I know you don’t like losing money any more than I do.
You absolutely must do your investing by the numbers.
When a real estate agent tells you it’s a great deal, do you just take them at their word?
Of course not. That’s where the numbers come in to play.
The most critical time to evaluate your numbers on any real estate investment is going in. Before you make any offer.
There are two main issues. One is not doing any cash flow calculations at all. Don’t be that guy (or lady).
The other one is not having good numbers to work with, and as a result, you end up with garbage. If you do the analysis in this article, you shouldn’t end up being that guy.
All too often, I see investors underestimating the repair costs to make their property rent ready. Or, overestimating the rent that a property will bring.
This article breaks down the cash flow calculation. And, it shows you how to get a free rental property cash flow calculator.
Engineering Your Rental Property Cash Flow
Your evaluation of the properties that you think you might buy is much like a structural engineer who is designing a bridge. An engineer relies upon certain mathematical formulas to tell him how to design the bridge. If he doesn’t perform those calculations, the bridge could weaken and fail at some time. That’s why the engineer must utilize the right structural properties for the materials that will be utilized to build the bridge. For an engineer designing a bridge, a mistake in the math can be deadly.
You build a bridge with every property that you buy. Your aim is for that bridge to stand tall and strong financially once you open it up to traffic (i.e., lease it). The difference is that you’ll usually notice right away if there is a problem with the construction of your bridge. If you make a mistake, you may wind up with negative cash flow.
The property that you buy must be capable of sustaining the cash flow you need to pay the expenses and debt service. Any week section of bridge weakens the entire bridge. The math will not difficult as you will soon see.
Cash Flow Math for Dummies
The cash flow math is very simple. I’ll start with a simple example worked out by hand just to show you where the numbers come from. Then, I’ll introduce you to the Cash Flow Calculator.
The cash flow (CF) is calculated as follows:
|Cash Flow (CF) =||Net Operating Income – Debt Service|
Net operating income is the net income less all operating expenses. To keep it simple, do the calculation on a monthly basis. So if any of your expenses like property taxes or insurance are listed on an annual basis, just divide by 12 to get the value for that expense per month.
Debt service is whatever your monthly mortgage payment is.
The operating expenses include the property tax, hazard (fire) insurance, maintenance, property management, and vacancy.
Property Taxes. The property taxes are what you pay the county each year. You can get that total for any given property from your county assessor.
Hazard Insurance. Your property must be covered by a good hazard insurance policy. Hazard insurance protects against fires, storm damage, and in some cases vandalism.
Maintenance. In most cases, your landlord tenant laws will hold you legally responsible for maintaining your rental property. That includes providing heat, plumbing, and electrical.
You can assume a maintenance figure of 5% of the rental amount for homes built within the last 15 years. For example, a house that is brick with a slab foundation and newer plumbing and electrical will need relatively less maintenance than other types of construction.
If the property is more than 15 years old but has many of it’s systems like heat and air and electrical updated, you can assume a maintenance figure of 10% of the rent.
Older properties that have not been updated may have maintenance costs as high as 15% to 20% of the rental amount. For example, a two-story frame house built in the 1920’s will be high maintenance if it hasn’t had significant updates.
Vacancy. This is the percentage of time that a property sits vacant. A reasonable expectation is 10%. However, this figure can vary, depending upon the property.
The way to calculate how much your mortgage payment will be is to go to site like www.google.com and type into the search bar “loan calculator”. This will give you way to enter the principal amount of your loan (total starting amount), the interest rate, and term of the loan.
The interest rate and term of the loan will depend upon what type of financing you set up. If you are going to work with a bank, you might assume 6% interest with a 15-year note.
Example of determining Cash Flow
A single family home is refinanced with a 15-year note at 6% interest. The loan amount is $80,000. The property is rented for $997 per month. What is the cash flow?
Calculate Cash Flow. Projected income and expenses are as follows:
|Vacancy (assumed 10%)||$100|
|Net Operating Income (Monthly)||$472|
The monthly payment for the loan is $675.
Because the net operating income was $472, the cash flow is negative $203 per month.
Negative cash flow is never great, two factors to consider are that:
- Over the life of the loan, there is an average debt reduction of $444 per month.
- The property will likely appreciate.
- The rent is likely to go up.
But just to reiterate, the time to get the math right is before you do the deal. The owner of this property may have reconsidered had they done the math to find out the refinance would put them into a negative cash flow situation.
Rental Financial Calculator
My business coach Martin Holland created a renal cash flow calculator that he was nice enough to share with me, and allow me to give you access to download it. For more information about Martin Holland as a business coach, you go to https://www.annealbc.com/.
The beauty of this financial calculator is that it will provide you a very detailed financial statement of the investment projected out to ten years.
The calculator is a very useful tool to evaluate the return on investment from a potential purchase. You can get the calculator by going to the downloads and selecting the Rental Cash Flow Calculator.
There is an example already keyed into the calculator. The example numbers are as follows:
|Annual Interest Rate||6.0%|
|Rental Income||$1,250 per month|
|Insurance||$1,200 per year|
|Maintenance||$50 per month|
|Income Tax Rate||20%|
|Real Estate Tax||$1,200 per year|
Entering Information into the rental financial calculator
Here is the screen you will see with the example information shown in the table above. When you want to enter your own information about a property you are evaluating, you will enter the information into the blue cells.
The financial calculator is quite sophisticated. It calculates all these items:
- Owner’s cash position over their first ten years of ownership,
- Net profit year to year,
- Projected property value year to year,
- Loan balance year to year, and
- Net worth based on this one property year to year.
As you scroll down on the page, you will find a summary of the calculations which answer each of the above bullet points. Here is what you’ll see with the example data:
Based on the analysis at the end of the first year, the property is project to have a positive flow (net profit $4,477 and year ending cash $19). The property value is projected to be $108,150 (increase of $3,150). The year ending balance of the loan will be $80,437 (principal reduction of $3,563). And finally, the projected net worth based on this one property is $27,732 (an increase of $2,732).
These are definitely good numbers for this example.
Now that you have seen the example, key in the information for your potential rental property.
Remember, the time to get the math right is before you purchase the property.
Do the math to assure yourself that you will build a strong bridge that stands the test of time.
Again, you can get the calculator now for free by going to Rental Cash Flow Calculator.
Here is a good article about why the Oklahoma City metro area rental real estate market is perfect for the long term.