Many rental property investors get hooked on the simple arithmetic of the investment, such as rent collected, less mortgage payments and other costs to create a cash flow. However, there are hidden costs that can quietly wipe out that profit, some of them before you’ve even bought the property.
The Rent-Minus-Mortgage Mistake
Calculating the cash flow for a rental property as the rent collected minus the mortgage payments is a simple math problem. In reality, however, a host of costs that are not included in the simple calculation are incurred by the landlord. When you fill out the IRS’ Schedule E, for example, you see all of the many expense categories that generate deductions from the rental income. This easily-overlooked expense is the source of profits’ loss.
True cash flow analysis for rental income requires all dollars going out to be accounted for in order to gain an accurate understanding of how much real cash flow is generated from a rental property in any given time frame.
Vacancy and Tenant Turnover
Vacancy costs are often left out of a property’s budget as they can be seen as unlikely to occur in a strong rental market. According to the U.S. Census Bureau the rental vacancy rate can vary from year to year depending on the market, the type of property and even the economy as a whole. Therefore a smart landlord will leave at least a month’s worth of vacancy costs in their annual budget for their property. In addition to the cost of having a property vacant there are also the costs of turnover in a rented property.
On average each year a property rented out will have around 1-2 tenant moves each year. Each of these moves will result in some form of work being required to get the property back to rented standard. This can include, repainting, redecorating, new flooring, any repairs to damage caused by previous tenants, cleaning and more. All of these costs can be expensive and can quickly add up, especially for higher quality rental properties.
Between cleaning, painting, minor repairs to bring a unit back to rent-ready condition, and the time it takes to market and show it, a single tenant turnover can cost a landlord/investor several hundred dollars to several thousand dollars, depending on the real estate investment in question.
Repairs and Ongoing Maintenance
Fixed costs for maintenance: don’t think they will disappear! Cleaning, painting, repairs to the plumbing, to the air-conditioning, to the appliances, to the garden, pest control, wear and tear on all parts of the property, all these costs are recurring, but if you have not budgeted for them they will show up when you least expect them.
A 1% rule of thumb for annual property maintenance is widely accepted: for a $300,000 property, you would budget $3,000 per year for property maintenance. Which translates to $250 per month of money that you will spend and never see. Old properties with lots of detailing, or in very harsh weather conditions, can increase the property maintenance greatly.
Capital Expenditures
Large infrequent expenses for major repairs and replacements are capital expenditures. Examples of capital expenditures are: replacing a roof, HVAC, water heater, flooring, windows, and major appliances.
Capital expenditures deserve their own budget category, separate from routine maintenance. Estimate the useful life of each major system in the property, then set aside a monthly reserve for its eventual repair or replacement. A single $8,000 roof repair can wipe out the cash flow of an $80,000/year cash flow property.
Property Management Fees
Most investors assume that they will have time to run their property and to manage any vacancies. In reality, however, property management is a full time job and can be very time consuming. For this reason, many investors pay a property management company to look after their investment on their behalf. The cost of a property management company varies depending on the location of the property and the level of service provided but typical costs would be in the region of 8% to 12% of the monthly gross rent, plus additional fees for items such as leasing, lease renewals, and maintenance.
Many property investors forget to include the costs of property management within their overall property investment returns and cash flow figures. This holds true even if you’re currently managing the property yourself, since those costs would still be incurred if you ever needed a property management company to take over.
There are a lot of costs that property management firms can anticipate for a landlord and help manage around to ensure that the cash flow is what the landlord was expecting when they purchased the property. For example, one firm, J R Grace Realty, handles this through a full-service approach that manages properties to ensure that the owner receives the maximum cash flow possible by anticipating maintenance needs, managing vacancies, and keeping the owner fully informed of all activity regarding the property.
Insurance Costs
The typical homeowner’s policy does not cover the rental of property. Instead, most rental properties are covered with a landlord insurance policy, often referred to as a dwelling fire policy. This type of policy has different coverage features than a typical homeowner’s policy, and generally costs more to insure.
Some markets require landlord insurance that also covers floods. Some require an umbrella policy to cover for situations in which a tenant is injured while on the premises. In all markets, costs of insurance that are paid on a monthly basis should be included when determining cash flow.
Property Taxes and Reassessment Risk
Property taxes, like other fixed costs, aren’t normally expected to vary with the day-to-day operation of a property. However, unlike other costs which remain fixed for a period of time, property taxes can be subject to change as a result of a number of factors, including capital improvements to a property, the overall increase in value of a property and increases in local and regional government budgets.
The risk that a property’s taxes may increase is often greater than is realized by many potential property investors. In some jurisdictions a property’s taxes can increase by amounts in excess of the rate of return on a property’s investment, potentially resulting in the reduction of a property’s cash flow. Because of this risk it is generally a good idea to keep track of a property’s assessment and to increase the value of a property’s projected fixed costs by the amount of any expected tax increase.
The Lincoln Institute of Land Policy publishes detailed property tax trend data across U.S. markets, which is worth checking when stress-testing your projections.
Leasing and Advertising Costs
If a landlord uses a property management company to lease their property, it typically costs them 1 month’s rent in leasing fees for a lease of 1 year or more. If not using a property management company, they typically spend between $200 and $500 for online listings (e.g. Craigslist) for each month of vacancy for a rental property that does not have an ongoing leasing contract with a property management company. On average, this cost is spread out over the terms of a lease agreement and as such averages to about 1/12th of the monthly rent for each month of a typical 12 month lease term.
Emergency Reserves
Every landlord should keep a cash reserve of funds set aside for unexpected occurrences which could jeopardize a landlord’s cash flow. These events could include a tenant leaving in the middle of a rental term, a sudden requirement for a repair or improvement to the rental premises to comply with a building code requirement, or even damage to a rental unit not covered by the landlord’s insurance. Typically, a landlord aims to hold between three and six months of gross rent in such a reserve for each property in his or her portfolio.
No reserve fund means you will have to use your own money or take out a loan in case of financial problems with your rental properties.
What Accurate Cash Flow Analysis Actually Looks Like
Add up all of these “hidden costs,” and the true operating cost of a rental property typically comes out to 35% to 50% of gross rent, before the mortgage is even paid.
Cash flow modeling, when done correctly, is the foundation for any good rental property investor whether they manage one rental property or 20. They help to make the best decisions in terms of properties to purchase and they help to keep a real and sustainable portfolio of rental properties. Working with professionals who offer Accounting, HR and Tax Services for Small to Medium-Sized Businesses can help rental property investors build accurate financial models and stay on top of tax obligations across their entire portfolio.