It happens all the time to new real estate investors: they lose their shirt on a rental because they failed to calculate cash flow properly.
“Well, the mortgage payment is $500, and the rent is $700, so that’s $200/month cash flow, right?”
Wrong. That poor sap is about to lose a lot of money.
They’ve forgotten about a host of expenses, ranging from vacancies to property management services to maintenance to CapEx to accounting fees and beyond.
Is there any good news? A silver lining in all this doom and gloom?
It turns out that there is. Rental properties, unlike equities, have quite predictable returns. Investors can accurately calculate a rental property’s cash flow in a few minutes, on the back of a napkin. There’s even a shorthand they can use to estimate cash flow in a few seconds.
This post was written by our partners at SparkRental, who provides rent automation services (including rent deduction from the tenant’s paycheck), along with a series of free landlord resources.
We’ll follow Deanna as she evaluates a property listed for $200,000. She plans to put down 20% and has a lender ready to lend her the remaining $160,000 at 7% interest. After checking on the local property tax rate (1% of assessed value) and getting a quote from her insurance agent, here are her initial monthly expenses:
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
Vacancies
When old tenants move out, it’s extremely rare for new renters to move in the same day.
Usually, landlords must repaint the unit, clean it up, and potentially replace the carpets. They need to make overdue repairs and property updates, to keep the property competitive and attract better tenants.
And that says nothing of marketing the unit for rent, showing it, screening tenants, negotiating and signing a new lease agreement. Sure, in hot markets, it may not take long to find a replacement renter. But not every market is bursting at the seams, despite what you read in the paper.
In an average market, landlords can often expect about a month between tenancies – a vacancy rate of roughly 8% (one month/year). That number will be lower in hot markets, and higher in low-demand markets. It’s not uncommon for properties to sit vacant for six, nine, even twelve months in slower markets. I’ve had properties sit vacantly that long, with few nibbles or interest in signing a lease no matter how generous the terms.
Deanna’s prospective property rents for $2,400 in total. After talking to local landlords and property management services, she estimates the vacancy rate to be 8%. Her numbers now look like this:
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
- Vacancy Rate: $192/month
Repairs, Maintenance, CapEx
Properties need repairs sometimes. Sure, in a typical month, Deanna will have no repair costs. Then suddenly she’ll be hit with a $3,000 bill to replace the furnace.
Landlords need to budget money for repairs, large and small. Basic maintenance and repairs include items like painting and replacing carpets, which typically need to be done before each new lease agreement. Capital expenditures, or CapEx, include rare but recurring large expenses like new roofs, new furnaces, new appliances, etc.
Every component of a building has a life span and will need to be replaced when its lifespan ends.
After Deanna runs some numbers to calculate CapEx, Deanna decides to set aside 5% for it and estimates her maintenance and repair costs will run another 8% of rents.
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
- Vacancy Rate: $192
- Repairs & Maintenance: $192
- CapEx: $120
Property Management Services
Deanna plans to manage the property herself, so does she still need to include property management services in her cash flow calculations?
Oh, yes.
Why? She won’t actually incur that cost, right?
Actually, she will, it just won’t be neatly deducted from her rent deposits like it would if she hired a property manager. Managing rental properties costs time – it’s a labor expense, whether you are outsourcing the labor to a property manager or doing the labor yourself.
Ideally, you should be paying yourself a property management fee, for all properties you manage yourself. This keeps your returns “honest” and lets you compare passive returns to passive returns.
Imagine comparing a rental property to a mutual fund. If you want to compare apples to apples, you need to take into account the labor cost associated with the rental property, since mutual funds have no labor cost. Mutual funds are truly passive investments; rental properties are only semi-passive.
After researching local property management services, Deanna finds one with excellent reviews and references, that charges 5% of collected rents plus full a month’s rent when they place a new renter. She decides to set aside 10% for property management expenses.
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
- Vacancy Rate: $192
- Repairs & Maintenance: $192
- CapEx: $120
- Property Management Services: $240
Utilities
Who’s responsible for paying the utility bills?
Deanna plans to have the renters pay all utility bills. Still, she knows she’ll occasionally get stuck with water bills or other unpaid utility bills.
Knowing this, she adds $15/month to cover these occasional costs.
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
- Vacancy Rate: $192
- Repairs & Maintenance: $192
- CapEx: $120
- Property Management Services: $240
- Utilities: $15
Accounting, Administrative, Gas & Mileage and Beyond
Your accounting bill will go up, with each rental property you buy. Count on it.
Likewise, you’ll have bookkeeping costs. Who’s going to keep the rent ledger? Who’s going to keep files with all repair invoices, utility bills, tax statements, insurance policies, lead inspection certificates, etc.?
Where will you get a lease agreement package for your state?
You’ll need to print tenant notices, stuff them in paper envelopes, and physically mail them. With real stamps. Being a landlord means being bound by landlord-tenant regulations, which require snail mail notices, certified mail, and other vestiges of the ‘90s.
Every time you visit the property, it will cost gas, and wear and tear on your car.
These costs may seem negligible, but they’re real. They add up over time.
Deanna lumps these all together under miscellaneous, and sets aside 5% for them.
- Principal & Interest: $1,065
- Property Taxes: $167
- Insurance: $100
- Vacancy Rate: $192
- Repairs & Maintenance: $192
- CapEx: $120
- Property Management Services: $240
- Utilities: $15
- Misc.: $120
Deanna’s Deal
How does Deanna’s deal look, after all this scrutiny?
All those monthly expenses come to $2,211. That leaves $189/month in positive cash flow.
Is that good? Bad?
Let’s look at her cash-on-cash return, also known as annual yield. Her annual revenue forecast is $2,268.
For the sake of simplicity, we’ll exclude closing costs and any initial repairs required, and we’ll ignore any appreciation the property may accrue. In other words, we’ll just compare Deanna’s $40,000 down payment to her annual profit of $2,268.
Deanna’s annual yield is 5.67% ($2,268 / $40,000), which is hardly earth-shattering. With that said, there are a number of ways she can improve these numbers. She was pretty conservative with many of these numbers, assuming regular tenant damage, turnovers, and repairs. If her property is in a mid- or higher-income area, she can probably expect lower vacancy rates, fewer turnovers, and fewer repair costs. She probably won’t be stuck with utility bills from wayward tenants abandoning the property mid-lease.
Or Deanna could lower her offer to $180,000, instead of paying the full $200,000. If that fails, maybe she convinces the seller to hold a second mortgage for her, to cut her down payment in half.
Or she could make a few property upgrades to make the property more desirable. That comes with a slew of benefits, from higher rents to lower vacancy rates to higher-quality renters who treat the property better and stay longer.
Experienced investors know how to negotiate, tweak, and massage deals to make them work. The trick is to do so without deluding yourself into accepting a deal that is fundamentally flawed.
The 50% Rule
We promised a shorthand calculation, to estimate cash flow within a few seconds.
Here’s how that calculation works:
Step 1: Subtract out half the rent for expenses
Step 2: Subtract out the principal and interest costs
Step 3: There is no Step 3. You’re done. This is your cash flow estimate.
In Deanna’s case, she subtracts out $1,200 for expenses, then subtracts another $1,065 for principal and interest. That leaves $135 as her estimated monthly cash flow.
Not perfect, right? Not as accurate as of the $189 from her full calculation. But it gets her in the ballpark. She can use this shorthand to determine if a deal is worth a closer look.
If you run the 50% rule and come up with a return of -15%, you know the deal is probably not worth pursuing.
Be conservative when you calculate cash flow for a potential deal. It’s better to err on the side of being too conservative when evaluating properties – extra money from higher returns is far more welcome than losing money to unexpected repairs, vacancies, and other expenses!
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