Cash flow is not about what happens in a “normal” month.
In a “normal” month, your expenses will probably be minimal. And then a not-so-normal month hits, and you’re slapped with a $2,500 expense!
So when rental investors forecast cash flow, it’s about averaging out the peaks and valleys.
To illustrate that point, we’re going to, well, literally illustrate it!
But First, a Quick Overview of Typical Rental Expenses
We went deeply into many of these expenses when we talked about calculating cash flow, but here are some of the most important expenses landlords need to account for:
Repairs & CapEx: Your property will need repairs periodically, and some of them will be major.
After all, every single piece of your property will need to be replaced sooner or later!
Consider setting aside around 8% of the rent for repairs and CapEx (capital expenditures, or large property replacements & repairs that are uncommon but recurring).
Maintenance: Unlike repairs and CapEx, maintenance isn’t about occasionally fixing something that breaks. Instead, it’s about keeping the property humming along, able to be rented for top dollar.
It can include painting the property or replacing carpets in between tenants, for example. Don’t count on being able to deduct these from the security deposit – often this simply comes down to normal wear and tear.
Or it could mean sending a repair servicer out to fix a blown circuit in the dishwasher.
Budget around 5% of the rent for maintenance.
Beyond Physical Repairs & Maintenance
Landlords face more expenses than just physical repairs.
Vacancy Rate: Landlords forget this one all the time. This varies widely by market – hot markets might have vacancy rates in the 2-4% range.
Cold, low-demand markets might have vacancy rates as high as 20-30%
A good baseline is 8% of the rent (roughly one month/year), but make sure you know this figure for your specific market.
Property Management: Whether you hire a property manager or you manage the property yourself, property management is a labor expense. If you manage your property but don’t deduct expenses for your labor, then you won’t have a clear idea of your real property ownership costs.
(Because you could have put your money in an index fund, with no labor at all!)
Property managers typically charge 7-10% of the rent collected, and sometimes charge a fee to place new renters in vacant units. This can range from half to a full month’s rent. (And shady ones often charge other hidden fees – landlord beware!)
Administrative & Miscellaneous: You’ll have higher accounting costs, bookkeeping costs, mileage costs, occasional utility costs, and so forth. Budget 5-7% for these.
Pro Tip: Use our free rental income calculator to forecast a rental property’s cashflow!
Two Years in the Life of a Rental
Imagine a property that rents for $1,000/month. The mortgage (which includes property taxes and insurance), is $450. Property management costs 8% of the rent collected ($80), plus a one-month’s rent fee for filling vacancies.
In a “normal” month, cash flow is $470. Which drops sometimes though, as other expenses rear their ugly head.
Here’s how the actual monthly cash flow might look over the course of two years:
In this example, the average monthly cash flow is $179.46.
Here’s another way of looking at it, with the blue bars being total rental income, and the red line being expenses:
Breaking Down the Expenses
In March of Year 1, the roof needs repair work, to the tune of $1,458.
Six months later, in September, the furnace is serviced for $200.
Then the tenants move out at the end of November. You send in a crew to paint the inside of the unit, costing $1,850.
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You receive $0 in rent for December and January, while you advertise the property for rent, show it to prospective renters, run tenant screening reports on applicants, negotiate and sign a new lease agreement, etc.
Placing the new renters costs you one month’s rent, plus the normal 8%, so for February’s rent you chalk off $1,080 for property management expenses.
Your property hums along for a while, then in July another $375 repair comes along.
In October, you send a maintenance worker out to check on some additional furnace issues. Another $250 disappears.
It’s worth noting that repairs are not the landlord’s worst enemy here. Sure this is a made-up example, but this is a typical two-year snapshot of a rental property. You may have noticed that it was actually the turnover the cost the landlord the most: $2,000 in lost rent, $1,000 in extra property management labor expenses, and $1,850 in painting expenses.
Here’s a breakdown in chart format:
|Month||Rent Collected||Mortgage||Repairs & CapEx||Maintenance||Management Costs||Total Expenses||Cash Flow|
One Last Visualization
Yes, for most months in the example above, the landlord pocketed the full rent minus the mortgage.
But that hardly tells the whole picture, does it?
When you take the long-term averages of these costs, monthly cash flow looks more like this:
(Who doesn’t love a good Sankey diagram?)
If you want to succeed as a rental investor, learn to forecast these average costs accurately!
Stay Liquid, My Friends
Everyone should have an emergency fund or cash reserve. After all, you never know when an unexpected medical bill will come along. Or your car will need an expensive repair. Or your spouse will run off with an alligator wrestler from the circus and leave you with nothing but bills.
But for landlords, this goes doubly.
Look at the example above. Out of the clear blue sky, the occasional lightning bolt of expenses came crashing down on our imaginary landlord friend.
That’s how it is, owning rental properties. To prepare for these expenses, landlords need to stay liquid with an expense fund, which they fill up to a certain cash cushion before touching any of their profits.
A good rule of thumb for a cash cushion is the greater of either $2,500 or three months’ rent. Landlords need to be prepared for turnovers, for repairs, for whatever comes down the pike at them.
And yes, even if you have a $2,500 cash cushion, you could still be hit with a $3,500 roof repair bill. But it’s a lot easier to come up with an extra $1,000 than it is to come up with an extra $3,500, right?
Leave yourself options to draw on in emergencies, such as unused credit cards, HELOCs, equities, etc. When a repair or turnover rears up at you, you’ll be ready for it, which is the difference between “Well, that’s annoying,” and “Oh @$%&, how the @#*% am I going to feed my family this month?!”
Cash cushion = important.
What to Do Now:
- Comment below: How accurate are your cash flow forecasts over time? How have things gone sideways for you in the past?
- If you’re new to the rental investing game, download our free Recipe for Rental Income: 5 Steps for Your First $500/Month in Passive Income.
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