How to Accurately Estimate Expenses on a Rental Property in 3 Easy Steps
I have a proposition for you…
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You give me $20,000 and I’ll give you… nothing. In fact, you’ll give me another $50-$200 per month until you go crazy or broke.
Sound like a good trade?
Then why are so many landlords making this trade with every investment property purchase?
Yes, I’m talking about negative cash flow. I’m talking about losing money on a rental property. It happens all the time, and it leads to financial ruin. I should know — 90% of the deals I have purchased have been from “failed landlords.” So why do so many landlords fail?
Simple. As I talked about in my recent article, “Why Are So Many Landlords Going Bankrupt?,” landlords simply don’t know how to do the math correctly. They buy properties based on emotion, gut, or bad math and then wonder why they keep losing money.
And where are they losing the most money?
The fact is: most landlords severely underestimate the costs it takes to own rental properties.
This post is designed to help you make smarter decisions by enabling you to accurately estimate expenses on your next investment property purchase. Let’s get started.
How to Accurately Estimate Expenses on a Rental Property
Sure, if you already own a property in the area, it’s simple to find out what costs are: just look at your other properties.
However, most of the time, you’ll have no idea because you don’t own a property in the area. Instead, here are a few simple tips for uncovering the future potential expense on your rental property:
- Ask local property managers: Most property managers would gladly give you this kind of information, knowing that the more helpful they are, the greater chance you may use them as a management company someday. Simply call them up and say, “Hi, I’m looking to buy a rental property in the ____ area and am just beginning my research. Do you mind if I ask you a couple quick questions about expenses?”
- Make some phone calls: Secondly, feel free to simply call the company who issues the expense and ask them! For example, not sure what water will cost on your next rental house? Call the company or government institution in charge of the water billing and ask them! Most of the time, they will give you an average on the property for the previous few months or at least give you a good ballpark.
- Ask other investors: Finally, ask others who own rental properties in the area. You can find them through local real estate clubs, by looking up public records, by asking your real estate agent for referrals, or by simply connecting with them on BiggerPockets. If you are a BiggerPockets Pro member, you can use “BiggerPockets.com/meet” to find investors in any zip code in America. Simply reach out to them and ask for help!
Now that you know how to find out about the expenses, let’s talk about what expenses you need to account for.
Step One: Identify Fixed Expenses
The first thing we want to look at are the fixed expenses. Fixed expenses can be a little confusing because they are not always “fixed” per se, but they are regular in running your rental business in that they occur often and with repetition.
Below is an example of the most common fixed expenses you are likely to experience with your rental property. Not every one will apply to your property, but this should give you a pretty good idea.
Water/Sewer: Oftentimes connected on one single bill, this is the charge you’ll pay each month for the use of city water and sewer. On homes, this is often paid by the tenant rather than the landlord, but this is not true in all cases, so be sure to check with the competition in your area and find out if you can get away with offsetting this charge to the tenant.
Property Taxes: As they say, the only things sure in life are death and taxes, so of course you’ll need to account for this expense. Property taxes are sometimes included with the mortgage (along with insurance), but not always, so be sure to check on your property. Taxes are typically in America paid in two halves, usually in the spring and again in the autumn. When estimating your property taxes, be sure to always look at next year’s property tax bill — not last year’s. Taxes almost always go up each year!
Electricity: Although usually paid by the tenant, many multifamily properties still pay the electricity for the property or part of the property (such as parking lot lights or storage areas).
Garbage: Garbage can also be paid by either the tenant or the landlord, depending on the arrangement.
Natural Gas/Wood/Other Heat: Another expense that is often paid by the tenant, but be sure to investigate.
Insurance: Insurance (along with property taxes) is often included with the mortgage payment, but if not, be sure to set aside money for insurance expenses each month. Insurance is typically paid in one lump sum once a year, but many insurance companies do allow monthly payments, oftentimes for an additional fee.
Homeowners Association Fees: If your rental property is located within a Homeowners Association (which is a collection of neighbors who are legally bound to uphold certain rules to live within the area), you will have to pay a “Homeowners Association Fee.” This is most common with condos or upscale neighborhoods.
Special Assessments: Many times, a homeowner’s association or local government municipality will enact special assessments that will cost you each month. There is no great way to predict future special assessments, but talk with the neighbors to see if there are any current assessments in the neighborhood.
Other: Besides those fixed expenses listed above, there may be other expenses that are unique to your area. Again, talk with local landlords, property managers, and others in your local real estate market to find out, and be sure to include those.
Property Management Fees: Property management is, of course, when you hire someone else to manage your property for you. However, it goes deeper than that. If you decide to manage yourself, understand that this is the “business” side of your investment and, as such, there will be costs associated with it (paper, gas, your time, etc.). I suggest including an expense for “Property Management” whether or not you plan to hire someone else — because it’s still an expense. Besides, someday you will be successful and have numerous properties… and will be unable to manage them all yourself. You might as well start budgeting for that day now! To determine how much to allocate for property management, simply call up your local management companies and find out what they cost.
Keep in mind: most management companies include both a monthly percentage AND a fixed-fee every time they rent out a unit. So a property manager who rents your property for 10% of the rent and has to fill your unit once every year will cost you more than 10% because of the extra fee. The most common fee I see is equal to 1/2 of the first month’s rent, though some management companies may charge more — up to a full month’s rent. To be safe, I typically add 1-2% to whatever the monthly rate is. In other words, if a manager charges 8% of the rent collected each month, I will budget 9-10% just to be safe.
Step Two: Identify Variable Expenses
I like to break down these expenses differently than those above because these are generally “percentage-based expenses” instead of single cost expenses, as above. In other words, these expenses are calculated by using a percentage of the rent that comes in.
Vacancy: Your property is not going to be occupied 100% of the time. Sorry. Rather than complain about it, budget for it! This is why the “vacancy” factor is so important to include in your calculations. Generally, the vacancy rate is given as a percentage based on the income that comes in. Therefore, a property that is empty 1 month every year would be 1/12 = 8.3%.
Vacancy rates differ dramatically between various markets and property types, so be sure to do some research from local landlords on what you can expect. In my area, I typically plan on about a 5% vacancy rate.
Repairs: Repairs are another tricky expense to nail down because you never really know. Some months you could spend $100 on repairs, and other months you could spend $500 or $0. However, over time, on stable properties, maintenance expenses do tend to level out on an annual basis. However, when estimating expenses for a rental property, I like to average these out on a per-month basis. For example, I might spend $500 this month, $100 next, nothing for the following 10 months (which is fairly typical). This means I spent $600 for the entire year. Divide that by 12, and you get $50 per month. If the property brings in $1,000 per month, that would be a 5% repair budget (because $50/$1,000 = 5%).
CapEx: Perhaps the item that is most often ignored when doing expense calculations, the CapEx (short for Capital Expenditures, or “Capital Improvements” in IRS language) are the big-ticket expenses that occur only occasionally. These are not “repairs,” but actual improvements to the property that add significant value. This includes putting on a new roof, redoing the driveway, updating the electrical or plumbing, and more. Obviously, the amount of CapEx you will or will not have to do will greatly depend on the age and condition of the property. For example, a property just build this year will probably require far fewer major improvements than a property built in the 1920’s.
So how much should you estimate for CapEx?
While there is no rock-solid number, I tend to estimate between 5-7% of the gross rent. In other words, if I were looking at a six-unit property that rented for a total of $2400 per month, I would set aside between $120 and $168 per month for CapEx. This works out to between $240 and $336 per unit per year.
Other: Once again, in your area, there may be other miscellaneous monthly charges that are not monthly or annual. Be sure to ask local real estate investors what you might expect in this area.
Step Three: Put It All Together
Finally, it’s time to put all your numbers together and see what you get. At this point, it’s as easy as adding, subtracting, and a little multiplication.
To make things easier, I want to offer a very helpful tool:
This tool allows you to fully estimate your expected return on investment, cash flow, and more from your next property. Simply walk through the simple guided steps, and you’ll discover your total expenses in no time. The BiggerPockets Rental Property Calculator is designed to make the analysis process much easier — and give you a professional document to showcase your property to lenders, partners, and more. Check it out today at BiggerPockets.com/analysis.
If you are doing these calculations on your own, simply add up the numbers and discover how much your property will likely cost you each month. Remember, these numbers are averages, over time, but should give a fairly close guess at what the future will hold for your property.
Another Option to Analyze Rental Properties: The 50% Rule
Okay, great — now you know how to spend 20 minutes figuring out the expenses on a rental property.
But what if you just want to have a rough estimate? After all, if you are screening through dozens of properties everyday, you can’t spend all this time analyzing every single one.
Enter: the 50% Rule.
The 50% rule is a very simple rule-of-thumb calculation that allows you to quickly estimate the expenses, and therefore cash flow, of a rental property.
Very simply: the 50% rule says that half of what you make in income will leave in expenses, NOT counting the mortgage payment.
Here’s a quick video I made a while back explaining more:
So, a property that rents for $1,000 per month will likely have $500 per month in non-mortgage expenses. If the mortgage was $400 per month, you could potentially assume $100 per month in cash flow.
Now, how accurate is the 50% rule?
Well, it depends. It is JUST a rule of thumb, which means you should never make a decision based on it. Sometimes you’ll find expenses in the 40% range. Sometimes in the 60% range. It really depends on a lot of factors, which is why this is just a rule of thumb. However, I use it on a daily basis to quickly screen through properties so I can decide which ones I want to dive in deeper on.
Wrapping It Up
Look, I don’t want you to fail.
I want you to be so successful that you don’t know what to do with all your money (so you give it to some worthy charities and buy me some Starbucks!).
However, wealth creation through real estate starts with correct math.
Understanding how to calculate expenses is vital in making sure your math truly adds up. Obviously, there is no perfect way to predict the future of your investment property, but taking a simple, mathematical approach to estimating expenses will help you hedge your bets in the best way possible.
If you have any questions or just want to say hello, I’d love if you would take 30 seconds and leave me a comment below! I’m happy to chat with you more about this!