Last post we learned how to run the financials on a property in order to make sure we buy right. Within that was the key piece – Cash on Cash Return. This lets us know what % return we are getting on our investment, but more importantly lets us know if the property is producing a positive cash flow.
When it comes to owning rental properties, cash flow is the end goal.
This is because if a property doesn’t cash flow then I am not buying it. 100% no way. If you do, then you are betting on appreciation.
I’m going to bank on Cash Flow! Call it risk adverse (scaredy cat) or call it smart. The property should make money whether the housing market is going up, down or sideways.
When an investor chases appreciation they are speculating. When you speculate you are putting yourself at high risk. Just ask anyone who bought a property in 2007! If you want to speculate, buy some high flying growth stocks.
A cash flowing property will produce for you whether you have appreciation, depreciation or prices stay flat. This is why we buy right
Let’s now dig into the ins out outs of operating expenses that occur when owning a rental property.
We must account for vacancy because you will have tenant turnover and experience an empty property from time to time. The consensus standard is to assume one month of vacancy per year. It works out to roughly 8.3% of your annual rents. So that’s the number you will use in your calculations.
Real Estate Taxes:
This one is pretty simple. Your county assessor will send you an estimate and then a tax bill. This is also public information allowing us to just look it up, but usually the prior year’s taxes will be posted in property listings.
Call a local agent and get a quote for the property you are looking at. Agents are usually more than happy to do this. After you have some experience you can usually come up with a good idea of cost on your own.
Some discretion can be used on this amount, but I use 5% of annual rents to account for maintenance costs that may come up throughout the year. That’s the lowest I would go. So plug 5% into your calculation.
Not everyone allocates reserves. Reserves are basically funds to account for any major costs that would otherwise have to come out of pocket. Let’s so the HVAC unit goes. Well, that’s a $2-4k cost. If you don’t’ have reserves building up then those costs will be out of pocket. I allocate 5% for reseveres.
Management Costs – If you decide to hire management to handle your rental property the going rate is 10%. That’s the amount to plug into your calculation if you go that route. I self manage my properties, but do have friends that use management on theirs.
Utilities and/or HOA – If you are providing any utilities to the tenant those costs need to be factored in. Also, if the property is within a homeowner’s association (HOA) then there will be a fee for that as well. Plug in those costs as well if either are applicable.
Looking at the screenshot from the property calculator you can see the %’s and the dollar amounts I have plugged in for a sample property.
In this example I added in management along with the other items you regularly see (vacancy, taxes, insurance, maintenance, reserves)
However, when factoring that in Operating Expenses account for 56% of my annual rental income.
This is too high for me. You want 50% or less. Don’t get me wrong, technically you can still cash flow with expenses that high, but it is much more difficult too. You’ll need to get a sweet deal on the price of the property, which is certainly possible.
Conclusion: The only way I would look further into this sample property is if I planned to self manage, thus reducing operating costs to 46% otherwise, it’s a no go unless price can be negotiated down substantially.
See our prior post for complete detail on running the financials using the scaredycatguide property calculator.