You could argue that there is nothing that more investors aspire to achieve in the real estate industry than passive income. Some of the wealthiest people in the world have used passive income to acquire their fortunes. Most of them started out with small, multi-unit properties and eventually worked their way up to large commercial buildings. Any real estate investor can reap the benefits of this investment vehicle if they understand cash flow. While going to your mailbox every month to collect rent checks is the goal, it may not be enough if you don’t understand the numbers. There are many properties that look great on paper. However, after breaking down the numbers, aren’t what they seemed. This all starts with understanding the basic concepts of cash flow. Here is a brief breakdown of cash flow and some commonly overlooked expenses.
There are literally dozens of different calculations out there to help break down a rental property’s prices. Everything from the gross rent multiplier to the gross potential income are important in one way or another. All of these come back to understanding income and expenses. The most basic definition of cash flow is: rent income minus principal, interest, taxes and insurance, minus vacancy loss and expenses. While this may sound intimidating at first, it is actually fairly simple on the surface.
You know how much you will receive in rent every month. That is your starting point. Your loan repayment expenses are relatively fixed if you have a fixed-interest rate on your mortgage. Your property taxes and insurance are not fixed, but also typically don’t show much fluctuation annually. Take your monthly principal and loan repayment number, along with your taxes and insurance, and you have your PITI (principal, interest, taxes & insurance) monthly expense number. The vacancy loss is a sort of reserve fund in the event that your tenant leaves unexpectedly, or you can’t find a tenant for the short term. This number is anywhere between six and ten percent of the annual rents received. The final calculation is often the most misunderstood. To break down expenses, you need to be aware of them all. Overlooking or ignoring even one of these items can change the bottom line cash flow of the property. Here are some of the most commonly ignored monthly expenses:
- Utilities: Most potential rental property owners are aware of the basic utilities that come with buying a home. A rental property is a little different in that you may only be on the hook for a few of them. Before you can make your calculations, you need to research the market and see which ones you will pay and which can be passed onto your tenant. It is best to leave anything that is directly impacted by usage to your tenants. Cable, electric, and oil based heating should be your tenant’s responsibility. It is not uncommon for landlords to pay the water & sewer bills, if anything. Even though these are relatively minor bills, they are still expenses that need to be added to the mix. Depending on the market, you may have to make some concessions and include some utilities to get top dollar for your rent. Either way, you need to know which expenses you will pay, how much they are, and how frequently you will pay them.
- Property management: Many new investors start by managing their own properties. This works until they find that they either don’t have the time, desire, or skills necessary to do the job right. Whether you are considering property management now or not, you need to factor this into your cash flow estimate. The typical fee is usually around 10% of the monthly rents received. This may not seem like much but adds up quickly once you start looking at annual numbers. By adding this into your projections, it allows you to use property management if you see your business growing and you can no longer manage properties yourself.
- Repairs: Things will happen to every rental property. Even if you have the best tenants, there will always be minor items that need your attention. Little things like toilet clogs, appliance repair, or a broken garage disposal happen from time to time. Take one month of rent and use that as your reserve fund. If you are receiving $1000 a month, take about eighty-five dollars and add that to your monthly expense number. There will be months and possibly even a full lease term where you don’t use anything but out of the blue your furnace might break and you will be prepared.
- Seasonal expenses: This is perhaps the most commonly overlooked area of expenses. Different markets have different seasonal expenses. In areas that are impacted by snow, you need to come up with a snow removal budget. Depending on the size of your driveway, this can be anywhere from thirty to sixty dollars per storm. Some years could have only a handful of storms and others could be two or three times the previous year. You also need to factor in lawn maintenance and preventative updates to your fireplace, central air unit, and furnace. It is also important to add in any marketing cost you have to acquire new tenants. A few hundred dollars when you are looking at a thousand dollars a month in rent represents twenty percent of your income. Even through these will not be every month, they need to be added to your annual expense calculations.
A rental property that produces positive cash flow is a powerful thing. You can have your tenants pay your mortgage, all the while building up your portfolio. This only works if you understand the cash flow numbers on every deal.