticipated interest rate. Multiply the monthly payment by 12 and enter that number in c11 on your spreadsheet.
Ok, now you should have your DSCR.
In my experience, most banks like to see a minimum DSCR of 1.2, however, as your rental portfolio grows, they may want to see a higher DSCR. Personally, I like to see a DSCR at no less than 1.4.
So, now that you understand what is considered good profitability from a lender’s perspective, let’s convert DSCR into a dollar amount, so you can determine for yourself if your property’s profit is enough for you.
Arriving at this number is simple. Just take your NOI (cell c26) and subtract your annual debt service (cell c27), and you have your annual profit. Then, of course, just divide that number by 12, to get your monthly profit.