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Buying Real Estate for Cashflow

By Edited Apr 8, 2016 4 4

 

3Br 2 Ba

It’s the first of the month, and regardless of where I am in the world, thousands of dollars are automatically direct deposited into my bank account.  This is the dream of every cashflow real estate investor.  I’m often asked by friends and family questions like, “how will I know if a property will be cash flow positive”, and “how do you get so much cashflow out of your properties.” My answers are always that you need 3 things

  1. A strong “Why”  
  2. To buy right
  3. Operational excellence

 Why do you want to invest in real estate?  If this is a question that is hard for you to answer, it may not be your thing.  Personally, I’ve always loved houses of all different shapes, styles, and sizes.  As a child, I rode my bike around the neighborhood admiring them, and building my own versions in nearby trees, much to the frustration of my parents.  Additionally, I’m passionate about helping others, and am able to do this with rental properties.  Finally, the passive income properly managed real estate generates allows me greater freedom to do what I want, when I want.  Find your “why,” and if you want it badly enough, success will follow.

 Buying right is critical to having a rental property consistently provide positive cash flow every month.  By definition, for a property to pay you every month, the sum of the rents must be higher than the following costs

  • Mortgage Payment
  • Insurance
  • Taxes
  • Property Management Fee
  • Maintenance 
  • Replacement Reserves
  • Vacancy allowance

Note that I’m not including snow removal, landscaping, electricity, trash removal, and other miscellaneous costs.  In my market, tenants pay these items.  If your area is different, be sure to add these costs into your calculations.

 For example, if you've saved diligently and are now considering buying a 3 bedroom 2 bath single family home to rent, the first step in calculating your potential cashflow is to determine the amount of rent similar homes are bringing in.  This can be easily done by searching sites such as Craigslist, visiting vacant units in the same neighborhood, asking local tenants, or real estate professionals.  Let’s say your research has found that 3 bedroom 2 bath single family units rent for $900-$1100 per month.  (Notice that this amount is set by the market; if you try to get more than this, vacancies will follow.)  During your research, you’ll notice certain features that tenants are willing to pay more for, some examples include: double stall garage (instead of single), updated kitchen appliances, high end kitchen and bath features (such as granite countertops, spa like showers, etc),  and a fenced in yard for a pet.

Be realistic in your assumptions and run them by someone already in the business that you trust.  Let’s assume you’ve decided your target property will rent for right in the middle of your range at $1000 per month.  Unless you have other income from the property (coin operated washers/dryers, internet, etc), this is your total monthly income for the property.

The next step is to calculate your costs.  Taxes can be easily found by looking them up on your county assessor’s website.  If your state does not make this information available online (for example, in California) you can visit the assessor’s office to get this (tax information is public domain and is not confidential in any way.)  Sites such as Zillow and Truila can give you an estimate, but I’d recommend using the Assessor’s information to get exact numbers and avoid any surprises down the road.

Insurance costs can vary widely and you’ll need to get actual quotes from your broker/agent for this.  You’ll want to make sure you get a policy with landlord’s coverage.  This typically covers your lost rental income in case of a loss such as a fire and provides some protection in case a tenant gets hurt on the premises.  The two main types of insurance are Replacement Cost, and Actual Cash Value (ACV).  If your roof is destroyed in a hail storm (assume a total loss here), a Replacement Cost policy will reimburse you for the entire cost to tear off and put a new roof on your dwelling.  Lets say this is $15,000.  The insurance company will give you a check for this amount less your deductible.   An Actual Cash Value policy will reimburse you for the depreciated value of your roof.  Again, assuming your new roof will cost $15,000, the insurance adjuster will calculate the remaining useful life of your roof and pay you only that percentage.  As an example, if your roof is 10 years old and they calculate a 20 year typical service life in your area, they will issue you a check for $7,500 less your deductible.  Obviously, the Replacement Cost policy will be more expensive.  For this 3Br 2Ba example, a landlord’s policy will cost around $1200/yr for Replacement Cost and $750/yr for Actual Cash Value .  Which policy you select depends mainly on your strategy and the age of the unit.  We’ll use $1200/yr for our estimates.

Property management fees are the fees associated with whomever collects your rent.  This could be you, or a full on property management company.  Rates vary and I’ve seen anywhere from 6-12%.   Again, get some quotes and ask someone you trust to help you with your estimate.   This example will assume someone else does this for you at 8%.

Replacement reserves are funds you set aside for future major repairs.  These are things like roofs, furnaces, air conditioners, windows, appliances, etc.  An experienced investor will be able to help you generate an accurate estimate for this number.  This amount varies widely and depends greatly on the age and condition of the property.  Expect to set aside a much larger amount for a home built in 1905 than a home built in 2005.  Some people say to save 10% of all rental income for replacement reserves. For this example, we’ll go with this and call it $100/month. 

Your mortgage company will roll the Principal, Interest, Taxes, and insurance into one lump sum every month.  This makes it convenient for you in that you only pay one entity per month rather than setting aside money for taxes and insurance and paying large lump sums one.    

Vacancy rates are the amount of money you don’t make when your property is not being rented.  This information can be provided by the seller, but it should be independently verified by you for accuracy (trust but verify).  Even if the owner says he has a 0 percent vacancy rate for the past 3 years, and can prove it to you with receipts, it may be wise for a new landlord to factor in say 10 percent.  Checking with your trusted real estate investor friend will help here also.  If your rent is $1000 per month, this will be $100. 

Now we have assumptions for Rent, Principal, Interest, Taxes and Insurance, Management Fees, Replacement Reserves and vacancy, we can run scenarios for cashflow.  Online calculators make this easy.  

Lets say the property you’re considering is $125,000 and you put 25%.  For an investment property, most lenders require a maximum Loan To Value (LTV) of 75%.  In our example, the bank gives you a loan for 75% of $125,000 or $93,750 and your downpayment is the remaining 25%, or $31,250   Your monthly costs will be as follows

  • Principal and interest  $475 (4.5% interest rate and 30 yr fixed mortgage)
  • Property Taxes - $221  (2.17% Tax Rate)
  • Homeowners Insurance - $100 (Replacement Cost Policy)
  • Property Management - $80 (or 8% of rent collected)
  • Replacement Reserves - $100
  • Vacancy Rate - $100

Total Rent - $1000

Total Expenses - $1076

Unfortunately, at this purchase price, the property will lose $76 every month.  For this given property, you’ll have to lower your expenses for the property to cashflow.  Remember, the rent is set by the market.  If you buy the property and attempt to rent it for $1200/month to compensate for paying to much, tenants will choose to live elsewhere.  

Re-running the above numbers at a purchase price of $90,000 gives you costs of

  • Principal and Interest  $342 (4.5% interest rate and 30 yr fixed mortgage)
  • Property Taxes - $163  (2.17% Tax Rate)
  • Homeowners Insurance - $100 (Replacement Cost Policy)
  • Property Management - $80 (or 8% of rent collected)
  • Replacement Reserves - $100
  • Vacancy Rate - $100

Total Rent - $1000

Total Expenses  - $885

At this purchase price, the property will, on paper, pay you $115 every month.  Additionally, you can calculate your annual Cash on Cash Return by taking your yearly cashflow divided by your total cash outlay (down payment + closing costs).  I remember this formula by thinking (What do I get)/(What I pay for it).  In this example, recall the downpayment is 25%, and we’ll assume an additional 4% in closing costs and miscellaneous fees.  This makes (12 x 115) / (.29 x 90000) or 1380/26100 or 5.3% Cash on Cash Return.  This is another way to check if the investment is in line with your goals.

Many people think the sellers asking price is the value of the property and end up losing money.  Please remember, the value of the property to you is what you calculate, NOT what the seller is asking.  Respectfully provide the seller or agent with your offer and supporting documentation showing why it is worth that price to you.  Remember that an investment property is not an emotional decision and don’t be surprised if you have to make several offers before one is accepted.  In the past, I’ve made up to 10 offers before having one accepted at or near my desired terms.  If you are kind and respectful when dealing with sellers, even if the numbers don’t work out for you, they will call you back if they change their mind.  I’ve personally done this on 4 of my properties and the sale was a win-win for both parties in all cases.

Finally, cash flow can be raised on a property you already own through effective operations.  As you become a experienced cashflow investor, your costs will decrease in some areas.  For example, when taking care of your tenants by meeting their needs and treating them with respect, you may find your vacancy rates to decrease.  Additionally, as you begin to “catch up” on deferred maintenance from the previous owners, you likely will find your repair and maintenance costs to be smaller, less frequent, and less expensive.  As you build a relationship with your insurance agent, and provide them with lots of business for all of your properties, you may get a volume discount there as well.  Also, as you gain experience, and if its something you enjoy, you can save 8% by managing the property yourself.

Although buying real estate that cashflows takes some homework and persistence, it is definitely possible.  If you have a strong “why”, buy the property right, and achieve operational excellence, you’ll likely reap the benefits of strong, consistent, and positive cashflow.

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Comments

Feb 24, 2014 7:09pm
dogman007
Great article and excellent points to consider when investing in real estate. I would also stress the importance of selecting the right tenants to fill the property. Do your homework on the potential renters. Run a background check and never skip this step. Even better charge the person(s) a fee for the background. You will accomplish two things. 1. Qualify the renter. 2. Flush out a majority of the bad tenants. Selecting the wrong tenants will cost you dearly in terms of time, energy, and money.
Feb 27, 2014 6:05am
EnterprisingInvestor
Thanks for reading dogman007. Very true, although it is tempting to put just anyone in a vacant unit, picking the wrong tenant (or putting one in in haste) often comes back to "bite you" :-)

Feb 27, 2014 6:05am
EnterprisingInvestor
This comment has been deleted.
Feb 27, 2014 6:05am
EnterprisingInvestor
This comment has been deleted.
Feb 27, 2014 4:34am
jny986
Thanks for the great article. I have been studying property investment for a while and still learnt from your article.
Apr 4, 2014 12:31am
rohitsaxena
Great Your Article. Best Property information............
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