This post is about calculating cash flow. Don’t worry, there’s no fancy math here. I’ll get into more advanced cash flow and analysis in future posts. For now, the only prerequisite is some simple arithmetic that you learn in grade school.
A common misconception on calculating the cash flow on a rental property is to think that it is simply the rent minus the mortgage (Principal & Interest), Taxes, and Insurance or PITI for short.
If this is how you’re calculating cash flow then you will get badly burned. There are many more expenses that come into play that will eat into your income. While the PITI are the most obvious, let’s talk about calculating cash flow correctly so that you don’t get caught with any surprises.
We’ll get into a more formal definition of cash flow in Part 2 of this post, but in the most basic sense, cash flow is calculated as follows.
Cash Flow = Income – Expenses
Sounds pretty easy right? Just take all the sources of income and deduct every possible expense that may affect your property. While the math is simple, the difficulty with determining a property’s cash flow is in accounting for every possible item AND properly estimating each item.
The sources of income are pretty straightforward. Generally speaking, if your rental is a single family home, the income is just the monthly rent that you’re charging your tenant. For a multifamily property like a triplex, the income would be the sum of the rents for each of the 3 units. If you have a laundry service at your property, this extra income would also contribute to your total income.
While other items such as security deposits, pet deposits, or late fees may be collected from time to time, I do not include these items when analyzing a property’s cash flow. I don’t consider such deposits as income because they are specifically reserved to offset turnover costs (i.e. cleaning and/or repairs) when my tenant moves out. For the properties I own, however, I do include all of these items in my P&L (Profit and Loss) statements for accounting purposes.
Watch Out For Overestimated Rents
Where you can get into trouble is in overestimating the monthly rent. This can happen in more ways than you think. Whether you’re using a rent estimate that an online source (i.e. rentometer or Zillow), a real estate agent, or a property manager came up with, it’s important to know how that number was derived.
The rent estimate should be based on current rents of comparable properties of the same size, location, and condition.
This is essential. If you’re about to buy a turnkey rental property and on the same block there’s an identical house that just got rented for $1200, then what rental income should you run your cash flow analysis on? That’s right. $1200 max. What should you rent it out for? Well, that depends. If you can get more, than that’s even better. Just don’t base your buying decision off of an overoptimistic rent.
This may surprise some folks who live in moderate climates that don’t have changing seasons (like sunny CA), but the rent rate will actually fluctuate with the season in many places. That rental getting $1000 a month during peak moving season in early summer will likely not get filled for the same rent during a chilly winter of January.
Keep this in mind if you have an offer accepted at the end of summer. Consider that a property being financed will usually need at least 30 days to close and add to that an extra month if you’re rehabbing. Now you’re in November with the holiday season quickly approaching. Filling a vacancy during this time will be challenging, especially if you’re marketing at a rental rate based off of the summer!
Always run your cash flow analysis assuming a rent estimate that reflects when you’re property will become available for rent.
Here’s where we want to make sure we account for everything that can erode away our rental income. We mentioned PITI earlier, but here’s a list of expenses that you may encounter.
- Mortgage Payment (Principal & Interest)
- Insurance (hazard and liability)
- Property Management (PM) fees
- Leasing Fees
- Routine Maintenance
- Capital Expenditures (e.g. roof)
- Legal fees
- Trash removal
This isn’t an exhaustive list, yet you may not have every expense either. For instance, you won’t have a mortgage to pay if you bought the property with all cash or a PM fee if you’re self-managing the property. Though I’d recommend you still add in the PM fee, because you may want someone else to manage it in the future.
Estimating Vacancy and Maintenance
To be honest, several expenses can be difficult to estimate at a straight dollar amount. Unlike taxes and insurance payments, expenses such as maintenance, repairs, and a vacancy doesn’t happen each month. Which is why many investors use a percent of the rent to help budget for them.
For instance, I like to budget for 1 month of lost rent due to vacancy by taking 8% (about 1 month divided by 12) of the annual gross rents towards a vacancy reserve. You may not have 1 month of vacancy every year, but over the long run, this is a conservative estimate.
Similarly, many investors anticipate about 10% of gross rents will be spent on routine maintenance and minor repairs. Though do take caution applying percents. 10% of a $1000/month rental will estimate $1200 annually for maintenance and repairs. However, if you’ve got a cheaper rental at $500/month, then you’re only allocating $600 for the entire year, which may not cover the actual costs. Likewise, budgeting 10% to maintenance for a high end class A luxury rental that commands $3000 in monthly rent is over doing it.
The 50% Rule
A common rule of thumb for estimating all of your expenses is the 50% rule.
The 50% rules states that a rental property’s expenses (excluding the mortgage payment) will on average add up to about 50% of its total income.
The expenses included in the 50% rule are taxes, insurance, maintenance, PM fees, vacancy, and basically everything on the previous list above except for the mortgage payment.
So if your property rents for $1800/month, then over time your expenses will be about $900 a month. If you had no mortgage then $900 would also be your cash flow ($1800 income – $900 expenses = $900 cash flow). Let’s say you had a mortgage payment (P & I) of $600/month. Then your cash flow according to the 50% rule would be about $300/month ($1800 income – $900 expenses – $600 mortgage = $300 cash flow).
Watch Out For Underestimated Expenses
Here’s where a lot of investors (myself included) may begin to play some games. Say we set a $200/month positive cash flow criteria for any property that we buy, but the current prospect is falling short of our goal.
So what do we do?
We start to trim down our estimated expenses.
We may say to ourselves, “1 month of vacancy is too long for this particular neighborhood. My other property was rented out within 2 weeks so I’ll cut my vacancy expense in half.”
Or we may say, “the condition of this property isn’t too bad, so I don’t need to budget 10% of my rents towards maintenance. I’ll cut that in half too.”
Do not fall into this trap. Even if you are certain that you can lower your expense estimates, you should still stay conservative.
Look at it this way. Once you have your property rented out, is there any additional income that will magically appear to improve your cash flow? Nope. It’s set for the entire lease period.
Your expenses on the other hand? There’s no limit. Your property taxes can rise based on a higher assessed value or an increase in tax rates. Insurance premiums may go up. You may have unexpected repairs or damage caused by a careless tenant. Or your tenant may stop paying rent, which is lost income.
If your maximum income is set, but your expenses have the potential to increase, then that means the only direction your cash flow can potentially go is lower. If you run your cash flow estimates using the most optimistic scenario imaginable, then it’s highly likely your actual cash flow numbers will be much less than your optimistic estimates.
So do the safe thing and stay conservative with your estimates. If you’re applying the 50% Rule, remember that it’s just a general rule of thumb and should not take the place of using actual, property-specific estimates.
Meet Investor Joe – An Example on Cash Flow
Joe works in San Francisco full-time and he’s looking to purchase a single family home out in the mid-west to generate a minimum of $100 of monthly cash flow. Joe plans on using bank financing for a 30 year fixed loan at 5% interest, where he’d only have to put down 20%.
His agent finds a potential property listed at $90,000 and with the help of his property manager (PM), determines that it will rent for $1100 a month. The property was built in the late 70s, but has been recently renovated with a new HVAC and water heater. No other major upgrades are needed at this time, however, the roof will likely need to be replaced in about 5 years. With some research, Joe determines that a new roof will cost about $5000. So a monthly CapEx reserve of $83 ($5000 / 5 years / 12 months) should be withheld.
Public records show that this property has an annual tax bill of $1400. Joe calls a few insurance agents and gets an estimated quote for hazard insurance of $600 a year. Given that Joe is an out of state investor, he found a property manager that charges 9% of the gross rent for every month the tenant is paying. The PM also charges a flat $700 leasing fee that covers marketing the property, screening tenants, and ultimately filling the vacancy.
Joe assumes that a new tenant may move in every 2 years, so he needs to budget for the leasing fee over 2 years, about $29/month ($700/24 months). Joe also conservatively sets aside an average of 1 month of lost rent due to vacancy and assumes 10% of the rent will be used to cover small repairs and maintenance. Finally, as a single family rental, all utilities, lawn care, and snow removal will be covered by the tenant.
To summarize, Joe’s cash flow analysis looks like the following:
|Cash Flow (Income - Expenses)||134||1,604|
|Property Management (9% of collected rents)||-99||-1188|
|Lease Fee (assume new tenant in 2 years)||-29||-350|
|CapEx Reserve (new roof in 5 years)||-83||-1000|
|Vacancy (1 month)||-92||-1100|
In doing a bottoms-up estimate of all the expenses that pertain to this property, Joe calculates that his monthly cash flow on average would be about $134 a month. This property meets his monthly $100 criteria.
As a point of comparison, Joe uses the 50% rule to estimate expenses as shown in the table below. Applying this rule of thumb, Joe would also meet his monthly cash flow goal and would generate about $163 a month.
|50% Rule Analysis||Monthly||Annual|
|Income - Rent||1,100||13,200|
|Expenses (50% Rule)||-550||-6600|
|Mortgage Payment (P&I)||-387||-4638|
So there you have it. Cash flow is the total income minus all expenses. Some simple arithmetic, but the challenge as stated earlier is in estimating many of these numbers.
You can use the 50% rule as an initial cut, but be sure to also run a bottoms-up cash flow analysis that’s specific to your property. Compare the cash flow of your bottoms-up analysis to your 50% rule to gain further insight. Do they agree or are they drastically different? If they’re extremely different, try to figure out why.
If you’re uncertain of your numbers, at the very least, run them conservatively so that you give yourself plenty of contingency to account for unknowns. Ideally, your actual cash flows will come out much higher and you’ll be one happy landlord.