Topics:real estate investing
Guest Post by G. Brian Davis
One of the huge advantages of rental properties over stock trading or other paper assets through an investment brokerage is the ability to predict returns accurately.
With stocks, you buy and hope the price goes up. With rental properties, you know the precise cash flow you can expect each year.
Before you invest, however, make sure you understand exactly how to forecast rental cash flow.
Far too many novice real estate investors think their cash flow equals “rent minus the mortgage payment.” It's a good way to lose your shirt in real estate.
In fact, non-mortgage expenses generally add up to around half the monthly rent. Most of these expenses don’t hit you every month, so novice investors ignore them. But they add up, when averaged over time — rental investors refer to this as the “50% Rule.”
To calculate the monthly cash flow of a rental property, you need to first add up all expenses, many of which must be calculated as a long-term average. Subtract the total average monthly expenses from the market rent to calculate the average monthly cash flow.
Note that cash flow is not the same as your cash-on-cash return for a property. To calculate cash-on-return, divide your annual net cash flow by the total cash you personally invested to acquire the property. That includes both your down payment and closing costs, plus any renovations you paid for out of pocket.
For example, if you paid $30,000 in closing costs and the down payment, and the property nets you $3,000 per year in cash flow, then it’s earning you a 10 percent cash-on-cash return.
Use a free rental cash flow calculator to run the numbers quickly for both monthly cash flow and cash-on-cash return for any given property. But remember, your results will only be as accurate as your expense estimates.
To accurately forecast cash flow on a property before buying, you need to get the expense estimates right.
Here’s how to forecast every expense accurately — before shelling out money for a rental property or even an ADU.
Being able to leverage other people’s money to build your own portfolio of income-generating assets is one of the great advantages of investing in rental properties.
Real estate investors can borrow a mortgage, typically at 70 to 80 percent LTV (loan-to-value ratio). While they don’t have as many options as homeowners, they can borrow from a conventional mortgage lender, take out a rental property loan from a portfolio lender (many of whom are crowdfunded in today’s world), or even borrow money from friends and family once they’ve established a track record of success.
As a final thought, the monthly mortgage payment is the only expense that will stay fixed even as your rents rise. The other payments below typically go up over time, as your rents and property values rise.
No rental property is occupied every single day of every year, forever. You will have vacancies as a landlord, as you make repairs, advertise the unit for rent, screen tenants, and sign new leases.
So, you need to learn the vacancy rate for the neighborhood, to estimate how long you can expect future vacancies to last for your unit. It’s a question you should ask your Realtor, as you run the cash flow numbers before making an offer. Which means you need a knowledgeable real estate agent, intimately familiar with the neighborhood and accustomed to working with investors.
Real estate is, well, real. Buildings are physical assets, unlike stocks or bonds, and they need ongoing repairs and maintenance.
These costs vary based on many factors: the age and size of the building, how well the tenants treat it, and even its geography, as home maintenance costs vary across the United States.
As a general rule, maintenance and repair costs typically fall between 10 to 15 percent of the rent, when averaged over time.
It takes time and effort to manage a rental property. You can incur those labor costs yourself, or you can outsource them to someone else, but either way they’re still labor costs.
Most property managers charge 7 to 10 percent of the rent collected, plus one month’s rent for each vacancy filled. Some nickel and dime you for other fees as well.
Set aside at least 10 percent of the rent for total property management costs, even if you plan to manage the property yourself in the beginning. It’s a labor cost for you, and eventually you’ll likely outsource it to a pro when you get sick of tenants calling you to complain that a light bulb went out.
At the very least, property owners need landlords insurance.
Landlords insurance works similarly to homeowners insurance, although it doesn’t cover the belongings inside the home. It only covers the building itself. Like homeowners insurance, your lender will require it, if you finance your rental property.
You can optionally also purchase rent default insurance. These policies kick in if the tenant stops paying the rent: the insurance pays you the rent until you replace the tenant with someone more responsible.
The government always gets their due. Landlords pay property taxes, just like homeowners do.
But when you calculate cash flow, don’t use the current property tax bill. Instead, calculate the updated property tax bill based on the purchase price. The current assessment may be significantly lower than the purchase price, and the local government will bump up the assessment after you record the change in ownership and sales price.
Of course, landlords and homeowners alike should be prepared to appeal property tax assessments if they feel they’re too high. Which they often are, as local governments want to squeeze every tax dollar they can by estimating property values on the high side and putting the onus on property owners to contest them.
Most landlords don’t include utilities like water, gas and electric in the rent, and require tenants to pay for their own utility bills.
But that doesn’t mean landlords never get stuck with utility bills. Landlords pay for utilities while the property is vacant of course, and also sometimes get slapped with delinquent tenants’ utility bills. After all, it’s much easier for utility companies to collect from landlords than tenants, since they can simply attach a lien to the property.
Then there are all the other expenses that landlords incur. Their tax preparation gets more complicated, which means higher accounting bills.
They frequently have to visit their properties, which means gas and travel expenses. They incur legal expenses from evictions to lease agreement costs. It all adds up, typically to an extra 2 to 4 percent of the rent.
Laura Landlord is thinking about buying a property for $100,000, that rents for $1,200. She gets preapproved for a loan of $80,000 at 5 percent interest for 30 years. After doing her due diligence, she forecasts the monthly expenses as follows:
Laura’s average monthly cash flow is therefore $167 per month ($2,004 per year). If she paid $5,000 in closing costs in addition to the $20,000 down payment, then her cash-on-cash return would be 8 percent ($2,004/$25,000 = 8%).
In this example above, as often happens in real life, her non-mortgage expenses totaled around half the rent (in this case $604 per month). Laura won’t get hit with vacancy expenses or repairs every month, but when they occasionally hit, they’ll be expensive. Over the long term, they’ll average out to equal these monthly costs.
Don’t ignore these expenses simply because they don’t hit you every month. Account for them before buying, and you’ll be able to accurately forecast your cash flow and returns for every rental property you buy.
Which means you’ll never make a bad investment again.
G. Brian Davis is a real estate investor and founder at SparkRental.com, which helps middle-class people replace their day job with rental income. They offer a wealth of free courses and tools, along with online landlord software that’s (mostly) free for landlords. He spends 10 months out of the year traveling overseas with his family and has an insatiable appetite for reading, hiking, and perfectly paired wine and food.
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