When something is important, I like to repeat it. So here goes, cash flow is king. And because cash flow is king, many like to hype up their properties as excellent cash flow producers to attract interest. However, as with anything else, buyers should beware of the hype.
I have seen many people here on the BP forums, at my local reia club, on the MLS, on Craigslist and anywhere else properties are advertised hype their properties as generating excellent positive cash flow. Here is an example of what might be said:
123 Main Street – Red Hot Cash Flow!
| Monthly Cash Flow | |
|---|---|
| Rental Income | $1,000 |
| Principal and Interest | $350 |
| Insurance | $50 |
| Taxes | $150 |
| Total Cash Flow | $450 per Month |
At first glance, this appears to be an awesome property. $450 positive cash flow per month! Who can pass on that? But those of us with more experience know there are a few pieces of this puzzle that are missing. Here is what those pieces are.
Vacancy Factor
The property is not going to stay rented 100% of the time. There will be some periods of time where you are in between tenants and there will be some costs associated with moving tenants in and out. You should budget for at least 10% of your gross rents going towards a vacancy factor. Thus, in the above example, if rental income is $1,000 per month, add another $100 to the expense side of the equation.
Repair Expenses
Things break. You as the landlord are going to have to fix it. You can expect to pay about 10% of your gross rents in repair expenses. So again, like in the example above, add another $100 to the expense side of the equation. Do you actually spend $100 every month? No. But over the course of a year or two, it is amazing how repairs end up totaling about 10% of gross rents.
Capital Reserves
Roofs do not last forever, nor do air conditioners or hot water heaters. When these things break down, you are going to have to come up with the funds to replace them. These items are not cheap. They can run several thousands of dollars. So again you should be putting aside about 10% of gross rents for future reserves. Add another $100 to the expense side of the equation.
Property Management
Are you going to manage the property yourself? Will you be screening the tenants, doing the showings fielding the complaints? If not, you are likely going to hire a management company or buy a property from one of those turnkey operations. They are also going to take a cut. On average this cut is about 10% of gross rents, so add another $100 to the expense side of the equation.
Now, let’s look at that cash flow for our example at 123 Main Street again.
123 Main Street
| Monthly Cash Flow | |
|---|---|
| Rental Income | $1,000 |
| Principal and Interest | $350 |
| Insurance | $50 |
| Taxes | $150 |
| Vacancy Factor | $100 |
| Repair Expense | $100 |
| Capital Reserves | $100 |
| Property Management | $100 |
| Total Cash Flow | $50 per Month |
Quite a difference when you plug in all of the expected expenses. Still, $100 per month is not bad and could make this property a potential good deal. Is it “Red Hot” though, perhaps not.
One last thing. Be sure you verify your principal and interest payments as well as the insurance amounts quoted in the ad. How were the principal and interest payments calculated? Can you get the same terms? Is insurance really that cheap? Would you want and can you get such a cheap policy?
Remember sellers are going to hype up their properties the best they can. It is up to us buyers to know and understand what we are doing and how to calculate actual cash flows and returns based on all probable expenses. As with anything else in life, educate yourself before you buy, get trusted advice and most of all, don’t fall for the hype.
Photo Credit: Lorenia
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
