Rental Cash Flow Analysis: Investing in Rental Property For Beginners
Rental Investing has been a true and tested way of building individual wealth while earning cash flow every month when done even on a small scale. That said, buying a rental property can be a good investment if you can achieve a profitable rate of return on a rental property. A good rate of return is calculated by doing a rental property cash flow analysis.
Rental Property cash flow analysis helps to understand the profitability of an investment property before actually investing in it. Take into account all the expenses and subtract them from the gross rents that can be earned from a rental property into consideration. An 8%-10% positive cash flow is what is required to consider the rental property a good investment.
Why is Rental Property Cash Flow Analysis important for an investor?
Do you know who were those investors who got the maximum hit in the 2008 market crash? The investors who invested in real estate only by thinking about the market appreciation. On the contrary, investors who invested in cash flow cashed on this opportunity and got good profits even during the downs in the market.
In the 2008 crash, single-family homes saw a 7% decline in the prices and about 3.1 Million Foreclosures. What it meant for rental investors is less owner-occupied homes and more demand for rental housing. A 5% point jump in renting from owning a house which further results in an increase in Rent Prices. An overall win-win situation for rental investors
Cash Flow is the king when you are investing in real estate. You should always look for those investment properties which can provide a positive cash flow. Hence it makes sense, you do a rental property cash flow analysis before actually investing into it.
What is Cash Flow?
In a nutshell, Cash Flow from a rental property is a remainder which is obtained by subtracting the expenses from the income in that financial year.
Cash Flow = Income – Expenses
The Cash Flow equation is simple and even a beginner can do the math using this equation. But the important and little trickiest part is to understand the right-hand side of this equation. Calculating the income is fairly easy as it is simply the gross rent you receive from your tenants. But for the expenses part, the calculation can be tricky due to the uncertainty of an expense.
You can easily estimate those expenses that are certain and occur at regular intervals. But what about those expenses that are not certain and may or may not occur in your case? On a rental property, you occur a lot and lots of expenses. Let’s first try and list the maximum no. of expenses on a rental property that is pretty straight forward.
- Mortgage Origination Fees
- Property Inspection Fees
- Mortgage Closing Costs
- Property Appraisal Fees
- Mortgage Payments
- Mortgage Insurance
- Real Estate Taxes
- HOA Fees
- Landlord Insurance
- LLC Incorporation Costs
- Marketing Costs
- Property Management Fees
- Landscaping Costs
- Cost of Utilities
- Office Supplies
- Rental Application Fees
- Tenant Screening Costs
- Rental Agreement Costs
- Rent Collection Tools cost
- Maintenance and Repairs
- Cost of Damages
- Eviction Costs
- Vacancy Costs
- And yet some more unexpected expenses; still thinking in my head
The 50% Rule For Unexpected Expenses
Being an investor and it is always better to include even those expenses that have a little probability. In order to make things a little less complicated, you can account for the expenses by using the 50% rule.
Though it is based upon an assumption and is not a true indicator of the expenses at a rental property. But it becomes very useful when you are buying rental property in new or unknown markets.
According to the 50% rule, you can assume that all the expenses that will occur will be no more than 50 percent of the gross income you make from the rental property. Keep in mind that this rule excludes any of the costs incurred in mortgage payments.
This rule is sure an assumption, but estimating expenses at 50% is still a high number considering the expenses. Rarely, the expenses on a rental property reach to 50% if you are a careful landlord.
How to calculate the Rate of Return on a Rental Property?
The Rental Property you are considering should be able to provide a minimum of 8%-10% annual return on the equity to qualify a good investment in rental property. Every investor has a different way of calculating the rate of return on a rental property.
Investors use various rental terminologies to calculate the return when considering buying a rental property. Although, the aim behind doing the rental calculations is to ultimately estimate the rental property income. You can choose any of the rental property formulas depending on your condition.
Cap Rate for Rental Property is used to take into account the potential return that can be generated from a rental property if purchased with cash. The calculation for cap rate is easy and simply a percentage ratio of Annual Net Operating Income to Value of the property at that time.
Cap Rate Formula
Cap Rate= Net Operating Income/ Property Value
If you can see the cap rate depends upon the property value and the rent rates. It means it is subjected to change from time to time. It may not be an exact indicator, but it is definitely helpful to find a profitable location for your next rental property. A good cap rate for rental property generally falls between 6.5%- 7%. The apartment building in the US on an average sells between this range.
The 1% Rule
The 1% Rule in rental investing is a general thumb rule for estimating the profitability of a rental property. According to the 1% rule, the rental property you are considering buying should be able to collect 1% of the property purchase value in gross rents monthly.
If the rental property you are considering does not match up to 1% rule, you can have trouble repaying your mortgage payments. It is good to analyze your rental property under the 1% rule if you have to obtain a mortgage for your rental property.
Cash On Cash Return
Cash on Cash return is somewhat the most accurate way of calculating the rate of return on a rental property. It is also often termed as return on investment, rental yield, or return on equity. To calculate cash on cash return, you should have the annual net operating income after deducting all the expenses including the mortgage payments.
Cash on Cash Return= Net Operating Income / Cash Invested in Deal
The Cash on Cash return tells you how much the exact return you will get from your rental property. As an investor, you should buy rental properties that at least return 8% on the cash you have put upfront while buying the property.
Visualizing a typical Rental Property Cash Flow Analysis
Mark is considering buying rental property in Idaho. The investment property is a single-family home with 3 bedrooms that has a listed price of $300,000. The property is previously rented at $2000 per month. Will this investment property be a profitable rental property for Mark?
Mark renegotiated the prices and got a decent bargain at $290,000. He got the home appraisal and got an estimate of $5,000 in repairs. He has got $60,000 in hand. Rest he needs to obtain a mortgage. He is getting a 15 year fixed mortgage at 3.315%. He then obtains conventional financing of $240,000 considering he will also incur repair costs, legal fees, mortgage closing costs, and some other start-up fees.
|Mortgage Closing Costs||$2400||One Time|
|Home Appraisal Fees||$300||One Time|
|Real Estate Taxes||$2150||Annually|
|LLC Incorporation||$100||One Time|
|Vacancy Costs||$1200 (Estimated 6.21% in Idaho)||Annually|
Let’s use the Rental Property Formula to calculate the rate of return on the Property
- Gross Annual Rent: $24,000
- Expenses (Excluding Mortgage Payments): $4730 (Annually)+ $2800(One Time)
- Mortgage Annual Payments: $20,328
- Property Purchase price: $297,800 (For easy Calculations, add one time costs into property purchase price only)
The Cap Rate Calculation
Cap Rate: Net Operating Income/ Value of Property (after repairs)
Cap Rate= ($24000-$4730)/ $297,800 = 6.47
The 1% Rule
Property Cost: $297,800
Monthly Rent: $2000
According to the 1% rule, this rental property should be able to rent at $2978 monthly. But it is renting at $2000.
Cash on Cash Return
Cash-out of Pocket: $60,000
Mortgage Yearly Payments: $20,328
Annual Gross Rent: $24,000
Net Expenses: $20,328+ $4730= $25,058
Annual Cash Flow= $24,000- $25058= (-)$1058
Mark will lose $88.16 every month if he invests in this rental property with these numbers. The rental property Mark is considering buying doesn’t meet any of the minimum criteria of the rate of return to be profitable. In order to become profitable, he has to either purchase this property at a lower price or has to charge high rent.
If Mark is able to purchase this property at a 10% lower cost and can charge a 10% high rent, he can become profitable. The Rental Cash flow analysis on Mark`s property then would somewhat look like this
- Purchase Price: $268,000
- Monthly Rent: $2200
- Monthly Mortgage Payment: $1518
- Expenses: $4730
Rental Cash Flow Analysis
- Cap Rate= 8.08
- 1% Return is still less at 0.82%
- Cash Flow= $3454 (Annually)
- Cash on Cash Return: 5.75%
Mark will have small cash on cash return but still will have a positive cash flow of $287.83 monthly. He can consider this investment property as a good rental property. A surprising fact if you see, Mark will need 77.59 of net operating profit years to make back his investment.
Investing in cash flowing Rental Properties is a great way to achieve financial freedom. But always remember, cash flow is erratic and depends a lot upon market and economy conditions. But, doing a cash flow analysis before buying a rental property can help you avoid disasters.
Furthermore, investing in rental properties comes with inflation protection and is by far the most tax-friendly investment you can do today. Mostly all the expenses that occur in your rental business are deductible from your taxable income.
If you can see a little farther, most of the profits you earn in other types of investments are eaten up by taxes. And when you actually calculate, taxes make a big hit on the returns. Being a careful investor, it is advised you invest right and make the analysis before jumping on to buy any deal.
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