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 single-family homes and small apartment buildings (1-4 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 hold-up 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

Total Operating
Costs Per Unit

Total

1-4 Units

5-49 Units

>50 Units

Costs per unit1

$2,300  

$2,300

$2,600  

$3,300

Costs as a percent of rental income2

42.5%

42.5%

43.3%

50.0%

1Source: “Property Owners and Managers Survey (POMS) by US Census 2000.

2Percentages were calculated using rent data reported in the POMS survey. For additional information on how this data was determined, see appendix A.

Overall, total operating expenses per unit ranged from a low of 42% to a high of 50%, when reported as a percent of gross rental income. Expenses increased with the number of units in the apartment. Small apartments (1-4 units) had expenses totaling approximately 42.5% of gross rents, medium-sized apartments (1-49 units) had expenses of 43.3%, and large apartment complexes (>50 units) had expenses totaling approximately 50% of gross rents. The trend of increasing expenses with apartment size is not surprising. Large apartment buildings have more common areas to maintain and typically offer community amenities, all of which contribute to an increase in expenses.

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:

Yearly Total Maintenance Expenses by Unit

Maintenance Costs

Total

1-4 Units

5-49 Units

>50 Units

Costs as a percent of rental income

14.0%

14.0%

18.0%

18.0%

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.

As we will discover in the following sections, this expense data, when combined with accurate market rent determinations, will allow us to accurately predict cash flows for rental properties.

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:

Net Operating Income

Less Total Annual Debt

Cash Flow

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:

Gross Rental Income

Less Vacancy Rate

Less Total Operating Expenses

Net Operating Income

Clearly, when we consider our cash flow equation, we want our net operating income, or NOI, to be sufficient to cover our total annual debt, or TAD. The following simple relationship can be established between NOI and TAD:

If NOI > TAD ► Positive Cash Flow

If NOI = TAD ► “Break even” Cash Flow

If NOI < TAD ► Negative Cash Flow

Note that the cash flow calculations cover the entire debt, which includes the principal payments as well.  If your NOI is sufficient to cover your debt, you may have a zero cash flow but you are building equity by mortgage-pay down. This leads to a simple fact:

Let’s combine these concepts and look at a typical cash flow estimation for a potential investment property. Consider the previous duplex example that was listed for sale at $160,000. For financing we will assume a 20% down payment so our loan amount will be $128,000. Assuming a 6% interest rate on a 30-year loan, our principal and interest payment would be $767.42 per month, or $9,209 per year. The advertised rent for this duplex is $700 per side, or $16,800 in gross rental income per year. We will assume a 5% vacancy rate. To estimate our projected expenses, items such as taxes, insurance, management fees, and utilities, are usually available either from tax records, the seller, or other sources. For maintenance and repair we will use an estimate of 15% of gross rental income, which is based upon the values reported in the POMS survey. Combining all this information we can now calculate cash flow as follows:

Example Cash Flow Calculation for a Duplex

Address: 1002 Landlord Lane

Sale Price: $160,000

Building Type: 2 units

Financing: 20% down on a 30 year fixed rate loan at 6%

Market rent: $700 per unit

Gross Rental Income

$16,800

Less 5% Vacancy

-$840

Net Rental Income

$15,960

Less Operating Expenses:

 

Real Estate Taxes

$1,600

Insurance

$700

Repairs & Maintenance

$2,520

Utilities

$100

Management

$1176

Yearly Reserves

$1234

Total Operating Expenses

$7,330

 

Net Rental Income

$15,960

Less Total Operating Expenses

-$7,330

Net Operating Income (NOI)

$8,630

Net Operating Income (NOI)

$8,630

Less Total Annual Debt (TAD)

-$9,209

Cash Flow

-$579

 

 

Repairs and maintenance do not include capital expenditures, the so-called “reserves”, such as the replacement of appliances, a roof, heating systems, or new carpet. The annualized cost estimate for these expenses is known as your “yearly reserves”. Example calculations for yearly reserves can be found in Appendix B. 

 

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:

A simple “rule of thumb” is that total operating expenses for small apartment buildings should be between 40-50% of the total gross rental income. Use of this expense factor should be limited to small apartment buildings of 1-5 units. For larger unit buildings a higher expense ratio may be necessary. For newer construction, a lower expense factor should be used.  For more information on the assumptions that went into this expense factor, see Appendix A.

Simplified Cash Flow Calculation

Address: 1004 Landlord Lane [e2] 

Sale Price: $250,000

Building Type: 4 units

Financing: 20% down payment on a 30 year 6% fixed rate

Market rent: $550 per unit

Total Operating Expenses: Assume 45% of gross rental income.

 

Gross Rental Income

$26,400

 

Less Vacancy Rate (5%)

-$1,320

 

Net Rental Income

$25,080

$25,080

Less Total Operating Expenses (45%)

 

-$11,880

Net Operating Income (NOI)

 

$13,200

Total Annual Debt (TAD)

 

$14,389

Cash Flow

 

-$1,189


In this case, the yearly cash flow is estimated to be negative $1,189 per year. In order to make up this cash flow deficit, you would need to put more than 20% down, find better financing, or make a lower offer. This is where the fun comes in and where you can make the deal work by getting the seller to come down in price, obtaining better financing, or putting more money down to reduce your annual debt.

 

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 1004 Landlord Lane at 5% interest rate

Net Operating Income

$13,200

Less Total Annual Debt

-$12,883

Cash Flow

+$317

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 1004 Landlord Lane at 5% interest only rate

Net Operating Income

$13,200

Less Total Annual Debt

-$9,996

Cash Flow

+$3,204

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 none-the-less. If the units are new, or have been newly renovated, then the expense component would be less in the early years, maybe 30-40%. 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).

 

Tip: If you plan on managing the property yourself and handle the maintenance, total operating expenses can be as low as 20-30% of your gross rental income.  

 

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: 1004 Landlord Lane

Sale Price: $250,000

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.

 

GRM =

Price

=

$250,000

= 114

Rent

$2,200

 

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 excel-based 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 up-front 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 highly-appreciating areas, as well as the poorer less-appreciating 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 well-established suburban neighborhood. We paid $123,000 for our Manchester Drive house, a three bedroom two bath home. We rented this house to start at $1200 per month. Even a back of the envelope calculation would predict this to be profitable, and, in fact, it was in the beginning. In the following two years we managed to get $1,150, and then eventually it sat vacant for 6 months. Our top rent five years later? $925! Keep in mind this was a very nice house in a very upstanding neighborhood, and it remains so to this day. There are no multifamily properties and maybe only three or four rental properties in the whole subdivision. It turns out that during this period rents had precipitously fallen due to a glut of single family homes. Everyone wanted to be a landlord and instead of people moving and selling they moved and rented their homes. These novice landlords were largely uninformed and assumed if their rent covered their mortgage payment, then they were making money. This perception along with increased supply served to drive down rents to unprofitable levels. Such rent depression is not unique to our metropolitan area and is typically found in sprawling areas where land is readily available for development. Oddly, the National Association of Realtors (NAR) records for our area actually indicated that rents climbed during this period. They probably did, on the average, but not for older single family homes which we happened to own. My point? Cash flows are extremely important. It is critical your new purchase is profitable based upon today’s dollars. If the numbers don’t work in today’s dollars, you may experience that negative cash flow for many years to come. If you own five such properties, it could ultimately cause your financial ruin. As you can see, even if the numbers are positive when you buy, you may still need to survive some hard times. The likelihood of success however is high when you start out with the correct assumptions.

  Summary

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  Given the tax advantages, appreciation potential, loan reduction, and eventual increase in rents due to inflation, a “break even” cash flow will turn out to be a good investment for the long-term investor.

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For the purposes of screening profitability of potential investments, total operating expenses for most small apartment buildings can be estimated at 45% of gross rents.

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It is important to determine the true market rents of a potential purchase as these rents may or may not be the same as the current rent roll.

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Profitability in today’s market can be razor thin and it essential to accurately predicting cash flows by using the correct numbers for total operating expenses and rental income.