The big question when (especially now due to the pandemic) is how much should you be putting aside per rental unit for CAPEX, repairs, and vacancy? $100 a month? Maybe $200? 4 months' worth of vacancy? Maybe 6 months? I bet after a year of COVID and these constant rent moratoriums, you wished a year, huh? You may never know when a recession, pandemic, vacancy, or major repair may come about. Still, you can always prepare to not find yourself or your business in significant financial trouble within months. The key objective is to insulate your properties from the unexpected. Unfortunately, many landlords/homeowners due to the pandemic found themselves in pre-foreclosure or foreclosure. In my article Government Funded Programs That Help Your Tenants Pay Rent, I discuss how else you can insulate your real estate business. I recommend at a minimum, you save $100 a month towards Vacancy, Repairs, and Capex per unit. This will protect you and your business from failure. This goal in mind forces you to ensure you find an excellent real estate deal.
Do Not Lie To Yourself
Often, when we run our numbers on the needed expenses of our property, we lie to ourselves so that our cash flow can look prettier. This will be your downfall. Take your time when selecting a property to ensure you do not have negative cash flow monthly. Doing this will give you the breathing room to save for repairs, vacancy, and CAPEX.
Below are expenses to take into consideration when calculating a real estate deal:
Repairs and Capex
Repairs and Capex more than likely will not come at you every month as your mortgage will, but when they hit, they can sometimes hit hard. I mentioned earlier that you want to at least put $100 aside per month for repairs and capex but for those of you that have units that are higher end, I recommend you set aside 10-15% of your rental income. For example, if your rental income for a 3 bedroom is $2000 a month, then 10% of that would be $200 a month you put aside for Repairs and Capex. I utilize section 8 and other rental assistance programs extensively in my units, and the standards in order to participate in these programs needed repairs cannot be overlooked.
The higher the turnover rate in your market is, the more your repairs will cost. Take this into consideration when purchasing your next deal. The vacancy rate also plays a part in this equation. When you are completing your turnover, you will more than likely have to repaint, clean the carpet, retile, and redo the flooring. On top of that, there's still a mortgage to pay which is where the Vacancy rate comes into play.
Do not be that rookie (or even experience) real estate investor who ignores the vacancy rate. Just because it is not a monthly bill that comes out of your pocket does not mean it cannot hurt you in the future. Doing more research on the vacancy rate in your market when you are frustrated that after 90 days, you haven't been able to get a new tenant is incorrect. Your best chance in helping yourself get a tenant in sooner is by providing some kind of move-in incentive, which I have explained in 8 Landlord Lessons Learned (Year 1).
You can ask real estate investors and property managers in the market you are currently in or one you are interested in to get an idea of the vacancy rate. To get more specific percentages, I use rent.com to identify rental vacancies. The current market I invest in has a 1.9% rental vacancy rate. The average vacancy rate of the state I invest in is 6.5%. Shoot for a vacancy rate at or below the average in your real estate market's state. You can use the U.S. Census website to identify the vacancy rate of your state or area.
Unless you plan to pay for your rental property fully in cash, you will be paying a mortgage. This is more than likely the biggest expense you will have when calculating your cash flow for a rental property. A good rule of thumb is to go by the 1% rule when investing. For example, if the property you purchased costs $100,000, you will want a total rental income of $1000. Now, this is simply a rule of thumb and not a concrete law. This rule of thumb just allows you to vet through properties for sale faster. You still need to do your due diligence and comb through the rest of the expenses. A terrific deal is having a property that has the 2% rule going for it. This would be a $100,000 property that brings in $2000 of rental income a month. These are hard to come by, but they exist. To know more about mortgages, we have an article called Mortgage Breakdown Explained that provides more in-depth information.
Property insurance provides protection coverage over your property. You will be financially reimbursed with property insurance for any damage/theft to the structure or contents within the property you have covered. There are several kinds of insurance: homeowners, renters, flood, and earthquake insurance. According to Policygenius, the average annual homeowner's insurance is $1200 a year. That's $100 a month at least to account for when doing expenses.
Property tax is a tax paid by you or a legal entity you may own, such as a corporation. The property's calculated tax is based on the value of the property and the land. Assessors calculate property value using the mill levy or also know as a millage tax. The mill levy is the tax rate levied on the property value. Using this method, one mill represents one-tenth of one cent. For example, for $1000 of assessed property value, one mill would equal $1. I have my property taxes paid for through my loan provider. The money is taken out of the escrow that I build up throughout the year when I pay my mortgage. If you own a rental property fully then, you will have to pay out of pocket.
Personally, I do not like Condo Owner Association and Home Owner Association fees because I do not appreciate how much they eat into my cash flow. If you find yourself finding such a great deal that COA/HOA fees do not matter, then consider this into your equation as well when calculating cash flow. HOA/COA fees, on average, are $200 a month but can range from $100 to 700. These fees go towards maintaining the properties and the community you are in.
Property Management Fee
Property management companies help a landlord manage their rental properties at a price. Usually, that price can range from 8-10% of the monthly rental income. Which is not a bad price considering how valuable a great property manager can be. For simple math, if your total monthly rental income is $1000, then your property manager receives $100 a month. If you plan to use a property manager, then consider this expense in your equation. Shop around in your local area for what property managers charge and provide. If you plan to manage your property on your own, please read our article, 6 Lessons Learned When Managing My Own Rental Properties.
Keep in mind that if you have already purchased your property and you are either having negative cashflow months or not the cash flow you desire, you can incorporate new methods to make your situation better, i.e., increase the rent when the tenant's lease is up. You can provide your tenant a 60-day notice before their lease is up that their rent is going up to $50. If you have four tenants coming up on lease renewals, that is a $200 monthly increase in income and $2400 annually.
Do your due diligence on a property before buying it. There is no incentive known to man that could make me rush into a bad deal just to say I have more units underneath my belt. Do yourself that favor and ensure you have enough cash flow after your expenses to not be in the negative. You will be patting yourself on the back years down the road, and glad you listened to this article.
Recommended books to further educate you more on your due diligence: