Running the Numbers on RE Deals Should be Easy

For beginners, running the numbers on a potential real estate deal can seem complicated.

It doesn’t have to be.

If you’ve been practicing good budgeting habits with your personal finances, this part should actually be easy.

The key is simple: more needs to come in than goes out.

When you have more coming in than going out, that means you have positive cash flow.

Today, we’ll discuss what information you need to forecast positive cash flow. My goal is to make this part of the process as simple as possible.

I’ve read full books dedicated to evaluating the numbers on real estate deals. If you want to take a deep dive, I recommend Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis by J. Scott and Dave Meyer.

But, the truth is that most of us lawyers and professionals targeting rental properties as a supplemental income stream don’t need that kind of depth.

Sure, if you’re targeting large multifamily properties or hoping to make rental property investing a full-time pursuit, you’ll absolutely want to pick up a book like Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis.

For the rest of us acquiring rental properties to accelerate our journeys to financial freedom, we don’t need to overcomplicate things.

What we need to know is whether a property is going to put more money in our pockets than it takes out.

In other words, we want to buy assets, not liabilities. When we’re tracking our net worth each month, we want to see that a rental property is helping.

So, the question is: how do I know if I’m buying an asset and not a liability?

Let’s take a look.

There are fixed costs and speculative costs involved in evaluating a rental property.

Whenever you evaluate a rental property, there are some fixed costs and some speculative costs involved. This holds true whether you are a beginner or an experienced investor.

Fixed costs generally include reoccurring monthly bills that are relatively constant.

Speculative costs include those unpredictable, irregular costs that do not occur every month and maybe not even occur every year.

It’s helpful to differentiate between the fixed costs and the speculative costs. In a lot of ways, we can control the fixed costs, but we cannot control the speculative costs.

Regardless, we need to account for both in our deal analysis.

Here are examples of fixed costs when evaluating a rental property.

The clearest example of a fixed cost is your mortgage payment. If you take out a 30-year fixed-rate loan, you’ll know exactly what your monthly mortgage payment will be for the next 360 months.

You’re required to pay that amount each month, that’s why it’s a fixed cost. Easy enough.

I also include insurance costs and property taxes in my fixed costs. These are fixed costs, at least for 12 months at a time, that you are required to pay each month.

You’ll oftentimes see the acronym PITI to reflect the above basic elements of a mortgage payment:

• Principal
• Interest
• Taxes
• Insurance

It’s safe to also include utility bills, like water, trash, and common electricity, in your fixed costs since there shouldn’t be much variation month-to-month in these expenses.

The same goes for landscaping, snow removal, and pest control. I refer to these fixed costs as property upkeep.

The final category of fixed costs includes preventative maintenance, like regular HVAC tune-ups.

Yes, it’s true that the cost of insurance, taxes, utilities and other bills will go up over time. But, you usually don’t see dramatic increases in these fixed costs year over year. At least, in ordinary times. Plus, rents also go up, which offset the higher costs.

To recap, the fixed costs you’ll want to know when evaluating a rental property include:

• Mortgage payment (Principal and Interest)
• Taxes
• Insurance
• Utility Bills
• Property upkeep
• Preventive maintenance

If your goal is monthly cash flow, there’s no excuse for ignoring any of these fixed costs when evaluating a rental property.

Here are examples of speculative costs when evaluating a rental property.

Speculative costs are, by definition, harder to forecast. Even for experienced investors, the best we can do is guess at what these costs will be.

I separate the speculative costs into three main categories:

• Vacancy Rate
• Unexpected Repairs
• Property Improvements

What is vacancy rate?

Vacancy rate refers to the percentage of available units that are unoccupied at a particular time. Obviously, vacancy is bad for rental property investors because we are not collecting rent from the unoccupied units.

To calculate your vacancy rate, simply divide the amount of weeks (or days or months, if you prefer) in a year by the amount of weeks (or days or months) your rental unit was unoccupied.

Then, multiply that number by 100 to see your vacancy rate as a percentage.

If you have multiple rental units, add your units together to get your total vacancy rate, like I show you below.

Vacancy Rate = (Weeks Unoccupied / Total Weeks) x 100

For example, I have 10 rental units in Chicago. This past spring, we had eight lease renewals and two leases end.

We filled one of the two units without a single day of vacancy. The other unit resulted in six weeks of vacancy so we could tackle some needed repairs. More on that below.

This means that I had 6 weeks of vacancy spread over 10 rental units. To calculate my vacancy rate, I can take 520 (10 rental units x 52 weeks in a year) and divide that by 6 weeks:

(6 weeks of vacancy / 520 weeks) x 100 =1.154%

Now, what do we do with this information?

This is where the guesswork comes in. That’s because there’s no guarantee that next year I will have a vacancy rate of only 1.2%. In some years, we have 5 or 6 units to turnover. We may have 24 weeks of total vacancy instead of 6 weeks.

The best I can do is speculate what my vacancy rate will be moving forward.

I wish I could tell you that a 1.2% vacancy rate is a good forecast. In reality, predicting 5% vacancy is a better idea. That allows for about 3 weeks to turnover a vacant unit, reasonable estimates in decent markets.

So, when running the numbers on a prospective rental property, be sure to add in the cost of 5% vacancy.

As an example, if a potential property brings in $6,000/mo in rent, subtract $300/mo to account for 5% vacancy.

What are unexpected repairs?

Remember the leaky toilet?

When you own rental properties, things are going to break and require money to fix.

Predicting how much money you’ll need for these unexpected repairs depends on a variety of factors.

If you are handy and don’t have to pay a plumber to fix the leaky toilet, you’ll save money on these kinds of repairs.

Likewise, if you have a new construction property instead of a 100-year-old property, you’ll likely need to do less repairs.

The bottom line is you’ll have to make educated guesses how much you’ll need to save for these kinds of repairs.

This is actually one of the main reasons I recommend beginner investors don’t quit their day jobs. It’s a powerful advantage to have income coming in from your primary job to help cover any major, unexpected expenses.

If you target properties in decent condition, I recommend saving 5% of the monthly rent for unexpected maintenance. With our prior example of $6,000/mo in rent, you should deduct another $300/mo for unexpected repairs.

You shouldn’t need to use that 5% every month, so that balance should build up until you need it.

What are property improvements?

I mentioned above that we took 6 weeks to improve one of our vacant units. The floors were in rough shape and the apartment needed a full paint job.

By the way, these are two relatively easy jobs that can add a lot of value to a property.

Since we were in great shape with our other units all being occupied, the timing was right to spend a bit of money and lose out on a bit of rent.

In the end, we spent about $5,000 and have brand new floors and a nice looking apartment. We didn’t have to spend that money, but we risk our units becoming unattractive if we don’t keep them fresh.

How should you account for this type of property upkeep?

Again, if you target decent properties to begin with, I recommend saving another 5% per month for property improvements. That’s another $300/mo subtracted in our deal analysis based on $6,000/mo in rental income.

Too many beginner real estate investors skip these speculative costs in their deal analysis.

It’s tempting to ignore these speculative costs when you otherwise like a rental property. You might see monthly rents of $6,000/mo and fixed costs of $5,000 and convince yourself that this is a great deal.

By ignoring the speculative costs, you’ve ignored the additional $900 for vacancy, unexpected repairs, and property upkeep that this property will cost you.

Those extra costs might make this property unattractive.

You can easily find most of the information you need to run the numbers online.

It has never been easier to access the key numbers you need to know when evaluating a rental property.

Sites like Redfin and Zillow typically have all the information you’ll need for your initial evaluation.

One of the most useful features of these sites is the mortgage payment estimator. You can quickly see whether the PITI payment is going to exceed the amount of rent you can reasonably expect.

Because of high interest rates and high property costs, most deal analysis I’m doing today ends right there.

Of course, if the PITI payment is too high, you can play around with the asking price to see at what cost the property might be worth pursuing. Just don’t forget to take into account the other costs discussed above.

Note: above, I specifically wrote “initial evaluation.”

Before closing on a property, you’ll want to confirm the numbers in the property listing are accurate and not being exaggerated.

For example, you’ll want to get verification from the seller on the actual monthly rent. As part of the due diligence process, sellers are required to turn over the current leases.

Sometimes you’ll see listings where the rent is listed as “maximum monthly rent” or “potential rent.” That means the seller is suggesting the apartment could rent for that much, but there is no lease in place for that amount.

I’m always skeptical of listings like this. If it was so easy to obtain the maximum monthly rent, why didn’t the seller get leases for that amount? If they did, they could surely expect a higher sales price.

Always confer with your real estate broker on what the rents are in your market. And don’t forget, a five-star real estate broker should be able and willing to teach you how to run these numbers.

Likewise, you’ll also want to verify with your mortgage broker exactly what your monthly payment will be based on current rates and your qualifications. The same goes for verifying what your actual insurance costs will be.

Did you notice that I did not include a cost for property management in the above?

If you are pursuing your first rental property or have a small portfolio, I recommend you self-manage.

Most importantly, you need to learn how to be a landlord.

There’s no better training than first-hand experience. If you do end up hiring a property manager someday, you need to know how to “manage the property manager.”

There’s another good reason why beginner investors should self-manage.

Unfortunately, it’s hard to find good property managers who are willing to work with small investors. It’s a near certainty that your property manager will not care about your property as much as you do.

Plus, because of the cost involved, a property manager will likely suck up most of your monthly cash flow.

While it varies by market, in major cities you can expect a property manager to charge between 8% and 10% of the monthly rent. It’s hard to cash flow with that kind of drag on your profits.

If your portfolio grows or your circumstances change to the point where you can no longer self-manage, be sure to factor in this major cost to your deal analysis.

Buying a rental property does not require an advanced degree in math.

If you’ve been reluctant to buy your first rental property because of that math involved, hopefully you now see that it doesn’t have to be that complicated.

You need to account for certain fixed costs and predict some speculative costs.

There are countless online calculators to help with the math. You can also use a basic spreadsheet.

Plus, your real estate team can help you with running the numbers.

In an upcoming post, we’ll run through some examples of how I run the numbers on potential rental properties.

Experienced real estate investors: what did I miss?

Beginner investors: what else would you like to know about running the number?

Let us know in the comments below.