You’re getting ready to rent your home, or maybe you’re looking at other homes to invest in. Prior to doing this, it is crucial to understand the financials of your property to see if it’s the right call. Below, you will find a couple ways to analyze your property in a quick manner.
Step 1. Understand Real Estate Expenses. You need to understand what goes into analyzing your property. You need to find, or determine, the below numbers:
Monthly property taxes. Expect this number to go up year-over-year.
Monthly insurance. Expect this number to go up year-over-year.
Maintenance. This can be difficult to correctly forecast. You need to consider the age of your home and any deferred maintenance you may have. Typically, it is recommended to put aside 5-15% of your rental income to inevitable maintenance issues.
Capital Expenditures (CAPEX). These are those large, episodic expenses like replacing a roof, repainting the exterior of the home, or putting an HVAC into the home. It is recommended to put aside 5-10% of your rental income to these inevitable expenses.
Management Fees. Typically, these are on a percentage (%) of rent basis. As an example, if you rent your home for $3,000 per month, you will pay a property manager $300 (10%) per month to manage it.
Debt Service. You will most likely have a mortgage on the property.
Homeowners Association (HOA) Fees. Gotta love ‘em!
Step 2. Gather Your Data. Answer the below questions.
How much is the property worth?
How much will the mortgage be per month?
How much do you have to invest initially?
How much does the property rent for?
Do you need to replace any appliances or make significant repairs prior to renting? How much does all this cost?
Considerations for other expenses like vacancies, future repairs, damage, etc.
Step 3. Use Data For Key Metrics.
Cash Flow. Cash Flow = Income – Expenses.
Calculate what your income will be with your property manager. Your income will be how much the property rents for. For expenses, make sure you factor in the potential for maintenance, vacancies, and major repairs.
Return on Investment (ROI). ROI = Cash Flow / Initial Investment.
Your initial investment is everything that is required to get your property rent-ready. Any downpayments, remodeling costs, cleaning costs, etc.
What’s a reasonable ROI? Let’s consider that the average ROI of the S&P 500 is ~8%. Savings accounts can give you 2-5% ROI. Whatever your benchmark ROI is for investing, use that to consider if the investment is quality or not. Keep in mind, it is not recommended to add the property’s expected appreciation, as this is not guaranteed.
Capitalization Rate (Cap Rate). Cap Rate = Net Income / Property Price.
Cap Rate is a common tool used along with ROI to determine the quality of an investment. It is commonly used to assess risk as well. With a higher cap rate corresponding to higher risk in commercial real estate.
Example.
Below is a table based on Erin’s rental property, showing how she allocates her money to mitigate risk.
Monthly Rental Revenue | $1,900 |
Mortgage & Taxes | -$1,000 |
HOA Dues | -$250 |
Insurance | -$100 |
Vacancy (5%) | -$95 |
Capital Expenditures (5%) | -$95 |
Management Fee (10%) | -$190 |
Net Income | $170 |
Monthly Rental Revenue: amount the tenant pays our property management company.
Mortgage Amount: amount of monthly debt service you owe your lender.
Homeowners Association (HOA) Dues: amount you owe to your HOA board so they can fine you for inconsequential matters but then do nothing when you actually need something done. Joking….but really though.
Insurance: monthly insurance premium amount you pay for the rental property.
Vacancy: amount allocated for vacancies; you can allocate more or less than 5% based on your risk tolerance.
Capital Expenditures (CAPEX): amount for major repairs; you can allocate more or less than 5% based on your risk tolerance.
Management Fee: amount we (the property management company) take from the rental income.
Net Income: amount left over after all expenses.
Have discipline and do not be irresponsible.
In the example above, the client, Erin, would receive $1,710 in her bank account each month ($1,900 – Management Fee ($190) = $1,710). If Erin was being irresponsible, she would interpret this as a net income. Others subtract the debt service from this number ($1,710 - $1,000 = $710) and believe they have $710 of net income in their wallet at the end of each month. Both are wrong. $170 (and potentially even less, based on what you allocate) is the monthly net income that can be used at your discretion. Being disciplined in your investment and allocating money for future expenses is critical. Your risk tolerance determines how and what you allocate money to. This example is simply one way to do it.
All properties are different. You are the final decision authority.
Some homes will go years without a vacancy and others will have months on end. It all depends. In some years you may have to replace a roof or the floors, fix the dishwasher, and paint the entire home. Whereas some properties may go a decade without any of these expenses. It all depends. There is no guarantee to rental properties, and each property is different. The best things you can control are (1) having a great relationship with your property manager to get the best picture on the ground for your investment, and (2) allocating for unforeseen expenses.
