I cringe every time I hear a new rental investor say “Well the mortgage payment is only $1,000, and the rent is $1,300, so that’s a $300/month cash flow!”

Sound the air raid siren, because that investor’s dreams are going to end in flames.

Cash flow calculations go way, way beyond the PITI of the mortgage payment. PITI stands for principal, interest, taxes and hazard insurance, and even those may not make up the entire mortgage payment.

If you borrowed more than 80% of the purchase price, you’ll likely have mortgage insurance. If your property is in a flood plain, you’ll have flood insurance.

And that’s just scraping along the surface. Rental properties come with a lot of expenses, and you need to understand and account for them all.

That’s the bad news. What’s the good news? Luckily for you, this is what makes real estate such a great investment: you can accurately forecast future returns.

In under 30 seconds, you can make a shorthand calculation to determine if a deal is in the ballpark. In under 30 minutes, you can make a detailed cash flow calculation to determine a property’s return on investment.

Ready to learn how to do both?

 

Repairs, Maintenance, New Appliances & CapEx

Real estate is, well, real. It’s physical, and like everything physical, it falls apart if it’s not maintained properly.

Brand new homes need very little maintenance or repairs in their early years. Older homes need much more.

You’ll also incur costs every time you have a turnover, in the form of cleanout, new paint, perhaps new carpet, etc. What, you thought every tenant would leave the place in sparkling condition just like they found it? Think again.

Then there’s capital expenditures, or CapEx. CapEx is the long-term average of costs associated with big-ticket repairs: new roof, new furnace, new AC condenser, and so on. You can read more on how to calculate CapEx here.

Heidi is considering a duplex. Each unit rents for $800/month (psst: that’s $1,600/month gross revenue). After running some numbers, Heidi determines that CapEx will cost her about 5%. She estimates another 8% for maintenance, repairs and replacing appliances periodically. That means:

  • CapEx: $80/month
  • Maintenance, repairs & appliances: $128/month

But she has a long way to go from there.

 

Vacancies

Rental properties don’t have perfect, 100% occupancy rates. After a renter moves out, typically it takes some time to repaint, replace the carpet, clean the unit, advertise it for rent, show it to prospective renters, sign a new lease agreement, etc.

In blazing hot markets, turnovers may take place as quickly as a few days. In slower markets, rental properties can sit vacant for six, nine, even twelve months at a time. (I’ve had properties sit vacant a year. Seriously. It’s like a slow-motion root canal for your wallet.)

A common baseline vacancy rate is 8%, which is about one month/year. But for slower markets, ratchet that up. Talk to other local landlords, property managers and real estate agents to get a good sense of the vacancy rate for the neighborhood in question.

After asking around, Heidi feels comfortable with an 8% vacancy rate. Her expense numbers now read:

  • CapEx: $80/month
  • Maintenance, Repairs & Appliances: $128/month
  • Vacancy Rate: $128/month

 

Property Management Fees

Another common line from newbie investors: “I don’t need to include property management fees, I’ll be managing it myself!”

Property management is a labor expense. Whether you’re doing the labor or someone else is, it’s still an expense.

You could take your money and go buy stocks or bonds, and have no labor. No weekends spent hassling with rental properties. No 3 AM phone calls from tenants whining that they need a light bulb changed.

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The point is, you need to account for this labor expense. And besides, the time will likely come when you have no interest in managing these properties yourself anymore.

Include property management expenses in your calculation.

The typical rate in the industry is 10%, although it can be as low as 7%, or as high as 15%. Property managers often charge a month’s rent to place a new renter as well. Set aside at least 10% for the property management fee, and perhaps as much as 18%, to account for tenant placement fees.

Heidi is setting aside 12% for property management fees, and her numbers are getting more accurate all the time:

  • CapEx: $80/month (5%)
  • Maintenance, Repairs & Appliances: $128/month (8%)
  • Vacancy Rate: $128/month (8%)
  • Property Management: $192/month (12%)

 

Utilities

Are you paying the utilities, or are the renters?

Even if the renters are paying utilities, expect to get stuck with utility bills occasionally. Your tenants might move out and leave a hefty bill, and you’ll have to pay for utilities during vacancies.

Heidi’s renters will be paying for their own utilities, but she knows she’ll occasionally have to pay utility bills herself. She sets aside $10/month per unit.

  • CapEx: $80/month (5%)
  • Maintenance, Repairs & Appliances: $128/month (8%)
  • Vacancy Rate: $128/month (8%)
  • Property Management: $192/month (12%)
  • Utilities: $20

 

Accounting, Bookkeeping, Administrative

For a single rental property, your auxiliary expenses may be negligible. Something you can round away.

But what if you own five rental properties? Ten? Twenty?

Will you still do your own taxes using online software? Probably not. You’ll likely need an accountant.

What about bookkeeping and administrative help? Will you keep proper books with rent ledgers, expenses, depreciation, etc.?

You may well need a virtual assistant or bookkeeper to help out, in addition to your accountant.

These costs can vary, but count on at least 2-3% for them.

Heidi’s costs:

  • CapEx: $80/month (5%)
  • Maintenance, Repairs & Appliances: $128/month (8%)
  • Vacancy Rate: $128/month (8%)
  • Property Management: $192/month (12%)
  • Utilities: $20
  • Accounting, Bookkeeping, Administrative: $32 (2%)

 

Software, Office Supplies, Gas & Mileage, and All the Rest

Do you use online software to help you manage your rentals? Maybe you ensure on-time rent payments by having SparkRental deduct the rent from the tenant’s paycheck? (Hint hint!)

How often do you have to print and mail physical tenant notices?

What about physical trips to the property? Semi-annual inspections (which you’re doing… right?) take time, gas, and mileage on your car. When a property is vacant and you have to turn it over, expect many trips to and from the vacant unit.

It all adds up. Consider a “miscellaneous” category for these types of expenses, at around 5%.

Heidi’s new expense list:

  • CapEx: $80/month (5%)
  • Maintenance, Repairs & Appliances: $128/month (8%)
  • Vacancy Rate: $128/month (8%)
  • Property Management: $192/month (12%)
  • Utilities: $20
  • Accounting, Bookkeeping, Administrative: $32 (2%)
  • Miscellaneous: $80 (5%)

 

Example: Heidi’s Numbers

Heidi is looking at paying $150,000 for the duplex. She’s putting 20% down ($30,000), and borrowing the remaining $120,000 at 7% interest for 30 years, for a principal and payment of $399.18. Let’s round that to $400 for easier numbers, shall we?

So Heidi avoids mortgage insurance, and her property is not in a flood plain. The property taxes are $1,500/year, and the insurance is $900/year. That comes to $2,400/year, or $200/month. So, Heidi’s PITI mortgage payment is $600.

Here’s a final breakdown of her monthly cash flow:

  • Mortgage (PITI): $600
  • CapEx: $80  (5%)
  • Maintenance, Repairs & Appliances: $128  (8%)
  • Vacancy Rate: $128  (8%)
  • Property Management: $192  (12%)
  • Utilities: $20
  • Accounting, Bookkeeping, Administrative: $32  (2%)
  • Miscellaneous: $80  (5%)

Total Expenses: $1,260

Her gross monthly revenue is $1,600, so her monthly cashflow is $340.

What about her cash-on-cash return on investment? Heidi put $30,000 down, plus we’ll say $5,000 in closing costs. We’ll assume the property needed $10,000 in repairs when she bought it.

So Heidi invested $45,000 in cash. Her annual revenue is $4,080. That means she’s earning about a 9% return on her investment: $4,080 / $45,000 = 9.07% ROI.

Is that good? Bad? That’s your judgment call, not mine, but personally I would find that ROI acceptable.

Why? Because it’s predictable. Sure, the stock market may surge 15% this year… or it might drop 15%. I have no control over my stock investments. I don’t know what I’ll earn from them.

But Heidi knows with excellent accuracy how much yield she’ll earn from her duplex. And best of all, these numbers don’t even include appreciation, or take into account the gradual decline in her mortgage’s principal balance. In 30 years she’ll own the property free and clear, and then she’ll really have strong cash flow!

 

Shorthand Calculation: The 50% Rule

“Hang on Brian, you promised a quick calculation that would take less than 30 seconds!”

So I did, so I did.

Enter: The 50% Rule. Quite simply, you can estimate a property’s expenses at 50% of the rent, plus the P&I mortgage payment (just principal and interest – the property taxes and insurance are included in the 50% estimate).

So in Heidi’s case, 50% of the gross rents is $800, plus the P&I payment of $400, for a total monthly expense of $1,200. This method puts her monthly cash flow at $400.

It’s a rougher estimate, far less accurate. In this example it was off by $60/month, and in the wrong direction. That comes to $720/year in unexpected expenses, on average. Perhaps not so devastating, but what if she’d been looking at a property for $750,000, not $150,000? The error would have been compounded fivefold.

Use the 50% Rule as a shorthand way to evaluate whether a deal is worth looking into further. If it looks like it could potentially work, you can invest more time to look at the property more closely, and properly calculate cash flow. If the deal clearly doesn’t work, well, you only lost 30 seconds of your life!

If you don’t calculate cash flow properly, prepare for a miserable experience as a rental investor. Year after year of saying “Well, this year we had that $2,500 furnace problem and lost money, but next year will be different!” Except it won’t be. Next year it will be electrical wiring that needs replacing, and so forth.

When you calculate cash flow properly, you don’t have to wonder when your “luck” will turn around. Instead you say “Another year of passive income! Our expense budget easily covered the $2,500 furnace repair. I’m going to put my feet up and have another cup of tea.”

Get cash flow projections right, and you’ll never buy a bad deal in your life.

Ever ran into trouble over cash flow calculations? What happened? What have you learned since? Don’t be shy, we’re in the Trust Tree here! 

 

 

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