Summary: In this article you’ll learn how to predict ROI and potential cash flow when evaluating a rental property. Topics include how to account for property management fees, vacancy rate, repairs and maintenance, property taxes, insurance, HOA and condo fees, and other miscellaneous expenses. Our guest author also explains how leverage can change the game when it comes to mortgages.
Not many investments let you pinpoint your returns before you take the plunge.
With rental properties, you know the purchase price, you know the market rent, and you can accurately forecast the expenses. Not on a month-to-month basis; in most months, you won’t have any non-mortgage expenses. Then you’ll get hit with a $5,000 roof bill.
Novice investors get caught off-guard by that roof bill. They splutter and panic and scramble to find the funds. They tell themselves that this year they lost money on the property, but next year’s returns will be different.
Then next year they have a turnover and lose $4,000 in lost rents, new paint, and new carpets. The year after that it’s the furnace. Then the air conditioning condenser, and it continues until the landlord throws up their hands, sells the property, and swears off real estate forever.
Savvy real estate investors know that they need to take these irregular-but-inevitable expenses into account when they calculate cash flow. Fortunately, it’s easy enough to learn in the course of five minutes.
Averaging Non-Mortgage Expenses
To forecast a rental property’s cash flow, you need to take the long-term average of irregular expenses. The easiest way to do so is as a percentage of rent.
As you plug numbers into a rental cash flow calculator, be sure to include all of the following expenses. When in doubt, estimate on the conservative side – better to overestimate expenses than underestimate them!
Property Management Fees
New investors object all the time: “But I’m going to manage the property myself! I don’t need to pay property management fees.”
Good for you. That works until you move out of town, or get a promotion that leaves you no time for hassling with tenants, or you give birth to twins and average four hours of sleep each night.
Or you simply hate managing rental properties. That turned out to be the case for me.
But even if none of that happens, the simple fact is that property management is a labor expense, whether you do the labor or someone else does. Your index funds don’t require ten hours of labor each month to manage. Your rental properties might.
So, you need to include property management fees when you run the numbers in a rental income calculator. And not just the monthly percentage of rent collected, either. You also need to estimate how often you’ll need to pay the new tenant placement fee (typically one month’s rent).
As a general rule, I estimate 4% of the rent for new tenant placement fees – that comes to a turnover every two years – plus the ongoing monthly rent percentage. Thus, if property managers in your market typically charge 8% of the rent plus one month’s rent for new tenant placement, you should estimate 12% of the rent for property management fees.
Make no mistake: you will have vacancies. Hopefully not frequently, or for longer than a month, but they happen.
As with property management fees, I estimate a turnover every other year. I aim for longer-term tenants and lower turnover rates, but again, estimate conservatively.
For each turnover, I estimate a one-month vacancy. If your property manager proves attentive and effective, they can get the property re-rented before the outgoing tenant leaves and knock out any turnover-related maintenance and cleaning within 24 hours. But life doesn’t always go according to plan.
Therefore, I typically estimate a 4% vacancy rate for stable, reasonably warm rental markets. In cooler markets, where you may see a turnover every year, or a multi-month vacancy, an 8% vacancy rate assumes one month vacant out of each year.
Repairs & Maintenance
Technically, repairs represent either fixes to specific damage or property upgrades, while maintenance refers to regular periodic upkeep like repainting. But nitpicking doesn’t help in the context of calculating rental cash flow, so I lump them together.
For the average house, I estimate between 10-15% of the rent for repairs and maintenance. Sooner or later everything in every property needs to be replaced. And the more often your property turns over, the more often you’ll need to go in and repaint, re-carpet, and otherwise put the unit in marketable condition.
In higher-demand areas and new properties, you can likely get away with 10%. In cooler markets or older properties, estimate closer to 15% of the rent.
After buying the property, set aside these funds (and those for the vacancy rate) in a separate account each month. When you do get hit with that $5,000 roof bill, you’ll have the money to cover it.
Most investors remember to include property taxes when they run numbers through a rental cash flow calculator. It helps that lenders typically escrow for them and include them in your monthly mortgage payment.
But where new investors trip up is in using the existing property tax bill in their calculations. Many municipalities reassess the property value in the year following a transfer, based on the purchase price. This means that your property tax bill can leap upward within a year of buying.
Look up the property tax rate in each prospective property’s municipality. Ignore the current property tax bill, and instead calculate the property tax bill based on the purchase price. Use that number when you run your cash flow calculations, as it reflects what you will likely pay.
Property insurance is the easiest number in your cash flow calculations. You should develop a sense for what investment property insurance costs in any given market, for different types of properties.
If you don’t, start building relationships with a few insurance agents in each market. Ask for quotes for properties similar to those you’re looking to buy.
Keep in mind that lower-end properties don’t mean lower insurance premiums. Quite the opposite in fact – insurance costs more in areas with high vacancy rates and high crime rates.
HOA & Condo Fees
Investors who consider condominiums or areas with homeowners’ associations have to include the monthly fees in their cash flow calculations as well.
They should also inquire about special assessments. These occasional bills can prove budget-busting and ruin your returns for the entire year.
Administrative, Travel, Legal, Accounting, & Miscellaneous Costs
These costs include driving to and from your properties, paying for property management software, buying lease agreements, serving eviction notices, court fees, bookkeeping costs, higher tax return preparation fees, and a dozen other minor expenses.
By themselves, none of these costs would break the bank. But these small costs add up over each year, and significantly impact your returns.
I typically estimate 2-4% of the rent for these expenses. How much depends on how stable the neighborhood and tenants are, and how many other units you own; the more units, the greater the economy of scale you can implement.
Mortgages: How Leverage Can Change the Math
Mortgages amplify your returns. For better or worse.
Imagine you’re evaluating a property in a solid working-middle-class neighborhood with sound fundamentals. You can buy it for $80,000, and it rents for $1,000. The expenses in this neighborhood look like this:
- Property Management Fees: $120 (12% of the rent)
- Vacancy Rate: $40 (4%)
- Repairs & Maintenance: $120 (12%)
- Property Taxes: $150 ($1,800/year)
- Property Insurance: $75 ($900/year)
- Misc.: $30 (3%)
- Total Non-Mortgage Expenses: $535
- Monthly Cash Flow: $465
- Annual Net Revenue: $5,580
- Annual Yield (Cash Flow): 7.0%
You have the $80,000 in cash, and you could buy it. But to explore all options, you run another set of numbers through the rental cash flow calculator as well. You consider taking out a $64,000 mortgage, at 5% interest, which adds another $343.57 for your monthly payment.
That drops your monthly cash flow to $121.43. But it also drops your initial investment to $16,000: a 20% down payment.
Which means you’d earn $1,457 per year on your $16,000 investment, for an annual yield of 9.1%.
Keep in mind the numbers don’t always favor financing. At an 8% interest rate, your mortgage payment would be $469.61, which would mean a negative cash flow.
This is precisely why you always need to run the numbers through a rental cash flow calculator before committing.
On a month-to-month basis, your cash flow from each rental property will vary. But averaged over time, the cash flow becomes extremely predictable – if you take the time to do your due diligence on the neighborhood.
Don’t assume values such as the vacancy rate. You need to talk to landlords and property managers already operating in that neighborhood to get a sense for turnover rate and vacancy rate. Turnovers are where most of the labor and expenses lie for landlords, so pay particular attention to neighborhood turnover rates.
The other source of returns on rental properties, appreciation, proves less easy to predict accurately. Sometimes, neighborhoods skyrocket in value over just a few years. Other neighborhoods languish with no real appreciation beyond inflation.
You can invest for both, while acknowledging that long-term appreciation lies largely outside your control. Still, investors can look for properties with strong cash flow, in areas with all the right ingredients for appreciation. A strong, diverse job market, historically strong schools, improving economic fundamentals, and easy access to amenities and transportation all suggest long-term stability and increased demand for housing over time.
And if the neighborhood doesn’t appreciate rapidly? Well, at least you earned predictably strong cash flow.
Do you invest for cash flow appreciation? What mistakes have you made in the past in calculating cash flow? What do you do differently now?