Don’t Fall For the Hype: How to REALLY Discern a Good Deal

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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

About Author

Kevin Perk

Kevin Perk is co-founder of Kevron Properties, LLC with his wife Terron and has been involved in real estate investing for 10 years. Kevin invests in and manages rental properties in Memphis, TN and is a past president and vice-president of the local REIA group, the Memphis Investors Group.

19 Comments

  1. This is a mistake many new investors make and quite frankly many sellers are good at preparing pro forma packages and marketing (i.e. selling!). When I started out, I prepared a list of 10 questions, the answers to which guided my investment. The trick is to put the right questions together

  2. Also, you need to know if you the landlord are required to pay any utilities (garbage, water, etc). And in some areas, snow removal or landscaping are a landlord responsibility. All of those can really be cash flow eaters.

    • Mike McKinzie on

      Either I missed it or it’s not there. The numbers are great on a $40,000 house but are really bad on a $200,000 house. Another thing I like to use is, “How would the return be if I paid all cash for the house?” If it is not at least 3 times the return on a 30 year TBill, it is not worth the risk. BP has always talked about the 50% guideline and it is a great rule of thumb. I also like to make sure the PI payment is LESS than 50% of the rent.

      Great blog.

    • Kevin Perk

      Sharon,

      Thanks for pointing this out.

      I was thinking of a single family rental house where utilities are paid by tenants which would otherwise be captured in the vacancy expense.

      But you are right. It might make sense to place these expenses in a another category. In fact, it does make sense if you are looking at a multi-family property such as a duplex or apartment building. With these types of properties, you will absolutely have some utility expense.

      Thanks again and thanks for reading,

      Kevin

  3. Great Article! Its always good to remember all the little things the people so often overlook when determining a property’s potential cash flow.

    in some cases, there are also HOA fees and if the owner is paying for things like water, electricity, gas; those need to be factored in too. You can find historical data on the electric/ gas/ water from the electric company and water from the city’s water department to get an average for how much those cost if you plan to cover those expenses.

    Also the example in the article actually only cash flows $50 a month according to the numbers.

    • Kevin Perk

      Alex,

      Yes, Homeowners Associations (HOA) can certainly add another line to the expense side of the equation

      But I wonder how I made it this far without being able to add. 🙂 That’s why I use a spreadsheet.

      Thanks for reading, commenting, the kind words and correcting my error. I’ll see about getting that fixed.

      Kevin

  4. Kevin,
    Great post, I wish someone would have told me all of this before I bought my first dozen rental homes! Take 30-40% of the bottom line and none of them would have shown any positive cash flow, which was actually the truth.

    • Kevin Perk

      Dick,

      Sorry I was not there to help out. 🙂

      You are not the only one though. I have seen several come through my local reia group basically asking “How do I get out of this?”

      Thanks for reading and commenting,

      Kevin

  5. I really like the way you simplified this concept. When I try to explain to agents that these “screamin’ deal” properties they present to me are much less so, I often struggle with explaining the 50% rule. This really takes it down to the easiest way to explain it.

    • Kevin Perk

      Page,

      Simple is best. I like this method because it clearly explains what I am looking for. I will even show people my numbers and then ask them again where that cash flow was. It is interesting to watch them get hit by reality. 🙂

      Thanks for reading and commenting,

      Kevin

    • Kevin Perk

      Jeff,

      It could be worth it. Everyone is different and everyone’s tastes are different.

      I was going to talk about appreciation and such, but I see Nick beat me to it with his comment.

      Thanks for reading and commenting,

      Kevin

  6. Jeff, the $50 is only the cash on cash return. To get the total return you would need to factor in the amortization, or the amount of the loan that gets payed off by the tenant. You also need to estimate appreciation. When you put 20% down and the property value goes up a modest 2% in value, your down payment just made a 10% return in that year. Not bad. All the while inflation drives rents up and the real value of your payment down. Cash flow is necessary for longevity and staying power, but not the only source of returns.

      • Anytime! I am going through this right now with my first few rental properties, they are cash flow positive but not by much. So I have been more conservative going forward. Lucky for me the properties have appreciated nicely. 🙂

        Note to anyone using a realtor… Their numbers are more than likely made up! You have to know the numbers for yourself and the only way to do that is experience and reading articles like this. I have had so many realtors and sellers tell me how great their “10 cap” property was and when I ran my own numbers they were terrible! Know your numbers!

        • Kevin Perk

          Nick,

          Thanks for sharing your experience. I have experienced the same thing. Many realtors do not know how to properly analyze a deal and thus think they have a great deal when they really do not.

          Run your own numbers and trust what they say. Remember that 2+2 is always 4. Do not try to fudge it to make 5 or you will get burned.

          Thanks again Nick,

          Kevin

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