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: