In real estate, you make your money when you buy. Buying right all comes down to analyzing the property correctly. It is ALL about having the right math going in to a deal.
The best thing you can do is to start analyzing properties RIGHT NOW. Even if you do not have the funds ready, you need to start learning the process and learn your market. Look at all types of opportunities that may interest you. Run the numbers until you are confident in your analysis. Then when you are ready to pull the trigger you will know which type of property to go after and you will confidently know that you are going after a fantastic opportunity.
This is a lengthy post. But it is the most important part of real estate investing, so it deserves an in depth post. Stick with it. Bookmark this and come back to it often if you are serious about real estate investing. It takes time in the beginning, but with effort and practice you will soon be able to judge potential investment properties at a quick glance. Let’s dig in.
RUNNING YOUR NUMBERS
As a buy and hold investor for passive income, cash flow is what you are wanting to calculate. Cash flow is the amount left over after all bills have paid, including the mortgage. In short, the cash flow equation is simply:
Cash Flow = Cash In – Cash Out or
Cash Flow = Income – Expenses – Mortgage Payment
Simple enough right? The sad reality is so many people screw this up. Income can sometimes include more than just the rent such as laundry income, pet fees, and late fees. But the main thing people mess up is the expenses. The cash out includes much more than just the mortgage.
Here’s a list of expenses that may need to factored:
- Property Management
- Capital Expenditures
- Lawn Care
- Snow Removal
- HOA Fees
- and more
Not all of these will apply to every property. Some will be very easy to determine. Other expenses are much more difficult to accurately factor. Let’s break them apart and start with easy ones.
HOA Fees – If they apply and aren’t listed, call the HOA president
Lawn Care and Snow Removal – Sometimes tenants are responsible for this. If you will be providing this call local companies for a quote.
Utilities – Call your local providers for average costs (water/sewer/electric/gas). Even if the tenants are responsible for all of these, you still have to factor for paying for these during vacancies.
Taxes – These are typically available on online at the county assessor’s page or you can call the county office.
Insurance – Call a couple insurance companies or brokers for a quote.
Now let’s look at some of the more difficult ones:
Property Management – This one isn’t too difficult. Call local companies and ask about all of their charges and fees. They typically charge a percentage of the rents collected, usually around 10%. But some also charge a percentage of the 1st month’s rent any time they put a new tenant in.
Even if you plan to manage your property yourself this expense should still factored in. Why? As you acquire more and more properties, there will come a point when you don’t have enough time to do it yourself and will have to start using a property manager. If you haven’t factored this in, that additional fee could wipe out all your cash flow.
Vacancy – Talk to a local property management company on what to expect here. I never factor less than 5%, and typically factor 10% for my area, but it could even be 15% or more. It varies based on location as well as property type. So talk with some local property management companies. Let them know what type of properties you are looking at and what areas. They should be able to let you know what average vacancies to expect.
Repairs – Estimating repairs can be very difficult to nail down accurately. There are many variables that affect how much repairs you should budget. A brand new house will have far fewer repairs than an old home. If a property has recently undergone a large remodel it will have far fewer repairs than a home that has been neglected for years. Properties in “C” neighborhoods will usually have higher repair costs than ones in “A” neighborhoods. Talking to local property managers or other property owners in your area is the best source of help in nailing this number down.
Capital Expenditures – These are the big ticket items that have to be replaced once in a long time. Things such as roofs, siding, bathroom remodels, flooring replacement, appliances, HVAC replacement, and many other items fall under the CapEx umbrella. This is one that many people leave out because it is hard to determine. But if you leave it out of your analysis, one major item like a roof could wipe out years of cash flow. The most accurate way to calculate this is assign a life expectancy and replacement cost for every item. Then you can average that to a monthly amount.
A note about Vacancies, Repairs, and CapEx: These are all going to be estimates of the long term averages. Sometimes for months, or even years these expenses could be zero. But then all of the sudden maybe the roof and HVAC have to be replaced around the same time. Or a you may have a long term, low maintenance tenant that leaves. When they move out you may have a lot of repairs to get it rent ready again. You may have to replace all the carpet and repaint the entire unit along with many other little repairs. That much work also means a longer vacancy before it’s rented again. For analyzing a property, you have to determine what those big costs will average over the life that you will hold the property.
TIP FOR SUCCESS: Run your numbers conservatively. If you think an expense will be between $100-150, use $150 in your analysis. If you use $100 and are wrong you lose $50 a month. It’s much better to end up with an extra $50 cash flow if you use $150 and are wrong.
Ok, so that’s a lot of information. What does is look in practice? Let’s say you bought a duplex for $100,000 and each side rents for $700. Your monthly numbers would look like this:
Rent – $1400
Vacancy – $140
Management – $140
Repairs – $125
CapEx – $100
Utilities – $25
Lawn/Snow – $40
Taxes – $60
Insurance – $70
Total Expenses: $700
Net Operating Income (NOI) = Income – Expenses
So NOI = $1,400 – $700 = $700
$1,400 – $700 = $700
The only thing missing to calculate your cash flow is your mortgage payment. That obviously changes based on your purchase price, amount down, and loan terms. Let’s say you put $20,000 down on this duplex and you have a $80,000 mortgage. You get a 25 year loan at 4.5%. Your payment is $450 per month (rounding for simplicity, technically it’s $444.67). Now we have everything to calculate cash flow.
Cash Flow = All Cash In – All Cash Out
Breaking that down further
Cash Flow = Income – Expenses – Debt Service (also Cash Flow = NOI – Debt Service)
Cash Flow = $1,400 – $700 – $450
Cash Flow = $250 per month
SO WHAT DOES THIS MEAN?
Ok, so you’ve calculated cash flow, now what? Well, first off you know that on this property, you can expect an AVERAGE of $250 per month over time. Sometimes you will have no repairs and your only expense will be property management. Those months you’ll cash flow $810 ($1,400-$140-$450). Other months you’ll have vacancies, repairs, and CapEx. Those months you’ll be negative and it will take several months to make that back. But, over time, we know it will average $250 per month of positive cash flow.
So is this a good deal? The only way to know that is to compare it to other deals. This is why it’s important to run analysis on a lot of options and to do so early and often. But no two properties are identical. Every property will have a different price, rents, and expenses. So how do you compare one rental property to another?
Enter: Cash on Cash Return on Investment
(also called Cash on Cash ROI or Cash on Cash Return)
Cash on Cash Return = Annual Cash Flow / Cash Invested
In the example from above lets assume you negotiated for the seller to pay closing costs so your cash invested is just your down payment of $20,000. Your annual cash flow is $3,000 ($250 x 12).
Cash on Cash Return = $3,000 / $20,000
Cash on Cash Return = 15%
So is 15% cash on cash return good? Well, the S&P 500 has averaged around 7% return over time so it’s much better than that. Then add in appreciation and that someone else is paying off that $80,000 mortgage for you and it’s clearly a great investment compared to the market. But how do you know if this is the property you should go for? You need to know how these returns compare to other properties in your target area.
Run the analysis on multiple properties. The Cash on Cash Return lets you easily compare different properties with different variables. If the average is 10% then this example is a great investment. If you are often seeing 20%+ then this is not as good of an investment. Maximizing your cash on cash return is the key to financial freedom in the shortest amount of time possible.
BONUS SECTION – FINDING SHORTCUTS
After you analyze enough properties you may begin to spot patterns. Pay attention to the expense ratio. In our example 50% of the $1,400 in rent went to expenses. Then 50% was the NOI left to pay the mortgage and the rest was cash flow. If you start seeing that similar properties have close to the same 50% expense ratio, you may have just found a useable shortcut to analyze future properties.
If you think you have found a pattern, test is out. Say the next property you look at gets $1,200 in rent. The 50% rule would mean $600 in expenses and $600 to pay the mortgage and cash flow. Now run your full analysis and see if it holds true. If it does, then you may have found a useable pattern.
Don’t just start using 50% though. That number can vary widely. Location, condition, rental rates, and property size can all affect the expense ratio. A luxury high dollar unit could be as low as a 35% expense ratio. An old, outdated home at low rents could be as high as 60% expenses. A duplex that is recently remodeled will have a lower expense ratio than a duplex that is dated, even with the same rents. Don’t just start plugging in ratios.
In the beginning, you HAVE to run full analysis on all the properties if you want to be successful. Eventually though, you’ll get a feel for the market and start recognizing the patterns. If you think you have found one, start testing it out. If it holds true you may have just found an amazing shortcut.
HOW I USE MY SHORTCUTS
At this point I never run full analysis on properties right away. I have recognized and found the patterns for nearly every type of property I look for. Now when I find potential investment property, I plug in my shortcut expense ratio for that specific type of property, location, and condition. I know in under one minute if I’m interested in a property or not. If I like what I see from using the shortcut, then I will dig in and do the full analysis.
Notice that I still do full analysis. I never fully rely on the shortcut. The shortcut is just the gatekeeper to determine if I think it is actually worth looking in to.
Hopefully this post provided a solid overview and outline for analyzing properties. Learning to accurately analyze rental properties is THE most important part to becoming a successful real estate investor. You make your money when you buy. You buy right by correctly running your math.
Start running analysis on any and every property you may be interested in. Do not wait until you have the funding ready. If you wait until you have your funding ready, you will have a huge learning curve to overcome and you will have to wait even longer. It takes time in the beginning, but with effort and practice you will be able to judge potential investment properties at a quick glance.
Analyze properties until you are comfortable and confident. Learn your market. Being able to spot the great deals right away gives you the advantage of speed. Look for average expense ratios to use for shortcuts in your analysis. Bookmark this page and come back to it often if you are serious about real estate investing.