I know, I know, you don’t like math. We’ll keep it manageable.
Landlords lose money on their rental properties for many reasons, but the main one is that they don’t factor in all the costs of owning, managing and maintaining a rental property. Far too many landlords just subtract the monthly mortgage bill from the rent, and even those that factor in vacancies, maintenance, property management fees, accounting costs and the likelihood of rent default are still getting it wrong. (Quick aside: use our free Rental Property ROI Calculator to evaluate any property’s ROI!)
Let’s beat up on a landlord named Bill to illustrate this point. Bill bought a property that leases for $1,000/month, and his mortgage payment is $750/month. Bill thinks he’s a genius. But he has other expenses, before we even get into CapEx:
Vacancy Rate: 10% = $100/month
Maintenance: $1,000/year = $83.33/month
Property Management: 8% = $80/month
Property Accounting: $400/year = $33.33/month
Before CapEx, his property costs average $1,046.66/month. We’ll be generous and give Bill the benefit of the doubt that his property taxes and insurance are included in his mortgage payment of $750. But he’s still cash flow negative.
And the news gets worse from here for our simple-minded friend Bill.
So what is CapEx?
CapEx, or capital expenditures for non-finance-nerds, are large scale repairs that only need to be made rarely… but still regularly. For example, maybe the roof only needs replacing every 20 years or so… but it costs a lot of money. And then there are furnaces, air conditioning condensers, flooring, framing, electrical systems, plumbing systems, HVAC and ductwork, kitchens, bathrooms, windows… every component in every home needs to be replaced or updated, and on a somewhat predictable schedule.
Landlords are always being taken by surprise when a furnace breaks, or the roof needs replacing, or the AC condenser drops out. Last year, it was the roof, and after shelling out the $5,000 to replace it, Bill consoled himself by saying “Well, this was an off year because of that roof bill, but next year will be better.” But this year, the furnace broke, and he’s howling in frustration after the $2,000 bill.
Bill is worse off than we originally thought even a few paragraphs ago. Here are some invented numbers to illustrate the point:
|Capital Expense||Replacement Cost||Lifespan (years)||Annual Cost||Monthly Cost|
Look at all the money he’s failed to account for each month! No wonder he’s losing money on his rental property.
And yes, I know the numbers above will vary wildly depending on the property. Don’t get cheeky on me.
Hard truths will save you from harder lessons
“But,” you ask, “didn’t I already budget for maintenance?”
Maintenance comprises costs you incur between each tenancy, and mild repairs during it. New paint, new carpets, trimmed landscaping. Not a brand new roof.
Capital expenditures, and other unaccounted-for expenses, are why so many landlords fail. Rental properties are a lot of work to maintain, manage, and financially care for, and most landlords don’t fully grasp all of the work and expenses involved.
Let’s break down an imaginary rental unit’s monthly budget:
Mortgage (P&I): $500
Property Taxes: $100
Property Management (if applicable – example: 8%): $120
Vacancy Rate (example: 10%): $150
Regular Maintenance: $100
Total Expenses: $1,370
Monthly Cash Flow: $130
The Numbers May Intimidate, But They Don’t Lie
When you think about the above, it’s actually pretty terrifying. Where is anyone supposed to find an investment property that rents for $1,500 but will only cost $500/month in mortgage payments?
There are a few answers to that question. One is that if you manage the property yourself, you’d cut out the property management expense and free up some money there. Another is that aggressive tenant screening will cut down on your vacancy rate, and therefore also cut down on maintenance expenses (which are most brutal between tenancies). So perhaps you can afford to spend closer to $700 on the mortgage.
But the important point is that this is why it’s so hard to find excellent investment properties. If it were easy, everyone would be doing it, right?
Before buying a rental investment, get as many details as you can about when each and every system, appliance and component of the property was last replaced or updated. Get copies of receipts and invoices if you can. That will give you a better sense of when some of these chickens will come home to roost.
And, of course, if you’re renovating the property you’ll know exactly when these systems have been replaced. But you should still calculate the monthly cost of CapEx and include it in your ROI calculations.
The good news? You can learn and become knowledgeable enough as a real estate investor to map out semi-accurate cost projections, you’ll be able to quickly dismiss losers and identify winners when shopping for your investment portfolio.♦
Have you made cash flow calculation mistakes, due to CapEx? Don’t be ashamed, I have too. Tell us about what you learned, and what you’re doing differently now!