There are two ways you can make money with investment properties. They can generate rental income from the tenants who live in them, and they can appreciate in value over time.
While equity appreciation is certainly nice, most experts agree that cash flow is the more important thing to consider. For one thing, cash flow is predictable, while long-term price appreciation is not. Additionally, positive cash flow allows all of the property’s expenses to get paid without money coming out of your pocket.
With that in mind, here’s a quick guide to estimating the cash flow of potential rental properties to help you narrow down your search.
Cash (flow) is king
The most basic definition of cash flow is income minus expenses. That is, if an investment property’s rental income is greater than the expenses of owning, operating, and managing the property, you would have positive cash flow. On the other hand, if a property cost you more than it brought in, it would have negative cash flow.
When I’m screening potential investment properties, the most basic test I perform to see if I’m interested is to determine if the property will produce positive cash flow or not. If conservative estimates indicate positive cash flow, I’ll look into the property further. If not, I automatically eliminate it from consideration. I often tell people that I can determine whether I’m interested in a property within the first 30 seconds of looking at its listing, and this is how.
To be clear, not every investor just wants positive cash flow. Some have their own rules, such as at least $100 per month in cash flow, or a certain cash-on-cash return percentage on their initial investment. Whatever particular guideline you end up following, one thing is certain -- cash flow is an incredibly important concept when investing in real estate. In fact, it was a lack of focus on cash flow and too much emphasis on equity appreciation that got so many investors into trouble during the housing bust of 2008–09.
With that in mind, let’s go over how to quickly -- and conservatively -- estimate the cash flow of potential investment properties.
Will your property really generate positive cash flow?
It would be fantastic if you could collect rent from your tenant(s) each month, pay your mortgage, insurance, and property taxes, and just pocket the difference as your profit. Unfortunately, it doesn’t usually work out this way -- especially on a long-term basis. At some point, your property is going to need some maintenance or repairs. And at some point, your property will likely be vacant as you search for new tenants.
There’s no set-in-stone rule when it comes to projecting these setbacks. By nature, they are rather unpredictable. However, I’ll share how I approach them when evaluating potential rental properties to buy.
When it comes to maintenance, it depends on the age and condition of the property. Assuming that I’m going to spend a fair amount of money initially taking care of whatever immediate repairs and deferred maintenance items need to be done, I’ll assume that ongoing maintenance will range from 5% to 15% of the rent. The lower end of the range is what I’ll use if the property is relatively new or in fantastic condition, while I’ll use the higher end if a property is old or is in so-so condition. For the majority of properties I consider, I use the middle (10%) of the range when it comes to maintenance.
I use a similar strategy to account for vacancy expenses. Generally speaking, I assume that all of my properties will be vacant for one month each year, and to be safe, I round this up to 10% of the time.
If I don’t end up spending the money on maintenance and the property is occupied 100% of the time, great. However, you want to plan for a real-world situation, so it’s best to err on the side of caution.
Finally, unless you plan on self-managing the property, it’s important to budget for property management. If you already have a property manager, you can use their actual rates, but the industry standard for long-term rental properties is 10% of the collected rent.
An example of calculating cash flow
Here’s a real-world example of how this could come together. One of the properties I’m currently considering has a price tag of $110,000. Including taxes and insurance, and assuming 20% down, I can reasonably expect to pay about $750 per month based on a recent quote from my lender. If the property’s current rent is $1,100 per month, here’s how my cash flow calculation could look:
|Mortgage Payment (PITI)||$750|
This property passes my most basic test -- positive initial cash flow. Sure, $20 per month might not sound like much and more would obviously be better, but this is based on generous reserves for vacancies and maintenance.
And keep in mind that this is initial cash flow -- rental income tends to rise over time. The point of this cash flow calculation is to show that after all reasonable expenses, I can expect this property to add to my bank account every month and not be a money drain from day one. (Tip: Multifamily properties tend to cash flow better than single-family homes like this one.)
Be realistic when estimating rental income and your expenses
As a final word of caution, it’s important to realize that your cash flow estimates are only good if you’re realistic about your assumptions when it comes to income and expenses.
For the rental income, this is obviously easier if the property you’re considering is already occupied. For example, if you’re looking at a triplex that’s fully rented and bringing in $3,000 per month, it’s safe to use that figure in your cash flow estimates. On the other hand, if the property is vacant, it’s important to be realistic about what the property could rent for.
Using comps in the area (you can usually find some on Zillow or another real estate website) can be a great way to get an accurate estimate of potential rental income. I rely on my property manager to help estimate rental income, and if you’re new to the real estate investment world, a local property manager can be your best source of realistic rental income expectations.
On a similar note, be realistic with your expense assumptions when it comes to vacancies, maintenance, and financing. For example, don’t just assume you can get investment property financing with 20% down and a 5% APR. Take the time to get a quote from a lender, as you may be surprised how much more expensive rental property financing can be. Also, be realistic about how much you think you could actually get the property for -- if a rental property is listed for $200,000, it may be a bit too optimistic to simply assume you can buy it for $150,000 when determining cash flow potential.
The bottom line is that you want to know if your property will cash flow in reality, not just under the circumstances where everything works out perfectly.