I recently had a friend who, because of his financial circumstances, had to move out of his home and rent it out. He had purchased the home at the height of the real estate market in 2005, and for a number of reasons, his mortgage payment had gotten the better of him. Rather than let the home go back to the bank he decided to rent the home out.
At the time, he asked me to help him get things setup, and the first thing I asked him is whether the house would cash flow. He kind of looked at me funny and said, well I’m gonna try to get $1600 per month and that should cover my mortgage payment which is $1550. You see, this is the common thought for most accidental landlords. They think that as long as they cover their principal, interest, taxes and insurance (PITI) that they will cash flow. What they fail to realize is that there are a number of other expenses that need to be accounted for.
Well, he ended up renting the property for $1550 (less than what he wanted) and he’s struggled ever since. About a month into the rental contract he had some electrical issues with the house that cost him about $300. Then a few months later his septic tank needed to be pumped to the tune of a few hundred dollars. He hadn’t accounted for these maintenance costs, and when they come up, he has to come out-of-pocket to pay for them.
Now, if you’re considering becoming a landlords don’t be like my friend. Please take the time to analyze your numbers correctly. If you think you can make it work, you’re just fooling yourself because these costs are real.
When talking about rental properties, the number you need to analyze is your monthly cash flow. Cash flow is simply the amount of money left over after you pay all of your expenses and any debt service on the property. So here’s what you need to consider…
Rental Income
The first thing you need to establish is how much income the property will generate on a monthly basis. The first place I normally start is by looking at a few online rental estimators. There are three that I know of:
Of these three I like Zilpy the best because they give you a map showing comparable properties to yours. Nevertheless, you need to take these numbers with a grain of salt because these estimates are based upon properties that are listed on classified sites like Craigslist and Kijiji.com. You cannot be sure that properties are actually being rented for these amounts because these are the list prices, but they will give you a good start on what you may be able to get…plus they’re just a mouse click away.
To get a better idea of your expected rental rate, you should speak with a realtor who can pull rental comps for you. The rental comps that a real estate agent pulls are a much better indication because these will be actual rental rates for the properties that are found. Another resource you can consult is a property manager that works in your area. They should also have a very good idea of the rental rates because they are managing properties in your area. Once you conclude this research you should have a very good estimate for what your property will rent for.
Expenses
As I talked about above, this is usually where most newbie landlords get into trouble – they simply do not account for all the expenses involved with a rental property. Here’s what you need to consider:
Vacancy – Vacancy is the expense you will incur when the property goes vacant. It is the single biggest expense you will face as a landlord. You will want to do everything in your power to minimize it, but you must account for it. With our rental properties I normally apply an 8% – 10% vacancy expense every month. This means if I’m collecting $1000 per month, I will account $80-$100 per month for vacancy in my monthly cash flow calculation.
Taxes – This one normally doesn’t get missed, but you need to account for paying your property taxes. However, if you are converting your home into a rental one thing you should consider is that your taxes might increase. In Michigan, you will be taxed at the non-homestead rate because you will no longer be living in the home. To get an idea of your tax rate in Michigan, you can visit Michigan’s Online Tax Estimator
Insurance – Again, this expense doesn’t normally get missed, but please acocunt for it in your calculation. You’ll want to speak to an insurance agent because you should change your policy. You will want to get a landlord’s policy instead of a standard homeowner policy. This type of policy covers the building (not the contents) and it normally also provides you with liability protection.
Maintenance – Okay, this is a big one that most newbies neglect. You will have things that come up, and if you don’t account for them, you won’t have the money to pay for the repairs when they are needed. Normally I account for $50 per month on each of our properties. This is a good number if you have several properties, but if you only have one, you may want to increase your maintenance expense to $75 or even $100 per month. As you collect more properties you can reduce the expense a little because you can share the maintenance costs across all your properties.
Association Fees – If your property is a condo, or there is a homeowner association, you need to account for the monthly or annual association fee that is charged.
Property Management – Even if you plan to manage your property yourself you should include a property management fee in your cash flow calculation. Doing this will give you the option later on to hire a property manager if you choose to do so. 10% is a standard rate for property managers, so again, if you are collecting $1000 per month, the property management fee would be $100.
Utilities – Normally we like to have our tenants pay all the utilities, but there are circumstances where we don’t do this, or it is not possible. If you will be responsible for the utilities on your property, then you need to include the cost in your cash flow calculation.
Lawn Care / Snow Removal – Again, we normally have our tenants take care of these items, but if you are responsible, you need to include this in your cash flow calculation.
Legal Fees – You may incur fees for setting up an LLC, maintaining your LLC, filing your taxes, preparing lease documents, etc. All of these expenses get lumped into tax and legal fees, and you should account for them. Typically $25 per month should more than enough to cover these costs.
Other Expenses – Okay, this is a pretty exhaustive list, but if you know of any other expenses that you need to account for, you should include them in your cash flow calculation.
Mortgage Payment – We leave your mortgage payment last because we normally calculate a net income for the property before subtracting the expense for the mortgage payment. We do this because the net income shows the maximum potential for the property once your mortgage is paid off.
Putting it All Together
Okay, I know this sounds like a lot, but honestly it’s pretty easy to put all of this together into a spreadsheet and make your calculations. Below is an example showing our net income and cash flow generated for a property. You can see that we collect $1000 per month, which after expenses results in a net income of $538.75. After the mortgage is paid the property generates $329.18 in cash flow.
I know, I know that title has you scratching your head. But rest assured, if you’re a rental property owner you’re gonna love this technique.
