How to Calculate Returns & Cash Flow for Any Rental Property

Posted by Brian Davis on Sep 18, 2020 9:00:00 AM

person using a calculator

A landlord’s cash flow isn’t quite as simple as “the rent minus the mortgage payment.”

In fact, many rental investors use a shorthand called the 50% Rule as an instant way to estimate cash flow. It poses that a rental property’s non-mortgage expenses typically come to around 50% of the monthly rent.

By underestimating these non-mortgage expenses, novice rental investors get into trouble and overpay for properties. Then they find themselves stuck with a property that costs them money each year, rather than earning positive cash flow.

Shorthand rules of thumb aside, how can real estate investors calculate cash flow accurately for any property? Fortunately, the math is easy, and you can make it even easier by using a rental cash flow calculator.

Accurately Estimating Income & Expenses

Income is easy enough to estimate. As part of your due diligence when evaluating a property, you should research the market rent and feel confident in your estimate. Use free tools like Rentometer and Zillow to research comparable rents in the neighborhood.

Expenses, however, make for a slightly more complex exercise. It’s important to make sure you include all of the following expense estimates as you run the numbers to calculate rental cash flow.

Vacancy Rate

Even in the hottest rental markets, properties don’t maintain 100% occupancy. It often takes a month or two to clean out a property after an outgoing tenant, perform maintenance work and repairs, market the unit for rent, screen tenants, sign a lease, and so forth. This means you need to calculate the vacancy rate and account for it as an expense.

An 8% vacancy rate represents around one month that the unit is vacant per year. In healthy markets, you should be able to do better than that, but it’s up to you to research the neighborhood’s vacancy rate before investing there. Talk to other landlords and property managers who operate there to get a sense of the rates they see to estimate what you might see for the property you are interested in.

Maintenance, Repairs, & CapEx

Maintenance involves routine upkeep like painting and replacing the carpet. Major repairs and capital expenditures (CapEx) represent significant improvements and system replacements that extend the lifespan of the building. A new roof, a new furnace, and updating the plumbing all qualify as CapEx.

The difference matters for tax purposes, but you can lump them together when I run numbers in a rental cash flow calculator.

When just starting out, many landlords underestimate these expenses. They say things like “Sure, my profits got thrown off this year because I had to spend $3,000 on a new furnace. But next year I’ll earn a great profit!” Next year, of course, they blow $5,000 on a new roof. The year after that, it’s $1,000 on plumbing repairs. And so it goes.

Budgeting 10-15% of the rent for repair and maintenance costs, depending on the age and condition of the property, is typically a good idea. These expenses don’t pop up every month, but you should still set aside money for them every month, so you have cash waiting and ready when you get hit with a $4,000 repair bill.

Property Management Costs

Property management is a labor cost, whether you do the labor or someone else does. To ignore it when calculating cash flow is to miscalculate your costs. How can you compare a 100% passive investment like a mutual fund with an investment like rental properties that require labor, if you don’t account for those labor costs?

Besides, the day will come when you cannot or will not want to manage the property any longer. Maybe you move out of town, or maybe you get a promotion to a high-stress job, or maybe you have triplets. Or you may simply discover you hate managing rentals and dealing with the 3 a.m. phone calls from tenants asking you to change a light bulb for them, the clogged toilets, the chasing down of delinquent tenants who don’t feel like paying for the service you provide, etc.

At that time you might hire a property manager. As long as you accounted for these costs when you calculated cash flow, you won’t have any surprises. Keep in mind that when you estimate property management costs, most property managers charge two types of fees. They charge an ongoing rent collection and management fee, typically in the 7-10% range. And they also charge a fee for placing new tenants, usually one month’s rent. A reasonable estimate is 12-14% for property management fees to account for both fee types.

Property Taxes

Some new real estate investors make the mistake of looking at the current property tax bill and using that as their property tax figure when they run the numbers in a rental cash flow calculator. The problem? It’s based on the current assessed value — which may well change when you buy it. Instead, look up the local property tax rate. Then multiply that by the purchase price you’re considering.

Local property assessors base their assessments on comps, and on the property’s sale price itself if it’s sold recently. Often this means a giant leap upward when the county reassesses a property based on its recent sales price. Granted, you can appeal your property tax assessment. But expect an uphill battle if you just bought a property for market value.

Landlord Insurance

Similar to homeowners insurance, landlords need to buy investment property insurance, at least if they take out a mortgage. It covers the building and protects against damage from fire, storms, and other disasters.

It does not protect against flooding, however; that requires separate flood insurance. It also doesn’t protect the furniture or personal belongings of your renters. For that, they need to buy renters insurance. Get a sense of what landlord insurance costs in your market and get a free quote from your insurance broker if you want a more precise number.

Mortgage Payments

Planning on leveraging other people’s money to build your portfolio of rental properties? Get a rental mortgage quote to determine what kind of interest rate and monthly payment you can expect. While a significant expense each month, at least this is one that even novice investors never fail to remember!

Travel, Accounting, Legal, & Other Miscellaneous Expenses

Alone, none of these expenses amount to much. But together, they generally add up to 2-4% of the rent when combined for the year.

It costs money to drive around town, showing vacant units, inspecting occupied units, and hunting for new rental properties. Your accounting, bookkeeping, and tax return preparation costs go up with every property you add. When you have to take a tenant to court over non-payment of rent, you incur legal fees. If you buy under an LLC name, that costs money to renew each year, so everything adds up.

Sample Numbers & Using a Rental Calculator

Imagine you find a property for $100,000 with a down payment of $25,000, that rents for $1,000 per month. Is it a good deal?

Let’s run the numbers two different ways, one buying in cash and one buying with an investment property loan. In the cash purchase scenario, say your expenses look like this:

  • Vacancy Rate: 5% ($50/month)
  • Maintenance & Repairs: 13% ($130/month)
  • Property Management Costs: 12% ($120/month)
  • Property Taxes: 1.2% of the property value ($1,200/year, or $100/month)
  • Landlord Insurance: $600/year ($50/month)
  • Travel, Accounting, Legal & Misc.: 2.5% ($25/month)
  • Total Expenses: $500/month
  • Monthly Cash Flow: $525 ($6,300 per year)
  • Annual Yield/Return: 6.3%

Now let’s assume you get a rental mortgage at 5% interest for 30 years, covering $75,000 of the purchase price. Here’s how the numbers change:

  • Vacancy Rate: 5% ($50/month)
  • Maintenance & Repairs: 13% ($130/month)
  • Property Management Costs: 12% ($120/month)
  • Property Taxes: 1.2% of the property value ($1,200/year, or $100/month)
  • Landlord Insurance: $600/year ($50/month)
  • Travel, Accounting, Legal & Misc.: 2.5% ($25/month)
  • Mortgage: $402.62
  • Total Expenses: $877.62/month
  • Monthly Cash Flow: $122 ($1,464 per year)

To determine your cash-on-cash return, divide that $1,464 annual return by the $25,000 down payment you made, to reach a return of 5.9% on your down payment.

If all those numbers give you a headache, use a free rental cash flow calculator instead. Just plug in the numbers to determine your monthly cash flow and cash-on-cash return.

Final Thoughts

When you buy a stock, you hope for the best based on historic returns. When you buy a rental property, you can precisely calculate the annual return it will yield. One year may deliver a little more, the next a little less, but over time these expenses and returns prove stable and predictable. If you can accurately estimate the return an investment will deliver, you never have to make a bad investment again.

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