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 most common is that they failed to factor in all the costs of owning, managing and maintaining the property before they bought it.
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.
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 who’s about to earn $250/month.
In reality, Bill is in big trouble. 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
Accounting, Bookkeeping, Administrative & Misc: $400/year = $33.33/month
(Psst: We have a free rental property calculator, that includes CapEx!)
Before CapEx, Bill’s property will cost him an average of $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 property repairs and replacements. They only need to be made rarely, but recurring, since everything in a home eventually needs replacing or repairing.
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 largely predictable schedule.
Landlords are always 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 $2,500 bill to replace it.
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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 Are Easier Than Hard 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, patching a small roof leak. It doesn’t involve replacing the entire 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 (in this example: 10%): $150
Vacancy Rate (example: 8%): $120
Regular Maintenance: $100
Total Expenses: $1,370
Monthly Cash Flow: $130
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The Numbers May Be Ugly, 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 answer is that rents are not fixed in stone; they rise or fall depending on the condition of the property, the amenities offered, etc. Another is that there are additional ways to earn money from rentals, beyond rents.
Also remember that costs aren’t fixed, either. Perhaps aggressive tenant screening will cut down on your vacancy rate and turnovers? Maybe you can reduce your turnovers with a two- or three-year lease agreement, to cut down on all the nasty maintenance, vacancy, labor and other expenses that come with turnovers?
As you find ways to trim expenses and boost revenues, you may find you can afford to spend closer to $700 on the mortgage, even while your competitors can only spend $500 on it.
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?
Become a Cash Flow Connoisseur
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? It doesn’t take long to learn how to accurately forecast rental cash flow, so you’ll be able to quickly dismiss losers and identify winners, as you shop 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!