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Wednesday, February 15, 2012

Rental Property Cash Flow Analysis

I recently saw a question on a forum that asked, "What percent of positive cash flow do you want on a rental?"

I'm not a big fan of percentages or yields when it comes to investing in single family houses. Reason being, most investors talk yield, but it is on such small amounts of money, a daily trip to Starbucks would wipe out all the profit. Therefore, I don't have a percentage for you, but in my office, we shoot for $300-$400 per door. I just can't get that excited about dealing with a tenant for $200 or less a month. The only way I would consider less money is if the financing is extremely favorable, such as zero interest. However, even on those zero interest deals that I have negotiated, I am still going to get my $300+ / month cash flow. We just put together a $60,000 seller carry back on a $70,000 house. No money down, no interest, and this little 2 bedroom house will still generate $340 a month in cash flow once it is rented.

I talk to so many investors who think they are making money because they use 30-40% for expenses (taxes, insurance, vacancy, repairs, management or overhead). Too many new investors leave that last one out. They think it is free to drive out to their properties and do inspections, lease ups, put signs up, type up and run ads. Big mistake!

40% is even too low. One large capital expenditure and all of the cash flow for 2-3 years is wiped out. I think the best number to use is 50% for expenses. I have a friend who owns over 100 houses and has managed those same houses for 20+ years. He told me his expenses run about 44% over the long term. Everything seems fine and dandy until that roof needs to be replaced, a water heater fails, tree roots destroy the sewer line, and don't forget about those lovely 'acts of god'. I just had a tree branch crash down on a roof and the HOA fixed the outside, but said the inside was my problem. That is when you discover if you have been budgeting for repairs or pocketing the money and calling it cash flow.

After you lop off 50% of your gross collected rent for your expenses, you still need to deduct out what your financing costs are from the remainder 50%. Whatever is leftover after financing is your real cash flow (which you  may still have to pay taxes on!). If you make the decision to join us lunatic landlords and hold a house instead of flipping it for a big fat check, shoot for a minimum $300-$400 per unit on your average rental property and you'll be a much happier lunatic. Otherwise, you may get one of my marketing pieces and decide to call me to get you out of the trap.

I don't like yields when investing in SFR. The numbers are just too small to waste time punching them into a calculator. If you claim you get a 20% COC (cash on cash) return, but you only have $15K into the house, you are making a whopping $3,000 a year. Trust me, $250 a month isn't worth the thrill of management and the loss of your $15,000. Especially if the underlying financing isn't 100% amortized! Too much risk for way too little cash flow. There are much easier ways to make an extra $250 a month without having to deal with a tenant and maintenance and keep your $15,000 cash in your pocket. Now, if you are consistently getting 20%+ on your $500K, you are starting to grab my attention and we should schedule a dinner, not lunch. (Your treat though since you're making all that loot!)

Not that I'm down on rental properties. A lot of my friends have become exceptionally wealthy holding houses. But in this market, it doesn't make much sense for me to do so. I wholesale almost all properties that come across my desk. I'd rather have $5,000-$25,000 in cash today than a $300 a month income and a long term liability with some short term financing. Until better financing options are available, or unless I negotiate favorable seller financing terms, that property is off to escrow and I'll be looking for my check. Next!

Just off the top of my head, I cannot think of one single family house investor billionaire. Coincidence?

3 comments:

  1. Agreed! Expenses are most of the time under accounted for. Every 5 years a $2-$5k expense seems to show up. Owning rentals with debt can be a tough business without the reward of appreciation. Appreciation is what makes the business very lucrative.

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