Determining
Cash Flows
When deciding whether you should buy a particular rental property, you need to be concerned with three things in the following priority. First, you will need to ensure you have a positive cash flow. Second, you should not pay more than fair market value for your property, and third, your investment must increase in value over time. Many investors are willing to settle for a negative cash flow in the hopes of selling someday for big capital gains. This is a poor investment decision. You may end up owning property that has a negative cash flow but you shouldn’t knowingly enter into such an agreement. After all, as we have seen from the POMS survey in Chapter 1, the number one reason why investors buy and hold onto rental property is for the income. Unfortunately though, we also learned that nearly half of those property owners were losing money on their investments. We also learned that the owners of singlefamily homes and small apartment buildings (14 units) were losing the most. Why then are so many private investors burdened with negative cash flows? Although neighborhoods can deteriorate and turn positive cash flow properties into negative flow investments, this is rarely the reason for negative cash flow earnings. The primary reason for negative cash flows is that the buyers of these properties used the wrong assumptions when they estimated cash flow. The two elements of cash flow are rental income and operating expenses. It is these two components that we need to get right before we can accurately project cash flow. If we buy a property that is renting for $800 per unit but later discover the actual market rents are closer to $750, we have made the wrong assumption. If we use a vacancy rate of 5% and the average vacancy for the area is closer to 10%, we have used the wrong assumption. If we don’t factor in bathroom renovations or a replacement driveway in 5 years, our expense estimates are wrong. To summarize, the two common mistakes made by novice investors that lead to negative cash flows are: [1] The cost of operating expenses such as maintenance, repairs, and yearly cash reserves is underestimated. [2] The projected income from rents is overestimated. In order to buy profitable properties it is essential you get your assumptions correct. If you miss your mark, you too will join the ranks of owners that lose money. The main focus of this chapter is to provide you with the tools to precisely predict expenses and market rents. With this data in hand, calculating cash flow is simple. Follow these basic rules and you should become a member of the property owners that are profitable, and be well on your way to building wealth through investing in real estate. Myth
vs. Reality
Pick up nearly any book on investing in real estate and the rule of thumb, or example used, is that a house that sells for $100,000 should rent for $1,000 per month. This 10% rule, or 100 gross rent multiplier rule, still dominates the investment literature. Unfortunately, such properties are becoming increasingly hard to find. Why does this myth persist then? The rule perpetuates because every investor knows that those properties will be profitable. If there were an abundance of such properties, the number of profitable owners of small apartments would be greater than the 40% we found in the POMS study. Unfortunately that is not the case. In fact, higher property values coupled with lower rents over the years make it increasingly more difficult to find such high cash flow properties. One can find properties that holdup to this 10% rule; however, they will not be in prime locations rather they will likely be located in high crime high risk areas. For these properties, the large cash flows are often offset by high vacancies, defaults in rent, high management costs, and risk of property depreciation over time. Unless you want to own property in these types of neighborhoods, you will need to lower your expectations on cash flow. In short, we need to dispel the myth, and move on to reality. We will therefore need to develop new standards that apply to our current investment market. So if a gross rent multiplier of ten times monthly rent is an impossible pie in the sky goal, then what number is the more realistic multiplier? What should our new standard of profitability be? More importantly, how can we ensure a profitable operation when investing in a single family home, duplex, triplex, quadraplex, or apartment building? The following sections will provide answers to these questions. Determining
Operating Expenses
In order to calculate profitability and cash flow accurately on your rental properties it is imperative you have a reliable way to predict your expenses. Predictable (fixed) expenses such as your mortgage, taxes, insurance, homeowner’s fees, and the like, are easy to get right. Granted, all of these can go up, but for the most part, there shouldn’t be huge surprises here. Variable expenses however, such as maintenance, repairs, and capital improvement expenses, are more difficult to forecast. These expenses will largely be determined by the age, type, and size of the apartment building, and also by the extent maintenance has been deferred. As a result of the POMS study referred to earlier, we have some excellent guidance on what we can expect to pay per unit on operating expenses. The following discussion summarizes the study’s findings. The first study presents data on the median yearly operating costs paid per unit by the 16,000 participating property owners. Total operating expenses is defined as including all expenses except mortgage debt. The data is presented both in absolute dollar cost as well as a percent of gross rental income. The study queried both small and large property owners. This data is summarized in the table below. Yearly total
operating expenses by unit
^{1}Source: “Property Owners and Managers Survey (POMS) by US Census 2000. ^{2}Percentages were calculated using rent data reported in the POMS survey. For additional information on how this data was determined, see appendix A. The next study we will look at presents data on the repair and maintenance expenses paid per unit. For this expense, which is a subset of total operating expenses, the costs as a percentage of gross rents ranged from a low of 14% for small properties to a high of about 18% for medium and large properties. The actual distribution for maintenance repair costs as a function of unit size is shown in the figure below:
Source: “Property Owners and Managers Survey” by US Census 2000. As
was observed with the total operating expense data presented previously, the
cost of maintenance and repairs is also found to increase uniformly with the
size of the apartment building. Calculating
Cash flows
We have talked in general terms about cash flow but let’s now look into how cash flows are actually calculated. The definition of cash flow is simply the money you have left after you have collected all your rents and paid all your expenses. The formula for cash flow can be presented as follows:
Total annual debt (TAD) would be your annual loan payments in the form of principal and interest. Net operating income (NOI) is simply the cash you have left after you have collected your rental income and paid all your expenses. NOI can be defined as follows:
If
NOI > TAD ► Positive Cash Flow If
NOI = TAD ► “Break even” Cash Flow If
NOI < TAD ► Negative Cash Flow
In this case we find that the net operating expenses (NOI) are less than the total annual debt (TAD). The property therefore has a slight negative cash flow of $579 per year. In our previous example we were provided with all the operating expenses. Although the total operating expenses can vary greatly from property to property, it turns out that for most rental properties the total expenses can be approximated at 45% of gross rents. This expense factor assumes the units are in good condition and not in need of immediate repairs. If the dwelling in question is very old or very new then adjustments would need to be made. For most small apartment buildings though, this value will provide a good benchmark to predict cash flows. With these assumptions, let’s look at some examples that illustrate the use of this expense factor to predict cash flows. We will make the same assumptions as in our previous example but now we will assign a value for total operating expenses of 45% of gross rental income:
Effect
of interest rates on cash flow
Using the previous example, if we are able to get a 5% interest rate instead of 6%, our yearly debt is reduced, and a slight positive cash flow is predicted. Cash
flow estimate for
If you obtained a 5% interest only loan, your yearly debt would be $9,996 per year. Substituting into our DCR equation, one obtains a strong DCR ratio, even for bank standards, of 1.32 and a yearly positive cash flow of $3,200. Cash
flow estimate for
Now you can see why interest only loans are very popular. Just be aware that with interest only loans no one is paying off your loan, thus your original loan amount will not be reduced over time. The expense factor of 45% is useful for quickly screening profitability, but is a crude estimate nonetheless. If the units are new, or have been newly renovated, then the expense component would be less in the early years, maybe 3040%. Another key point to remember is that this expense assumption does not include the cost of renovations, or replacing a driveway, removing trees, or putting up a fence. These costs would need to be considered as part of the sale in order to have a completely accurate cash flow prediction in the years to come. Once you have narrowed down your search to a few properties, you are encouraged to do exact calculations and break out all the expenses. As this is rather tedious without the aid of a computer, we recommend purchasing a simple software program to make these cash flow approximations (more on this later).
GRMs
to predict cash flow
Gross rent multipliers (GRMs) can be used to estimate cash flow potential. In the previous chapter we made a statement that a monthly GRM of less than 115 should provide positive cash flow, assuming certain financing conditions such as a 20% down payment and a 6% interest rate. Since GRMs do not factor in the local vacancy rate, operating expenses, or the financing you may be getting, they are less precise. For example if we calculate the GRM from our previous quadraplex example, we obtain the following: Address:
Market rent: $550 per unit ($2,200 per month) Recall that GRM is simply the ratio of sale price to gross rents. In the above case we obtain a GRM that is lower than 115, and would thus predict profitability.
As we have seen however, when we use more accurate cash flow calculations and factor in the financing terms this example property can range from profitable (at a 5% interest rate) to slightly unprofitable (at a 6% interest rate). For this reason the use of GRMs should be used only when very crude estimate of cash flow potential is desired.
Cash
flow calculators
Calculating cash flows assuming a 45% expense factor is a great way to screen properties for cash flow. Once you identify a potential property however you will want to perform more detailed cash flow calculations where you itemize all your expenses. A more accurate method of calculating cash flows makes use of one of the many cash flow calculator computer programs available. They are quite easy to use and provide accurate predictions of positive or negative cash flows. Like all computer calculations, they are only as accurate as your input data. This is where the data on maintenance and repair and yearly reserve data we provide in Appendix B are invaluable. Other expenses should be readily available from tax records, local utility companies, or the seller. Using this information you can accurately predict these variable expenses that every buyer worries about getting right. With a firm grasp of your operating expenses, you can input the right numbers into these computer programs and get meaningful outputs. You may find however, that when you break down all your expenses, you will be quite close to the 45% expense factor you used initially! These programs are also useful because they automatically do all the amortization schedules (PI) for you. They also allow “sensitivity” calculations. For example, note that in the previous examples we chose a vacancy rate of 5%. This may be the current vacancy rate, but what if vacancy rates went up to 10% for 2 years, would you be able to survive financially? These programs permit you to calculate these different sensitivity scenarios. One can purchase quite sophisticated programs for several hundred dollars but for a fraction of the cost, one can obtain excelbased versions that work quite well. Using these programs and the right data, your cash flow calculations should then be very close to being correct over the long term. Determine
the market rents
In order to obtain correct cash flow estimates your projected income from rents must be accurate. A $25 per month error in rent on your part could mean the difference between a negative or positive cash flow. So let’s consider the $700 per month rent we used in our previous duplex example. Where did that number come from? Is that the current rent? Are the units vacant and $700 is the market rent estimated by the seller’s agent? In fact none of these rent estimates should be used for your calculations. What we need to determine are the actual market rents for those units in that neighborhood. How do you accomplish this? You must perform a market analysis of rents for your property. Locate “For Rent” signs and call and ask about rents. Find adjacent property owners in the county tax records and call them up. Tell them you are interested in investing in that neighborhood. Tell them right off you are a landlord. I have had 100% success rate doing this. One rarely hangs up on a fellow landlord. You will find most folks are quite upfront about their rents. Some will say, “Oh I have rented that unit for $575 to the same tenant for over 9 years without raising the rent” (this is a below market data point). Another might say, “Well, I just renovated the place and it took me 2 months to get $725 for it”. Now you have a good data point for an actual market rent. Verify, Verify, Verify. Do not trust any information you obtain from the seller or seller’s agent at face value, even if it based upon existing tenants. If you discover that the actual market rents are lower than the $700 per unit, you can recalculate cash flow based upon the true market rents. You can then present a lower offer to the seller and explain why. Do not spend much time with the deal however if the seller isn’t willing to come down in price. Just move on to the next deal. As a final note remember that accurate cash flow calculations depend on accurate vacancy determinations. Recall that a convenient way to obtain the vacancy rate is by comparing the number of “For Rent” signs to the total number of mail boxes in the neighborhood. Appreciation
makes up for negative cash flows
It always upsets me every time I read
a new book on real estate investing and the assumptions are always the same.
“Rents and property values always
increase over time.” As with many truths in investing, this is only
partially right. As we have seen with the stock market recently, we can no
longer make the claim that stocks will increase over any 10 year period. Real estate is no different. Although
appreciation in property values may be more predictable than the stock market,
rent appreciation is not. Nationally, median rents have increased over the
last ten years. Although the National trend is upward, local rent trends can be quite different. In our metropolitan area
for example, ten years ago, a two bedroom two bath town house rented for $700
per month. Today, 15 years later, that same
unit still rents for $700. A three bedroom student rental 20 years ago brought
$850 per month in rent. Today, the same comparable units rent for $795. This
rent depression affected all parts of our rental market, both the
highlyappreciating areas, as well as the poorer lessappreciating areas.
Although these rent depreciations are admittedly rare, to the affected
investors these down cycles are very costly. We bought our very first rental
property in a wellestablished suburban neighborhood. We paid $123,000 for our

